10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents
Index to Financial Statements

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

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

For the fiscal year ended December 31, 2009

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 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)

Securities Registered Pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.01 par value   The NASDAQ Stock Market LLC

Securities Registered Pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  x

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  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate 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 such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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  ¨          Accelerated filer  x          Non-accelerated filer  ¨          Smaller reporting company  ¨

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

The aggregate market value of the registrant’s outstanding common stock held by nonaffiliates of the registrant as of June 30, 2009, was approximately $56.9 million, based on the registrant’s closing sales price as reported on the NASDAQ Global Select Market. There were 16,418,327 shares of the registrant’s common stock outstanding as of March 15, 2010.

DOCUMENTS INCORPORATED BY REFERENCE

 

Document

 

Parts Into Which Incorporated

Proxy Statement for the Annual Meeting

of Shareholders to be held June 2, 2010

  Part III

 

 

 


Table of Contents
Index to Financial Statements

TABLE OF CONTENTS

 

PART I

  

Item 1.

  

Business

   1

Item 1A.

  

Risk Factors

   21

Item 1B.

  

Unresolved Staff Comments

   33

Item 2.

  

Properties

   33

Item 3.

  

Legal Proceedings

   36

Item 4.

  

[Reserved]

   36

PART II

  

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

  

37

Item 6.

  

Selected Financial Data

   39

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operation

  

45

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   81

Item 8.

  

Financial Statements and Supplementary Data

   83

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

  

128

Item 9A.

  

Controls and Procedures

   128

Item 9B.

  

Other Information

   131

PART III

  

Item 10.

  

Directors, Executive Officers and Corporate Governance

   132

Item 11.

  

Executive Compensation

   132

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

  

132

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

   132

Item 14.

  

Principal Accountant Fees and Services

   132
PART IV   

Item 15.

  

Exhibits and Financial Statement Schedules

   133
SIGNATURES    135

 

i


Table of Contents
Index to Financial Statements

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of our statements contained in this Annual Report, including, without limitation, matters discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements relate to future events or our future financial performance and include statements about the competitiveness of the banking industry, potential regulatory obligations, our entrance and expansion into other markets, our other business strategies and other statements that are not historical facts. Forward-looking statements are not guarantees of performance or results. When we use words like “may,” “plan,” “contemplate,” “anticipate,” “believe,” “intend,” “continue,” “expect,” “project,” “predict,” “estimate,” “could,” “should,” “would,” “will,” and similar expressions, you should consider them as identifying forward-looking statements, although we may use other phrasing. These forward-looking statements involve risks and uncertainties and are based on our beliefs and assumptions, and on the information available to us at the time that these disclosures were prepared.

These forward-looking statements involve risks and uncertainties and may not be realized due to a variety of factors, including, but not limited to the following:

 

   

deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses;

 

   

changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments;

 

   

the failure of assumptions underlying the establishment of reserves for possible loan losses;

 

   

changes in political and economic conditions, including the political and economic effects of the current economic downturn and other major developments, including the ongoing war on terrorism;

 

   

changes in financial market conditions, either internationally, nationally or locally in areas in which First Security conducts its operations, including, without limitation, reduced rates of business formation and growth, commercial and residential real estate development, and real estate prices;

 

   

First Security’s ability to comply with any requirements imposed on it or FSGBank by their respective regulators, and the potential negative consequences that result;

 

   

fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing;

 

   

governmental monetary and fiscal policies, as well as legislative and regulatory changes;

 

   

First Security’s participation or lack of participation in governmental programs implemented under the Emergency Economic Stabilization Act (the “EESA”) and the American Recovery and Reinvestment Act (the “ARRA”), including, without limitation, the CPP administered under the Troubled Asset Relief Program, and the Temporary Liquidity Guarantee Program (the “TLGP”) and the impact of such programs and related regulations on First Security and on international, national, and local economic and financial markets and conditions;

 

   

First Security’s lack of participation in a “stress test” under the Federal Reserve’s Supervisory Capital Assessment Program; the diagnostic and stress testing we conducted differs from that administered under the Supervisory Capital Assessment Program, and the results of our test may be inaccurate;

 

   

the impact of the EESA and the ARRA and related rules and regulations on the business operations and competitiveness of First Security and other participating American financial institutions, including the impact of the executive compensation limits of these acts, which may impact the ability of First Security to retain and recruit executives and other personnel necessary for their businesses and competitiveness;

 

ii


Table of Contents
Index to Financial Statements
   

the risk that First Security may be required to contribute additional capital to FSGBank in the future to enable it to meet its regulatory capital requirements or otherwise;

 

   

the impact of certain provisions of the EESA and ARRA and related rules and regulations on the attractiveness of governmental programs to mitigate the effects of the current economic downturn, including the risks that certain financial institutions may elect not to participate in such programs, thereby decreasing the effectiveness of such programs;

 

   

the risks of changes in interest rates on the level and composition of deposits, loan demand and the values of loan collateral, securities and interest sensitive assets and liabilities;

 

   

the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in our market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone and the Internet; and

 

   

the effect of any mergers, acquisitions or other transactions, to which we or our subsidiary may from time to time be a party, including, without limitation, our ability to successfully integrate any businesses that we acquire.

Many of these risks are beyond our ability to control or predict, and you are cautioned not to put undue reliance on such forward-looking statements. First Security does not intend to update or reissue any forward-looking statements contained in this Annual Report as a result of new information or other circumstances that may become known to First Security.

All written or oral forward-looking statements attributable to us are expressly qualified in their entirety by this Cautionary Note. Our actual results may differ significantly from those we discuss in these forward-looking statements.

For other factors, risks and uncertainties that could cause our actual results to differ materially from estimates and projections contained in these forward-looking statements, please read the “Risk Factors” section of this Annual Report beginning on page 21.

 

iii


Table of Contents
Index to Financial Statements

PART I

 

Item 1. Business

Unless otherwise indicated, all references to “First Security,” “we,” “us,” and “our” in this Annual Report on Form 10-K refer to First Security Group, Inc. and our wholly-owned subsidiary, FSGBank, National Association (FSGBank).

BUSINESS

First Security Group, Inc.

We are a bank holding company headquartered in Chattanooga, Tennessee. We currently operate 39 full-service banking offices and one loan and lease production office through our wholly-owned bank subsidiary, FSGBank. We serve the banking and financial needs of various communities in eastern and middle Tennessee, as well as northern Georgia.

Through FSGBank, we offer a range of lending services that are primarily secured by single and multi-family real estate, residential construction and owner-occupied commercial buildings. In addition, we focus on serving the needs of small- to medium-sized businesses, by offering a range of lending, deposit and wealth management services to these businesses and their owners. Our principal source of funds for loans and securities is core deposits gathered through our branch network. We offer a wide range of deposit services, including checking, savings, money market accounts and certificates of deposit, and obtain most of our deposits from individuals and businesses in our market areas, including the vast majority of our loan customers. Our wealth management division offers private client services, financial planning, trust administration, investment management and estate planning services. We also provide mortgage banking and electronic banking services, such as Internet banking, online bill payment, cash management, ACH originations, and remote deposit capture. We actively pursue business relationships by utilizing the business contacts of our Board of Directors, senior management and local bankers, thereby capitalizing on our extensive knowledge of the local marketplace.

First Security Group, Inc. was incorporated in 1999 as a Tennessee corporation to serve as a bank holding company, and is regulated and supervised by the Board of Governors of the Federal Reserve System (Federal Reserve Board). As of December 31, 2009, we had total assets of approximately $1.4 billion, total deposits of approximately $1.2 billion and tangible stockholders’ equity of approximately $141.6 million.

FSGBank, National Association

FSGBank currently operates 39 full-service banking-offices and one loan and lease production office along the Interstate corridors of eastern and middle Tennessee and northern Georgia, and is primarily regulated by the Office of the Comptroller of the Currency (OCC). In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank, while FSGBank operates under the name of Jackson Bank & Trust along the Interstate 40 corridor. FSGBank also provides trust and investment management, mortgage banking, financial planning and electronic banking services, such as Internet banking (www.FSGBank.com), online bill payment, cash management, ACH originations, and remote deposit capture, as well as equipment leasing through its wholly owned subsidiaries, Kenesaw Leasing and J&S Leasing.

FSGBank is the successor to our three previous banks: Dalton Whitfield Bank (organized in 1999), Frontier Bank (acquired in 2000) and First State Bank (acquired in 2002). From December 31, 2004 to December 31, 2009, our business model has produced strong results through a combination of internal growth and acquisitions. Specifically, we have:

 

   

increased our total consolidated assets from $766.7 million to $1.4 billion;

 

   

increased our total consolidated deposits from $640.5 million to $1.2 billion;

 

1


Table of Contents
Index to Financial Statements
   

increased our total consolidated loans from $592.4 million to $952.0 million; and

 

   

expanded our branch network from 30 branches to 39 branches.

Dalton Whitfield Bank was a state bank organized under the laws of Georgia engaged in a general commercial banking business. Dalton Whitfield Bank opened for business in September 1999, and simultaneously acquired selected assets and substantially all of the deposits of Colonial Bank’s three branches located in Dalton, Georgia. In 2003, Premier National Bank of Dalton merged with and into Dalton Whitfield Bank for an aggregate purchase price of $11.7 million in cash and stock.

Frontier Bank was a state savings bank organized under the laws of Tennessee in 2000 as First Central Bank of Monroe County. We acquired First Central Bank of Monroe County in 2000 for an aggregate purchase price of $2.3 million in cash. After the acquisition, First Central Bank of Monroe County was renamed Frontier Bank and re-chartered as a state bank under the laws of Tennessee to engage in a general commercial banking business. Outside of the Chattanooga market, Frontier Bank operated under the name of “First Security Bank.”

First State Bank was a state bank organized under the laws of Tennessee engaged in a general commercial banking business since its organization in 1974. We acquired First State Bank in 2002 for an aggregate purchase price of $8.6 million in cash.

During 2003, we converted each of our three subsidiary banks into national banks, renamed each bank “FSGBank, National Association” and merged the banks under the charter previously held by Frontier Bank. As a result, we consolidated our banking operations into one subsidiary, FSGBank. FSGBank currently conducts its banking operations in Dalton, Georgia under the names “Dalton Whitfield Bank” and “Primer Banco Seguro.” Primer Banco Seguro is our Latino-focused banking initiative.

Since the mergers in 2003, FSGBank has continued the commercial banking business of its predecessors. In addition, in December of 2003, FSGBank acquired certain assets and assumed substantially all of the deposits and other liabilities of National Bank of Commerce’s three branch offices located in Madisonville, Sweetwater and Tellico Plains, Tennessee.

In October 2004, FSGBank acquired 100% of the capital stock of Kenesaw Leasing and J&S Leasing, both Tennessee corporations, from National Bank of Commerce for $13.0 million in cash. Both companies continue to operate as wholly-owned subsidiaries of FSGBank. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery primarily to companies in the trucking and construction industries.

In August 2005, we acquired Jackson Bank & Trust (Jackson Bank) for an aggregate purchase price of $33.3 million in cash. Jackson Bank was a state commercial bank headquartered in Gainesboro, Tennessee. Jackson Bank was merged into FSGBank, but we continue to operate our banking operations in Jackson and Putnam Counties, Tennessee under the name of “Jackson Bank & Trust.”

FSGBank is a member of the Federal Reserve Bank of Atlanta and a member of the Federal Home Loan Bank of Cincinnati (FHLB). FSGBank’s deposits are insured by the FDIC. FSGBank operates 32 full-service banking offices in eastern and middle Tennessee and seven offices in northern Georgia. Additionally, FSGBank operates one loan and lease production office in Tennessee.

Business Strategy for 2010 and Beyond

We believe there are opportunities for community banks our size to capitalize on the current financial cycle over the next few years. We are committed to enhancing our balance sheet and infrastructure and are focusing on long-term opportunities which improve our ability to benefit from the ongoing market disruption. We target both consumers and small to medium-sized owner-operated businesses in our markets and have developed a localized

 

2


Table of Contents
Index to Financial Statements

approach that focuses on providing superior customer service through our local employees who are relationship-oriented and committed to their respective communities. Through this strategy, we intend to grow our business conservatively, expand our customer base, deepen our customer relationships, and improve our profitability. The key elements of our current operating strategy are as follows:

 

   

Effectively Manage Current Asset Quality and Invest in our Future by Centralizing Credit Functions. We remain focused on our asset quality. Due to both an on-going evaluation of our credit policies and, in an effort to address the quality of our loan portfolio and the conditions affecting the broader economic market, we have taken several steps to manage our loan portfolio proactively, enhance our asset quality controls and centralize our credit function.

As part of our operating strategy in 2010, we have decided to continue to centralize our credit functions and underwriting processes at our Company’s headquarters and to increase our staffing levels in these areas. Specifically, the credit department is now aligned by line of business for commercial and retail credit. We believe that by taking these steps now we will better position ourselves for greater opportunities in the future. We recently added two experienced credit officers, two experienced loan review officers, two experienced special assets officers, an experienced consumer underwriter, an experienced small business underwriter, an experienced retail debt adjuster and we reallocated three existing employees to our centralized document preparation department and an existing employee to retail debt collections. We currently intend to hire an additional experienced special assets officer and a commercial credit officer as we continue to centralize our credit and underwriting processes. With the current and anticipated hiring or re-tasking of employees, we believe that we can improve our overall credit, loan review and underwriting functions which will allow us to compete effectively and strengthen our business and position ourselves to become a larger financial institution. We anticipate that these additional costs will be largely offset with overhead savings as we consolidate our existing regional credit functions.

In addition to centralizing our credit functions, in 2009, our Board of Directors established a board-level asset quality committee to focus exclusively on all aspects of managing the asset quality of our loan portfolio. Due to the rising level of other real estate owned (“OREO”) in our portfolio, we also established an OREO sales team to manage exclusively and sell these properties.

Our goal is to maintain better asset quality measures than our competitors. Based on our previous actions and these additional steps, we believe that we can continue to have asset quality metrics that compare favorably to our peers. Our peer group, as defined by the Uniform Bank Performance report (“UBPR”), consists of all commercial banks between $1 billion and $3 billion in total assets. Based on the December 31, 2009 UBPR, our non-performing loans as a percentage of gross loans was 5.25% compared to 3.77% for our peer group, our allowance as a percentage of non-performing loans was 53.01% compared to 58.76% for our peer group and our allowance as a percentage of gross loans was 2.78% compared to 2.03% for our peer group. We are optimistic that these added steps will help us maintain our performance relative to our peers despite a difficult economy.

In the fourth quarter, we engaged an independent consulting firm to conduct an additional review of our loan portfolio. The primary purpose of the loan review was to evaluate individual credits for compliance with credit and underwriting standards, and to assess the potential impairment of certain credits in which we might experience additional risk of loss. The consultants reviewed over 50% of the entire loan portfolio. Combining this additional evaluation with existing loan review processes, approximately 71% of the entire loan portfolio was reviewed in the last few months of the year. The efforts of these combined loan reviews included approximately 85% of commercial real estate loans and 95% of construction and development loans. The results of these reviews are reflected in the year-end financial statements.

 

   

Focus On Strong Capital and Liquidity. In light of the economic recession and the potential impact it may have on FSGBank, we have focused our efforts on strengthening our capital and liquidity ratios. In January 2009, we issued $33 million in preferred stock to the U.S. Department of the Treasury (the

 

3


Table of Contents
Index to Financial Statements
 

“Treasury”) along with a warrant for 823,627 shares of our common stock, through the Capital Purchase Program (“CPP”). The Company downstreamed $25.0 million to FSGBank in October 2009 in order to further solidify our comparatively strong capital position. Our consolidated tier 1 capital to risk-weighted assets ratio, total risk-based capital to risk-weighted assets ratio and tier 1 leverage ratio were 12.7%, 14.0%, and 10.6%, respectively as of December 31, 2009.

In October 2009, we engaged a nationally recognized, independent consulting firm to complete a stress test of our loan portfolio and to gauge the potential impact of future deterioration in asset quality on our capital position based on different economic scenarios. The method for stress testing the portfolio was based on the technique used by the federal regulators to evaluate the nation’s largest 19 financial institutions in the Supervisory Capital Assessment Program. The results from this stress test are not a prediction of the most likely scenario that exists for us, but rather provide an estimate of losses that we might incur if the current economic environment continues to worsen under certain adverse scenarios. The primary purpose of the stress test was to analyze the adequacy of our capital position against the risks inherent in our loan portfolio in an environment consisting of extremely detrimental economic circumstances. The stress test was tailored to reflect the risk inherent in our portfolio and markets. In December 2009, the independent consulting firm completed the stress test, which indicated that, assuming First Security experienced the credit losses projected under a “more adverse” scenario, we would need to raise and downstream to FSGBank a minimal amount of approximately $200 thousand to satisfy current regulatory well capitalized standards at December 31, 2010.

On January 27, 2010, to further preserve our capital resources, our Board of Directors elected to suspend the dividend on our common stock and elected to defer the dividend payment on our Series A Preferred Stock for the first quarter of 2010. Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our Board of Directors may deem relevant.

Other means of improving our liquidity include a focus on organic core deposit growth and the continued development of alternative funding sources. We use treasury management products and deposit promotions to support core deposit growth and enhance liquidity. In the fourth quarter of 2009, we issued additional brokered CDs to significantly increase our cash account balance at the Federal Reserve Bank of Atlanta. As of December 31, 2009, our balance at the Federal Reserve Bank of Atlanta was approximately $148.4 million.

 

   

Increase Our Market Share Along Interstate Corridors in Eastern and Middle Tennessee and Northern Georgia. We believe we are taking the necessary steps to make FSGBank scalable into a much larger institution. We will seek to increase market share in our primary markets along the Interstate 75 and Interstate 40 corridors as well as to extend into other interstate corridors in eastern and middle Tennessee and northern Georgia through organic growth opportunities. These interstate communities are primarily served by branches of large regional and national financial institutions headquartered outside of the area. As a result, we believe these markets need, and are best served by, a locally owned and operated financial institution managed by people from the communities served. As we grow, we continue to believe that it is important to be positioned to react to changes in local markets, while at the same time benefiting from the economies of scale created by our size.

 

   

Continue to Evaluate Strategic Acquisitions In Our Core Markets. Beyond 2010, we intend to continue our overall growth strategy in part through selected strategic acquisitions in our core markets. Specifically, we may consider seeking regulatory permission to acquire failed financial institutions that fit with our current strategy through FDIC-assisted transactions that will limit potential credit risks typically associated with acquisitions of this type in the current environment. We believe that many opportunities remain in our market area to expand, and with a strong capital base, we intend to be in a position to consider acquiring additional market share through one or more acquisitions if the appropriate opportunities arise. With thorough diligence and risk evaluation, we will work to identify

 

4


Table of Contents
Index to Financial Statements
 

targets that will help us achieve our strategic and financial targets. Although the interstate corridors are our primary focus, we may consider acquiring banking operations outside of the interstate corridors if we identify attractive opportunities.

 

   

Maintain Local Knowledge With Corporate Oversight and Control. We effectively compete with our regional competitors by offering personalized and flexible banking services in addition to providing superior customer service. We designate regional bank presidents and separate advisory boards in each of our markets so that we are positioned to react quickly to changes in those communities while maintaining efficient and consistent centralized reporting and policies. While we give our local markets certain flexibility to price products to compete effectively locally, we have implemented measures to increase the centralization of our credit functions and underwriting and standardize our deposit products, thereby maintaining better control over our overall asset quality and interest rate exposure as we grow.

Market Area and Competition

We currently conduct business principally through 39 branches in our market areas of Bradley, Hamilton, Jackson, Jefferson, Knox, Loudon, McMinn, Monroe, Putnam and Union Counties, Tennessee and Catoosa and Whitfield Counties, Georgia. Our markets follow the Interstate 75 corridor between Dalton, Georgia (approximately one hour north of Atlanta, Georgia) and Jefferson City, Tennessee (approximately 30 minutes north of Knoxville, Tennessee) and the Interstate 40 corridor between Nashville, Tennessee and Knoxville, Tennessee. Based upon data available from the FDIC as of June 30, 2009, FSGBank’s total deposits ranked 6th among financial institutions in our market area, representing approximately 4.5% of the total deposits in our market area.

The table below shows our deposit market share in the counties we serve according to data from the FDIC website as of June 30, 2009.

 

Market

   Number of
Branches
   Our Market
Deposits
   Total
Market
Deposits
   Ranking    Market Share
Percentage
(%)
 
     (dollar amounts in millions)  

Tennessee

              

Bradley County

   2    $ 17    $ 1,509    9    1.1

Hamilton County1

   9      388      6,078    4    6.4

Jackson County

   3      67      121    1    55.0

Jefferson County

   2      99      529    2    18.8

Knox County

   3      61      8,406    11    0.7

Loudon County

   2      32      743    7    4.3

McMinn County

   1      28      880    8    3.2

Monroe County

   5      68      629    5    10.9

Putnam County

   3      78      1,422    6    5.5

Union County

   2      45      120    2    37.3

Georgia

              

Catoosa County

   1      5      889    9    0.6

Whitfield County

   6      148      1,670    3    8.9
                        

FSGBank

   39    $ 1,036    $ 22,996    6    4.5
                        

 

1

Our brokered deposits, totalling $207.6 million at June 30, 2009, are included in the totals for Hamilton County.

Our retail, commercial and mortgage divisions operate in highly competitive markets. We compete directly in retail and commercial banking markets with other commercial banks, savings and loan associations, credit unions, mortgage brokers and mortgage companies, mutual funds, securities brokers, consumer finance companies, other lenders and insurance companies, locally, regionally and nationally. Many of our competitors

 

5


Table of Contents
Index to Financial Statements

compete with offerings by mail, telephone, computer and/or the Internet. Interest rates, both on loans and deposits, and prices of services are significant competitive factors among financial institutions generally. Office locations, types and quality of services and products, office hours, customer service, a local presence, community reputation and continuity of personnel are also important competitive factors that we emphasize.

Many other commercial or savings institutions currently have offices in our primary market areas. These institutions include many of the largest banks operating in Tennessee and Georgia, including some of the largest banks in the country. Many of our competitors serve the same counties we do. Within our market area, there are 68 different commercial or savings institutions.

Virtually every type of competitor has offices in Atlanta, Georgia, approximately 75 miles from Dalton and 100 miles from Chattanooga. In our market area, our largest competitors include First Tennessee, SunTrust, Regions, BB&T and Wells Fargo. These institutions, as well as other competitors of ours, have greater resources, have broader geographