10-Q 1 form10q.htm FIRST SECURITY GROUP 10-Q 9-30-2009 form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549
 

FORM 10-Q
(Mark One)

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the transition period from ____________________ to _____________________.

COMMISSION FILE NO. 000-49747

FIRST SECURITY GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)

Tennessee
58-2461486
(State of Incorporation)
(I.R.S. Employer Identification No.)

531 Broad Street, Chattanooga, TN
37402
(Address of principal executive offices)
(Zip Code)

(423) 266-2000
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address, and former fiscal year,
if changed since last report)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes       x       No       o

Indicate by check mark whether the Registrant has submitted electronically and posted on its Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).
Yes       o       No       o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,”  “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
Accelerated filer
x
Non-accelerated filer
o
Smaller reporting company
o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes       o       No       x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
Common Stock, $0.01 par value:
16,418,327 shares outstanding and issued as of November 5, 2009

 


First Security Group, Inc. and Subsidiary
 
Form 10-Q
 
INDEX

PART I.
FINANCIAL INFORMATION
Page No.
     
Item 1.
Financial Statements
 
     
 
1
     
 
3
     
 
4
     
 
5
     
 
7
     
Item 2.
24
     
Item 3.
56
     
Item 4.
57
     
PART II.
OTHER INFORMATION
 
     
Item 1.
57
     
Item 1A.
58
     
Item 2.
71
     
Item 6.
72
     
73

 

 
PART I - FINANCIAL INFORMATION
ITEM 1. Financial Statements
First Security Group, Inc. and Subsidiary
Consolidated Balance Sheets

   
September 30,
2009
   
December 31,
2008
   
September 30,
2008
 
(in thousands)
 
(unaudited)
         
(unaudited)
 
       
ASSETS
                 
Cash and Due from Banks
  $ 14,711     $ 23,222     $ 26,822  
Federal Funds Sold and Securities Purchased under Agreements to Resell
    -       -       -  
Cash and Cash Equivalents
    14,711       23,222       26,822  
Interest Bearing Deposits in Banks
    5,394       918       963  
Securities Available-for-Sale
    147,175       139,305       134,437  
Loans Held for Sale
    1,001       1,609       3,972  
Loans
    963,294       1,009,975       1,013,495  
Total Loans
    964,295       1,011,584       1,017,467  
Less:  Allowance for Loan and Lease Losses
    25,686       17,385       13,335  
      938,609       994,199       1,004,132  
Premises and Equipment, net
    33,587       33,808       34,289  
Goodwill
    -       27,156       27,156  
Intangible Assets
    2,012       2,404       2,592  
Other Assets
    61,420       55,215       51,622  
TOTAL ASSETS
  $ 1,202,908     $ 1,276,227     $ 1,282,013  

(See Accompanying Notes to Consolidated Financial Statements)

1


First Security Group, Inc. and Subsidiary
Consolidated Balance Sheets

   
September 30,
2009
   
December 31,
2008
   
September 30,
2008
 
(in thousands, except share data)
 
(unaudited)
         
(unaudited)
 
                   
LIABILITIES AND STOCKHOLDERS’ EQUITY
                 
LIABILITIES
                 
Deposits
                 
Noninterest Bearing Demand
  $ 146,820     $ 150,047     $ 162,631  
Interest Bearing Demand
    61,502       61,402       62,031  
Savings and Money Market Accounts
    164,490       151,259       132,646  
Certificates of Deposit less than $100 thousand
    244,127       249,978       256,727  
Certificates of Deposit of $100 thousand or more
    203,533       206,502       213,440  
Brokered Deposits
    198,815       257,098       149,045  
Total Deposits
    1,019,287       1,076,286       976,520  
Federal Funds Purchased and Securities Sold under Agreements to Repurchase
    20,463       40,036       50,571  
Security Deposits
    1,444       2,078       2,118  
Other Borrowings
    7,724       2,777       92,780  
Other Liabilities
    8,801       10,806       11,493  
Total Liabilities
    1,057,719       1,131,983       1,133,482  
STOCKHOLDERS’ EQUITY
                       
Preferred Stock – no par value – 10,000,000 shares authorized as of September 30, 2009 and December 31, 2008; 33,000 issued as of September 30, 2009; none issued as of December 31, 2008 and September 30, 2008
    31,248       -       -  
Common Stock - $.01 par value - 50,000,000 shares authorized; 16,418,327 issued as of September 30, 2009; 16,419,883 issued as of December 31, 2008 and September 30, 2008
    114       114       114  
Paid-In Surplus
    111,999       111,777       111,927  
Common Stock Warrants
    2,006       -       -  
Unallocated ESOP Shares
    (6,446 )     (5,944 )     (3,856 )
(Accumulated Deficit) Retained Earnings
    (524 )     32,387       36,487  
Accumulated Other Comprehensive Income
    6,792       5,910       3,859  
Total Stockholders’ Equity
    145,189       144,244       148,531  
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 1,202,908     $ 1,276,227     $ 1,282,013  

(See Accompanying Notes to Consolidated Financial Statements)

2


First Security Group, Inc. and Subsidiary
Consolidated Income Statements
(unaudited)

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
(in thousands, except per share data)
 
2009
   
2008
   
2009
   
2008
 
INTEREST INCOME
                       
Loans, including fees
  $ 14,462     $ 17,505     $ 43,859     $ 53,616  
Debt Securities – taxable
    1,097       1,149       3,435       3,410  
Debt Securities – non-taxable
    396       395       1,200       1,184  
Other
    3       9       38       41  
Total Interest Income
    15,958       19,058       48,532       58,251  
                                 
INTEREST EXPENSE
                               
Interest Bearing Demand Deposits
    45       69       146       262  
Savings Deposits and Money Market Accounts
    384       548       1,255       1,754  
Certificates of Deposit of less than $100 thousand
    1,738       2,525       5,687       8,202  
Certificates of Deposit of $100 thousand or more
    1,530       2,206       4,934       7,242  
Brokered Deposits
    1,225       1,114       4,478       2,941  
Other
    136       900       395       3,223  
Total Interest Expense
    5,058       7,362       16,895       23,624  
                                 
NET INTEREST INCOME
    10,900       11,696       31,637       34,627  
Provision for Loan and Lease Losses
    9,280       3,960       20,469       7,091  
NET INTEREST INCOME AFTER PROVISION
                               
FOR LOAN AND LEASE LOSSES
    1,620       7,736       11,168       27,536  
                                 
NONINTEREST INCOME
                               
Service Charges on Deposit Accounts
    1,184       1,338       3,501       3,950  
Gain on Sales of Available for Sale Securities, net
    -       146       -       146  
Other
    1,553       1,573       4,331       4,911  
Total Noninterest Income
    2,737       3,057       7,832       9,007  
                                 
NONINTEREST EXPENSES
                               
Salaries and Employee Benefits
    4,903       5,105       15,303       16,629  
Expense on Premises and Fixed Assets, net of rental income
    1,493       1,583       4,525       4,970  
Impairment of Goodwill
    27,156       -       27,156       -  
Other
    3,811       3,017       9,731       8,433  
Total Noninterest Expenses
    37,363       9,705       56,715       30,032  
                                 
(LOSS) INCOME BEFORE INCOME TAX PROVISION
    (33,006 )     1,088       (37,715 )     6,511  
Income Tax (Benefit) Provision
    (4,877 )     262       (7,326 )     1,838  
NET (LOSS) INCOME
    (28,129 )     826       (30,389 )     4,673  
Preferred Stock Dividends
    412       -       1,196       -  
Accretion on Preferred Stock Discount
    90       -       254       -  
NET (LOSS) INCOME TO COMMON STOCKHOLDERS
  $ (28,631 )   $ 826     $ (31,839 )   $ 4,673  
                                 
NET (LOSS) INCOME PER SHARE:
                               
Net (Loss) Income Per Share - Basic
  $ (1.84 )   $ 0.05     $ (2.05 )   $ 0.29  
Net (Loss) Income Per Share - Diluted
  $ (1.84 )   $ 0.05     $ (2.05 )   $ 0.29  
Dividends Declared Per Common Share
  $ 0.01     $ 0.05     $ 0.07     $ 0.15  

(See Accompanying Notes to Consolidated Financial Statements)

3


First Security Group, Inc. and Subsidiary
Consolidated Statement of Stockholders’ Equity

         
Common Stock
      Paid-In Surplus       Stock Warrants       Retained Earnings (Accumulated Deficit)       Accumulated Other Comprehensive Income       Unallocated ESOP Shares       Total  
(in thousands)
 
Preferred Stock
   
Shares
   
Amount
                         
Balance – December 31, 2008
  $ -       16,420     $ 114     $ 111,777     $ -     $ 32,387     $ 5,910     $ (5,944 )   $ 144,244  
Comprehensive Income:
                                                                       
Net Loss (unaudited)
                                            (30,389 )                     (30,389 )
Change Unrealized Gain:
                                                                       
Securities Available-for-Sale, net of tax (unaudited)
                                                    1,841               1,841  
Fair Value of Derivatives, net of tax and reclassification adjustments (unaudited)
                                                    (959 )             (959 )
Total Comprehensive Loss
                                                                    (29,507 )
Issuance of Preferred Stock (unaudited)
    30,994                               2,006                               33,000  
Accretion of Discount Associated with Preferred Stock (unaudited)
    254                                       (254 )                     -  
Preferred Stock Dividend ($36.24 per share) (unaudited)
                                            (1,196 )                     (1,196 )
Common Stock Dividend ($0.07 per share) (unaudited)
                                            (1,072 )                     (1,072 )
Stock-based Compensation, net of forfeitures (unaudited)
            (2 )             274                                       274  
ESOP Common Stock Purchases (unaudited)
                                                            (1,023 )     (1,023 )
ESOP Allocation (unaudited)
                            (52 )                             521       469  
Balance – September 30, 2009 (unaudited)
  $ 31,248       16,418     $ 114     $ 111,999     $ 2,006     $ (524 )   $ 6,792     $ (6,446 )   $ 145,189  

(See Accompanying Notes to Consolidated Financial Statements)

4


First Security Group, Inc. and Subsidiary
Consolidated Statements of Cash Flow
(unaudited)

   
Nine Months Ended September 30,
 
(in thousands)
 
2009
   
2008
 
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net (Loss) Income
  $ (30,389 )   $ 4,673  
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities -
               
Provision for Loan and Lease Losses
    20,469       7,091  
Amortization, net
    513       623  
Impairment of Goodwill
    27,156       -  
Stock-Based Compensation
    274       449  
ESOP Compensation
    469       587  
Depreciation
    1,582       1,879  
Net Gain on Sale of Premises and Equipment
    (2 )     (23 )
Loss / (Gain) on Sale of Other Real Estate and Repossessions, net
    71       (256 )
Write-down of Other Real Estate and Repossessions
    507       245  
Gain on Sale of Available-for-Sale Securities, net
    -       (146 )
Accretion of Fair Value Adjustment, net
    (140 )     (238 )
Accretion of Cash Flow Swaps
    (528 )     (859 )
Accretion of Terminated Cash Flow Swaps
    (1,252 )     (447 )
Changes in Operating Assets and Liabilities -
               
Loans Held for Sale
    608       404  
Interest Receivable
    142       716  
Other Assets
    (4,318 )     (1,315 )
Interest Payable
    (2,463 )     (1,389 )
Other Liabilities
    (715 )     (4,295 )
Net Cash Provided by Operating Activities
    11,984       7,699  
CASH FLOWS FROM INVESTING ACTIVITIES
               
Net Change in Interest Bearing Deposits in Banks
    (4,476 )     (667 )
Activity in Available-for-Sale-Securities -
               
Maturities, Prepayments, and Calls
    21,624       14,715  
Sales
    -       13,126  
Purchases
    (26,826 )     (30,608 )
Loan Originations and Principal Collections, net
    19,205       (74,283 )
Proceeds for Interim Settlements of Cash Flow Swaps, net
    938       (374 )
Proceeds for Termination of Cash Flow Swaps
    5,778       -  
Proceeds from Sale of Premises and Equipment
    16       131  
Proceeds from Sales of Other Real Estate and Repossessions
    6,720       2,699  
Additions to Premises and Equipment
    (1,406 )     (1,525 )
Capital Improvements to Repossessions and Other Real Estate
    (355 )     (219 )
Net Cash Provided by / (Used in) Investing Activities
    21,218       (77,005 )
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net (Decrease) / Increase in Deposits
    (57,002 )     73,881  
Net Decrease Federal Funds Purchased and Securities Sold Under Agreements to Repurchase
    (19,573 )     (11,715 )
Net Increase of Other Borrowings
    4,947       12,321  
Proceeds from Issuance of Preferred Stock and Common Stock Warrants
    33,000       -  
Repurchase and Retirement of Common Stock
    -       (2,803 )
Repurchase of Common Stock for 401(k) and ESOP Plan
    (1,023 )     (485 )
Dividends Paid on Preferred Stock
    (990 )     -  
Dividends Paid on Common Stock
    (1,072 )     (2,465 )
Net Cash (Used in) / Provided by Financing Activities
    (41,713 )     68,734  
NET CHANGE IN CASH AND CASH EQUIVALENTS
    (8,511 )     (572 )
CASH AND CASH EQUIVALENTS - beginning of period
    23,222       27,394  
CASH AND CASH EQUIVALENTS - end of period
  $ 14,711     $ 26,822  

(See Accompanying Notes to Consolidated Financial Statements)

5

 
   
Nine Months Ended
September 30,
 
(in thousands)
 
2009
   
2008
 
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES
           
Transfers to Foreclosed Properties and Repossessions
  $ 17,103     $ 6,725  
SUPPLEMENTAL SCHEDULE OF CASH FLOWS
               
Interest Paid
  $ 19,358     $ 25,013  
Income Taxes Paid
  $ 539     $ 5,548  

(See Accompanying Notes to Consolidated Financial Statements)

6


FIRST SECURITY GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of financial condition and the results of operations have been included. All such adjustments were of a normal recurring nature, except for the goodwill impairment as discussed in Note 6.

In June 2009, the Financial Accounting Standards Board (FASB) established the FASB Accounting Standards Codification (Codification or ASC) as the single source of authoritative U.S. generally accepted accounting principles recognized by the FASB to be applied by all nongovernmental entities. All previous authoritative guidance was incorporated into the Codification and is no longer considered authoritative. The Codification became effective for periods ending after September 15, 2009. The Company has amended all applicable footnotes to reflect this change.

The consolidated financial statements include the accounts of First Security Group, Inc. and its subsidiary, which is wholly-owned. All significant intercompany balances and transactions have been eliminated.

Operating results for the three and nine months ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009 or any other period. These interim financial statements should be read in conjunction with the Company’s latest annual consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

NOTE 2 – COMPREHENSIVE INCOME

Comprehensive income is a measure of all changes in equity, not only reflecting net income but certain other changes as well. The following table presents the comprehensive income for the three and nine month periods ended September 30, 2009 and 2008, respectively.

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
   
(in thousands)
 
Net (loss) income
  $ (28,129 )   $ 826     $ (30,389 )   $ 4,673  
Other comprehensive income (loss)
                               
Available-for-sale securities
                               
Unrealized net gain (loss) on securities arising during the period
    2,432       1,120       2,789       (164 )
Tax (expense) benefit related to unrealized net (gain) loss
    (827 )     (381 )     (948 )     56  
Reclassification adjustments for realized gain included in net income
    -       (146 )     -       (146 )
Tax expense related to gain realized in net income
    -       50       -       50  
Unrealized gain (loss) on securities, net of tax
    1,605       643       1,841       (204 )
                                 
Derivative cash flow hedges
                               
Unrealized gain (loss) on derivatives arising during the period
    -       2,155       312       2,952  
Tax (expense) benefit related to unrealized (loss) gain
    -       (733 )     (106 )     (1,004 )
Reclassification adjustments for realized gain included in net income
    (614 )     (493 )     (1,765 )     (1,306 )
Tax expense related to gain realized in net income
    209       168       600       444  
Unrealized (loss) gain on derivatives, net of tax
    (405 )     1,097       (959 )     1,086  
                                 
Other comprehensive income, net of tax
    1,200       1,740       882       882  
Comprehensive (loss) income, net of tax
  $ (26,929 )   $ 2,566     $ (29,507 )   $ 5,555  

7

 
NOTE 3 – EARNINGS PER SHARE

The difference in basic and diluted weighted average shares is due to the assumed conversion of outstanding options using the treasury stock method. The following table presents the computation of basic and diluted earnings per share.

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
   
(in thousands, except per share data)
 
                         
Net (loss) income available to common stockholders
  $ (28,631 )   $ 826     $ (31,839 )   $ 4,673  
Denominator:
                               
Weighted average common shares outstanding
    15,543       16,065       15,539       16,087  
Equivalent shares issuable upon exercise of stock options
    -       94       -       156  
Weighted average diluted shares outstanding
    15,543       16,159       15,539       16,243  
Net (loss) income per share:
                               
Basic
  $ (1.84 )   $ 0.05     $ (2.05 )   $ 0.29  
Diluted
  $ (1.84 )   $ 0.05     $ (2.05 )   $ 0.29  

On January 9, 2009, as part of the Capital Purchase Program (CPP) administered by the U.S. Department of the Treasury (Treasury) under the Troubled Asset Relief Program (TARP), the Company issued a ten-year warrant to purchase up to 823,627 shares of the Company’s common stock, $0.01 par value, at an exercise price of $6.01 per share. Note 8 discusses the transaction in further detail. The common stock warrants are treated as outstanding options under the treasury stock method for calculating the weighted average diluted shares outstanding. For the three and nine months ended September 30, 2009, the common stock warrants were anti-dilutive.

For the three and nine months ended September 30, 2009, the weighted average stock options and restricted stock awards that were anti-dilutive totaled 1,311 thousand and 1,361 thousand, respectively, compared to 782 thousand and 749 thousand for the same periods in 2008. Anti-dilutive options and awards are not included in the computation of diluted earnings per share under the treasury stock method.

8

 
NOTE 4—SECURITIES

Investment Securities by Type

The following table presents the amortized cost and fair value of securities, with gross unrealized gains and losses.

   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
   
(in thousands)
 
Securities available-for-sale
                       
September 30, 2009
                       
Debt securities—
                       
Federal agencies
  $ 20,262     $ 138     $ 1     $ 20,399  
Mortgage-backed
    80,765       3,202       559       83,408  
Municipals
    41,479       1,801       3       43,277  
Other
    126       -       35       91  
Total
  $ 142,632     $ 5,141     $ 598     $ 147,175  
                                 
Securities available-for-sale
                               
December 31, 2008
                               
Debt securities—
                               
Federal agencies
  $ 8,500     $ 245     $ -     $ 8,745  
Mortgage-backed
    85,878       2,086       769       87,195  
Municipals
    43,053       704       408       43,349  
Other
    125       -       109       16  
Total
  $ 137,556     $ 3,035     $ 1,286     $ 139,305  

For the nine months ended September 30, 2009, no available-for-sale securities were sold.

At September 30, 2009 and December 31, 2008, federal agencies, municipals and mortgage-backed securities with a carrying value of $14,973 thousand and $18,143 thousand, respectively, were pledged to secure public deposits. At September 30, 2009 and December 31, 2008, the carrying amount of securities pledged to secure repurchase agreements was $33,596 thousand and $46,829 thousand, respectively.

Maturity of Securities
 
The following table presents the amortized cost and fair value of debt securities by contractual maturity at September 30, 2009.

   
Amortized Cost
   
Fair
Value
 
   
(in thousands)
 
Within 1 year
  $ 2,017     $ 2,049  
Over 1 year through 5 years
    27,352       28,032  
5 years to 10 years
    27,624       28,649  
Over 10 years
    4,874       5,037  
      61,867       63,767  
Mortgage-backed securities
    80,765       83,408  
Total
  $ 142,632     $ 147,175  

9

 
Impairment Analysis

The following table shows the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2009 and December 31, 2008.

   
Less than 12 months
   
12 months or greater
   
Totals
 
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
   
(in thousands)
 
September 30, 2009
                                   
Federal agencies
  $ 1,370     $ 1     $ -     $ -     $ 1,370     $ 1  
Mortgage-backed
    -       -       4,574       559       4,574       559  
Municipals
    -       -       650       3       650       3  
Other
    -       -       91       35       91       35  
Totals
  $ 1,370     $ 1     $ 5,315     $ 597     $ 6,685     $ 598  
                                                 
December 31, 2008
                                               
Federal agencies
  $ -     $ -     $ -     $ -     $ -     $ -  
Mortgage-backed
    6,034       769       -       -       6,034       769  
Municipals
    10,525       408       -       -       10,525       408  
Other
    16       109       -       -       16       109  
Totals
  $ 16,575     $ 1,286     $ -     $ -     $ 16,575     $ 1,286  

As of September 30, 2009, the Company performed an impairment assessment of the securities in its portfolio that had an unrealized loss to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) the Company intends to sell the security, (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized costs basis or (3) the Company does not expect to recover the security’s entire amortized cost basis, even if the Company does not intend to sell. Additionally, accounting guidance requires that for impaired securities that the Company does not intend to sell and/or that it is not more-likely-than-not that the Company will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.

In evaluating the recovery of the entire amortized cost basis, the Company considers factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.

As of September 30, 2009, gross unrealized losses in the Company’s portfolio totaled $598 thousand, compared to $1.3 million as of December 31, 2008. The unrealized losses in mortgage-backed securities consists of six securities, with a $523 thousand unrealized loss in one security. This security is rated BAA3 by Moody as of September 30, 2009. This security’s junior tranches experienced a break in yield during the second quarter of 2009. The Company conducted a thorough review, including multiple stress tests, to determine if an impairment for credit risk had occurred. The Company holds a super senior tranche bond. The results of the analysis currently support full recovery of the Company’s cost. The unrealized losses in other securities are two trust preferred securities. The unrealized losses are primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. Based on results of the Company’s impairment assessment, the unrealized losses at September 30, 2009 are considered temporary.

10

 
NOTE 5 – LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES
 
The following table presents loans by type.
 
   
September 30, 2009
   
December 31, 2008
   
September 30, 2008
 
   
(in thousands)
 
Loans secured by real estate-
                 
Residential 1-4 family
  $ 284,811     $ 296,454     $ 284,256  
Commercial
    233,692       234,630       230,134  
Construction
    176,570       194,603       206,453  
Multi-family and farmland
    37,461       34,273       33,114  
      732,534       759,960       753,957  
Commercial loans
    148,473       157,906       166,024  
Consumer installment loans
    51,866       58,296       61,400  
Leases, net of unearned income
    24,679       30,873       33,663  
Other
    6,743       4,549       2,423  
Total loans
    964,295       1,011,584       1,017,467  
Allowance for loan and lease losses
    (25,686 )     (17,385 )     (13,335 )
Net loans
  $ 938,609     $ 994,199     $ 1,004,132  
 
The following table presents an analysis of the allowance for loan and lease losses. The provision expense for loan and lease losses in the table does not include the Company’s provision accrual for unfunded commitments of $18 thousand and $18 thousand for the nine months ended September 30, 2009 and 2008, respectively. The reserve for unfunded commitments is included in other liabilities in the consolidated balance sheets.
 
   
September 30, 2009
   
September 30, 2008
 
   
(in thousands)
 
Allowance for loan and lease losses-beginning of period
  $ 17,385     $ 10,956  
Provision expense for loan and lease losses
    20,451       7,073  
Loans charged-off
    (12,443 )     (4,853 )
Loan loss recoveries
    293       159  
Allowance for loan and lease losses-end of period
  $ 25,686     $ 13,335  
 
The Company classifies a loan as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Impaired loans were $23,608 thousand, $14,684 thousand and $2,478 thousand at September 30, 2009, December 31, 2008 and September 30, 2008, respectively. Nonaccrual loans were $31,463 thousand, $18,453 thousand and $8,773 thousand at September 30, 2009, December 31, 2008 and September 30, 2008, respectively. Loans past due 90 days or more and still accruing interest were $3,377 thousand, $2,706 thousand and $2,250 thousand as of September 30, 2009, December 31, 2008 and September 30, 2008, respectively. The Company had no significant outstanding commitments to lend additional funds to customers whose loans have been placed on nonaccrual status.
 
Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may change in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

11

 
NOTE 6 – GOODWILL

The changes in the carrying amounts of goodwill are as follows:

   
September 30, 2009
   
December 31, 2008
   
September 30, 2008
 
   
(in thousands)
 
Goodwill – beginning of period
  $ 27,156     $ 27,156     $ 27,156  
Goodwill acquired
    -       -       -  
Goodwill impairment
    (27,156 )     -       -  
Goodwill – end of period
  $ -     $ 27,156     $ 27,156  

The Company’s policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount as required by authoritative accounting guidance. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The impairment testing is a two-step process. Step 1 compares the fair value of the reporting unit to the carrying value. If the fair value is below the carrying value, Step 2 is performed. Step 2 involves a process similar to business combination accounting in which fair values are assigned to all assets, liabilities and other (non-goodwill) intangibles. The result of Step 2 is the implied fair value of goodwill. If the implied fair value of goodwill is below the recorded goodwill amount, an impairment charge is recorded for the difference.

The Company engaged an independent valuation firm to assist in computing the fair value estimate for the goodwill impairment assessment as of September 30, 2009.  The firm utilized two separate valuation methodologies for Step 1 and compared the results of each to determine the fair value of the goodwill associated with the Company’s prior bank acquisitions.  The valuation methodologies utilized included a discounted cash flow valuation technique and a comparison of the average price to book value of comparable bank acquisitions.  Both methods indicated a valuation below the book value of the Company. The firm conducted Step 2, which assigned fair values to all assets, liabilities and other (non-goodwill) intangibles.  The results of Step 2 indicated a full goodwill impairment of $27,156 thousand that is recorded in non-interest expense in the Consolidated Income Statements. The impairment was primarily a result of the continuing economic downturn and its implications on bank valuations.
 
The goodwill was associated with six prior acquisitions. Three acquisitions were taxable asset purchases and three were non-taxable stock purchases. The goodwill impairment that is deductible for tax is $6,953 thousand, which added $2,394 thousand to the tax benefit recognized in the third quarter of 2009.  The remaining $20,203 thousand goodwill impairment is not deductible for taxes and thus no tax benefit was recognized.
 
NOTE 7 – GUARANTEES

The Company, as part of its ongoing business operations, issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company to guarantee the performance of a customer to a third-party. A financial standby letter of credit is a commitment to guarantee a customer’s repayment of an outstanding loan or debt instrument. In a performance standby letter of credit, the Company guarantees a customer’s performance under a contractual nonfinancial obligation for which it receives a fee. The maximum potential amount of future payments the Company could be required to make under its standby letters of credit at September 30, 2009, December 31, 2008, and September 30, 2008 was $15,972 thousand, $21,880 thousand, and $18,987 thousand, respectively. The Company’s outstanding standby letters of credit generally have a term of one year and some may have renewal options. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

12

 
NOTE 8 – STOCKHOLDERS’ EQUITY

Common Stock and ESOP Activity

During 2009, the Board of Directors declared common stock dividends as presented in the following table.

Declaration Date
 
Dividend Per Common Share
 
Date of Record
 
Amount
(in thousands)
 
Payment Date
January 28, 2009
 
$0.05
 
March 3, 2009
 
$761
 
March 16, 2009
April 22, 2009
 
$0.01
 
June 1, 2009
 
$156
 
June 16, 2009
July 22, 2009
 
$0.01
 
September 1, 2009
 
$155
 
September 16, 2009
October 27, 2009
 
$0.01
 
December 1, 2009
 
$1551
 
December 16, 2009

1 Estimate based on current number of common shares outstanding.

On July 23, 2008, the Board of Directors approved a loan, which was subsequently amended on January 28, 2009, in the amount of $10.0 million from First Security Group, Inc. to the First Security Group, Inc. 401(k) and Employee Stock Ownership Plan (401(k) and ESOP plan). The purpose of the loan is to purchase Company shares in open market transactions. The shares will be used for future Company matching contributions with the 401(k) and ESOP plan. From January 1, 2009 to September 30, 2009, the Company purchased 248,800 shares at an average cost of $4.11. As of September 30, 2009, the cumulative purchases total 700,676 shares at a total cost of $4,056 thousand, or an average of $5.79 per share. Currently, the 401(k) and ESOP plan is not actively pursuing the purchase of additional shares and no shares have been purchased since February 19, 2009.

On September 30, 2009, June 30, 2009 and March 31, 2009, the Company released 38,499, 40,209 and 49,192 shares, respectively, from the Employee Stock Ownership Plan (ESOP) for the matching contribution of 100% of the employee’s contribution up to 6% of the employee’s compensation for the Plan year. The number of unallocated, committed to be released, and allocated shares for the ESOP are presented in the following table.

   
Unallocated Shares
   
Committed to be released shares
   
Allocated Shares
   
Compensation Expense
(in thousands)
 
Shares as of December 31, 2008
    710,163             241,713        
Shares purchased by ESOP during 2009
    248,800                    
Shares allocated during 2009
    (127,900 )           127,900     $ 469  
Shares as of September 30, 2009
    831,063             369,613          

Preferred Stock

On December 29, 2008, the Company filed with the State of Tennessee an Articles of Amendment to the Charter of Incorporation to authorize a class of ten million (10,000,000) shares of preferred stock, no par value. These Articles of Amendment were approved by the stockholders of the Company at a stockholders’ meeting held December 18, 2008, pursuant to a proxy statement filed by the Company on November 24, 2008.

On January 9, 2009, as part of the CPP, the Company agreed to issue and sell, and the Treasury agreed to purchase (1) 33,000 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock (Preferred Stock), Series A, having a liquidation preference of $1,000 per share, and (2) a ten-year immediately exercisable warrant to purchase up to 823,627 shares of the Company’s common stock, $0.01 par value, at an exercise price of $6.01 per share, for an aggregate purchase price of $33,000 thousand in cash. As a participant in the CPP, the Company is subject to limitations on the payments of dividends to common stockholders (other than a regular quarterly cash dividend of not more than $0.05 per share of common stock).

13

 
The Preferred Stock qualifies as Tier I capital and pays cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Dividends are payable quarterly on February 15, May 15, August 15 and November 15 of each year or the following business day. On February 15, 2009, the Company paid a 36-day prorated preferred stock dividend of $165 thousand. In May and August 2009, the Company paid the quarterly preferred stock dividend of $413 thousand. The $1,196 thousand preferred stock dividend shown on the consolidated income statements includes an accrued dividend of $206 thousand.

The total purchase price of $33,000 thousand was allocated between the Preferred Stock and the warrants based on the respective fair value of each. The warrants are valued at $2,006 thousand. The Preferred Stock original discount was $2,006 thousand. This discount is being expensed over the expected life of the Preferred Stock, or five years, utilizing the effective interest method. For the three and nine months ended September 30, 2009, the Company recognized $90 thousand and $254 thousand, respectively, in Preferred Stock discount accretion.

NOTE 9 – TAXES

The Company accounts for income taxes in accordance with ASC 740 (formerly FASB Statement No. 109, Accounting for Income Taxes) which requires an asset and liability approach for the financial accounting and reporting of income taxes. Under this method, deferred income taxes are recognized for the expected future tax consequences of differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. These balances are measured using the enacted tax rates expected to apply in the year(s) in which these temporary differences are expected to reverse. The effect on deferred income taxes of a change in tax rates is recognized in income in the period when the change is enacted.

For the three and nine months ended September 30, 2009, the Company recognized an income tax benefit of $4,877 thousand and $7,326 thousand, respectively. For the three and nine months ended September 30, 2008, the Company recognized income tax provision of $262 thousand and $1,838 thousand, respectively. The following reconciles the income tax (benefit) provision to statutory rates:

   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
   
(in thousands)
 
Federal taxes at statutory tax rate
  $ (11,222 )   $ 370     $ (12,823 )   $ 2,214  
Tax exempt loss on non-deductible goodwill impairment
    6,869       -       6,869       -  
Tax exempt earnings on securities
    (135 )     (134 )     (408 )     (403 )
Tax exempt earnings on bank owned life insurance
    (85 )     (77 )     (256 )     (231 )
Other, net
    (95 )     130       (180 )     193  
State tax provision, net of federal effect
    (209 )     (27 )     (528 )     65  
Income tax (benefit) provision
  $ (4,877 )   $ 262     $ (7,326 )   $ 1,838  

The benefit recognized during the three and nine months ended September 30, 2009, primarily relates to increases in deferred tax assets including the increase associated with the temporary difference of the allowance for loan and lease losses, the tax-deductible portion of the goodwill impairment and the year-to-date net operating loss. Based on the Company’s historical pattern of taxable income, the Company expects to produce sufficient income in the future to realize its deferred tax assets. A valuation allowance is established for any portion of a deferred tax asset that the Company believes is more likely than not that the Company will not be able to realize the benefits or portion of a deferred income tax asset. As of September 30, 2009, the Company has no valuation allowances associated with deferred tax assets.

The Company recognized a goodwill impairment of $27,156 thousand in the third quarter of 2009. Approximately $6,953 thousand of the impairment is deductible for taxes, which represents $2,394 thousand of the total 2009 income tax benefit. The remaining $20,203 thousand of the impairment is not deductible for taxes. As shown above, this non-deductible portion significantly impacts the effective tax rate for 2009.
 
The Company evaluated its material tax positions as of September 30, 2009. Under the “more-likely-than-not” threshold guidelines by current authoritative accounting guidance, the Company believes no significant uncertain tax positions exist, either individually or in the aggregate, that would give rise to the non-recognition of an existing tax benefit. The Company will evaluate, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant adverse tax position is determined to exist, penalty and interest will be accrued, in accordance with Internal Revenue Service guidelines, and recorded as a component of other expenses in the Company’s consolidated income statements.

14

 
As of September 30, 2009, there were no penalties and interest recognized in the consolidated income statement associated with significant uncertain tax positions, nor does the Company anticipate a change in its material tax positions that would give rise to the non-recognition of an existing tax benefit during the remainder of 2009. However, changes in state and federal tax regulations could create a material uncertain tax position.

NOTE 10 – FAIR VALUE MEASUREMENTS

The authoritative accounting guidance for fair value measurements defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Authoritative guidance establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the hierarchy. In such cases, the fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2009.

   
Balance as of September 30, 2009
   
Quoted Prices in Active Markets for Identical Assets
(Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
   
(in thousands)
 
Financial assets
                       
Securities available-for-sale
  $ 147,175     $ -     $ 146,925     $ 250  
Loans held for sale
    1,001       -       1,001       -  
Forward loan sales contracts
    15       -       15       -  
                                 
Financial liabilities
                               
None
    -       -       -       -  

15

 
The following table presents additional information about changes in assets and liabilities measured at fair value on a recurring basis and for which the Company utilized Level 3 inputs to determine fair value as of September 30, 2009.

   
Beginning Balance
   
Total Realized and Unrealized Gains or Losses
   
Purchases, Sales, Other Settlements and Issuances, net
   
Net Transfers In and/or Out of Level 3
   
Ending Balance
 
   
(in thousands)
 
Financial Assets
                             
Securities Available-for-Sale
  $ 250     $ -     $ -     $ -     $ 250  

The Company did not recognize any unrealized gains or losses on Level 3 fair value assets or liabilities.

At September 30, 2009, the Company also had assets and liabilities measured at fair value on a non-recurring basis. Items measured at fair value on a non-recurring basis include other real estate owned (OREO) and repossessions, as well as assets and liabilities acquired in prior business combinations, including loans, goodwill, core deposit intangible assets, and time deposits. Such measurements were determined utilizing Level 2 and Level 3 inputs.

OREO and repossessions are measured at fair value on a non-recurring basis. Upon initial recognition, they are measured at fair value, which becomes the cost basis. The cost basis is subsequently re-measured at fair value when events or circumstances occur that indicate the initial fair value has declined. The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis, for which impairment was recognized in nine months ended September 30, 2009.

   
Carrying Value as of September 30, 2009
   
Level 1 Fair Value Measurement
   
Level 2 Fair Value Measurement
   
Level 3 Fair Value Measurement
   
Valuation Allowance as of September 30, 2009
 
   
(in thousands)
 
Other Real Estate Owned
  $ 3,977     $ -     $ 3,977     $ -     $ (819 )
Repossessions
    1,389       -       1,389       -       (601 )

The following table presents the estimated fair values of the Company’s financial instruments.

   
September 30, 2009
   
December 31, 2008
 
   
Carrying Amount
   
Fair Value
   
Carrying Amount
   
Fair Value
 
   
(in thousands)
 
Financial assets
                       
Cash and cash equivalents
  $ 14,711     $ 14,711     $ 23,222     $ 23,222  
Interest bearing deposits in banks
  $ 5,394     $ 5,394     $ 918     $ 918  
Securities available-for-sale
  $ 147,175     $ 147,175     $ 139,305     $ 139,305  
Loans held for sale
  $ 1,001     $ 1,001     $ 1,609     $ 1,609  
Loans
  $ 963,294     $ 983,185     $ 1,009,975     $ 1,041,559  
Allowance for loan and lease losses
  $ (25,686 )   $ (25,686 )   $ (17,385 )   $ (17,385 )
                                 
Financial liabilities
                               
Deposits
  $ 1,019,287     $ 1,025,567     $ 1,076,286     $ 1,085,973  
Federal funds purchased and securities sold under agreements to repurchase
  $ 20,463     $ 20,463     $ 40,036     $ 40,036  
Other borrowings
  $ 7,724     $ 7,724     $ 2,777     $ 2,777  

16

 
The following methods and assumptions were used by the Company in estimating fair value of each class of financial instruments for which it is practicable to estimate that value:
 
 
Cash and cash equivalents – The carrying value of cash and cash equivalents approximates fair value.
 
 
Interest bearing deposits in banks – The carrying amounts of interest bearing deposits in banks approximate fair value.
 
 
Securities – The Company’s securities are valued utilizing Level 2 inputs with the exception of one $250 thousand bond. Level 2 inputs are based on quoted prices for similar assets in active markets.
 
 
Loans held for sale – Fair value for loans held for sale are based on quoted prices for similar assets in active markets.
 
 
Loans – For variable-rate loans that reprice frequently and have no significant changes in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans and other consumer loans are estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans and leases is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers of similar credit ratings quality. Fair value for impaired loans and leases are estimated using discounted cash flow analysis or underlying collateral values, where applicable.
 
 
Deposit liabilities – The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value for fixed-rate certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregate expected maturities on time deposits.
 
 
Federal funds purchased and securities sold under agreements to repurchase – These borrowings generally mature in 90 days or less and, accordingly, the carrying amount reported in the balance sheet approximates fair value.
 
 
Other borrowings – Other borrowings carrying amount reported in the consolidated balance sheets approximates fair value.
 
NOTE 11 – FAIR VALUE OPTION

Authoritative accounting guidance provides a fair value option election (FVO) that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. The guidance permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.

During February 2008, the Company began recording all newly-originated loans held for sale under the fair value option. The Company chose the fair value option to eliminate the complexities and inherent difficulties of achieving hedge accounting and to better align reported results with the underlying economic changes in value of the loans and related hedge instruments. This election impacts the timing and recognition of origination fees and costs, as well as servicing value. Specifically, origination fees and costs, which had been appropriately deferred and recognized as part of the gain or loss on the sale of the loan, are now recognized in earnings at the time of origination. The servicing value, which had been recorded at the time the loan was sold, is now included in the fair value of the loan and recognized at origination of the loan. The Company began using derivatives to hedge changes in servicing value as a result of including the servicing value in the fair value of the loan. The estimated impact from recognizing servicing value, net of related hedging costs, as part of the fair value of the loan is captured in the mortgage loan and related fees component of noninterest income.

As of September 30, 2009, December 31, 2008 and September 30, 2008, there was $1,001 thousand, $1,609 thousand and $3,972 thousand in loans held for sale recorded at fair value, respectively. For the three and nine months ended September 30, 2009, approximately $385 thousand and $826 thousand in loan origination and related fee income was recognized in non-interest income, respectively, and an insignificant amount of origination and related fee expense, respectively, was recognized in non-interest expense utilizing the fair value option.

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For the nine months ended September 30, 2009, the Company recognized a loss of $310 thousand due to changes in fair value for loans held for sale in which the fair value option was elected. This amount does not reflect the change in fair value attributable to the related hedges the Company used to mitigate the interest rate risk associated with loans held for sale. The changes in the fair value of the hedges were also recorded in the mortgage loan and related fee component of noninterest income, and offset $295 thousand of the change in fair value of loans held for sale.

The following table provides the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale for which the fair value option has been elected.

   
Aggregate fair value
   
Aggregate unpaid principal balance under FVO
   
Fair value carrying amount over (under) unpaid principal
 
   
(in thousands)
 
Loans held for sale
  $ 1,001     $ 1,016     $ (15 )

NOTE 12 – DERIVATIVE FINANCIAL INSTRUMENTS

The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity, as necessary, to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of September 30, 2009, the Company has not entered into a transaction in a dealer capacity.

When a derivative is intended to be a qualifying hedged instrument, the Company prepares written hedge documentation that designates the derivative as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or (2) a hedge of a forecasted transaction, such as the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).

The written documentation includes identification of, among other items, the risk management objective, hedging instrument, hedged item, and methodologies for assessing and measuring hedge effectiveness and ineffectiveness, along with support for management’s assertion that the hedge will be highly effective. Methodologies related to hedge effectiveness and ineffectiveness include (1) statistical regression analysis of changes in the cash flows of the actual derivative and a perfectly effective hypothetical derivative, (2) statistical regression analysis of changes in fair values of the actual derivative and the hedged item and (3) comparison of the critical terms of the hedged item and the hedging derivative. Changes in fair value of a derivative that is highly effective and that has been designated and qualifies as a fair value hedge are recorded in current period earnings, along with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. Changes in the fair value of a derivative that is highly effective and that has been designed and qualifies as a cash flow hedge are initially recorded in other comprehensive income and reclassified to earnings in conjunction with the recognition of the earnings impacts of the hedged item; any ineffective portion is recorded in current period earnings. Designated hedge transactions are reviewed at least quarterly for ongoing effectiveness. Transactions that are no longer deemed to be effective are removed from hedge accounting classification and the recorded impacts of the hedge are recognized in current period income or expense in conjunction with the recognition of the income or expense on the originally hedged item.

The Company’s derivatives are based on underlying risks, primarily interest rates. The Company has utilized swaps to reduce the risks associated with interest rates. Swaps are contracts in which a series of net cash flows, based on a specific notional amount that is related to an underlying risk, are exchanged over a prescribed period. The Company also utilizes forward contracts on the held for sale loan portfolio. The forward contracts hedge against changes in fair value of the held for sale loans.

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Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk is equal to the fair value gain of the derivative. The credit exposure for swaps is the replacement cost of contracts that have become favorable. Credit risk is minimized by entering into transactions with high quality counterparties that are initially approved by the Board of Directors and reviewed periodically by the Asset Liability Committee. It is the Company’s policy of requiring that all derivatives be governed by an International Swap and Derivatives Associations Master Agreement (ISDA). Bilateral collateral agreements may also be required.

On August 28, 2007, the Company elected to terminate a series of seven interest rate swaps with a total notional value of $150 million. At termination, the swaps had a market value of $2.0 million. The gain is being accreted into interest income over the remaining life of the originally hedged items. The Company recognized $120 thousand and $414 thousand in interest income from the terminated swaps for the three and nine months ended September 30, 2009, respectively.

On March 26, 2009, the Company elected to terminate two interest rate swaps with a total notional value of $50 million. At termination, the swaps had a market value of $5.8 million. The Company terminated the swaps to eliminate increasing credit risk with the counterparty. The gain is being accreted into interest income over the remaining life of the originally hedged items. The Company recognized $528 thousand in interest income through the termination date and an additional $22 thousand for the remainder of March 2009. The Company recognized $410 thousand for the three months ended September 30, 2009 for a total of $1,367 thousand for the nine months ended September 30, 2009.

The following table presents the accretion of the remaining gain for the terminated swaps.

      20091       2010       2011       2012    
Total
 
   
(in thousands)
 
Accretion of gain from 2007 terminated swaps
  $ 120     $ 394     $ 219     $ 62     $ 795  
Accretion of gain from 2009 terminated swaps
  $ 411     $ 1,628     $ 1,629     $ 1,272     $ 4,940  
                                         
1 Represents the gain accretion for October 1, 2009 to December 31, 2009. Excludes the amounts recognized in the first nine months of 2009.
 

The following table presents the cash flow hedges as of September 30, 2009.

   
Notional
Amount
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Accumulated
Other
Comprehensive
Income
 
Maturity
Date
   
(in thousands)
Asset hedges
                         
Cash flow hedges: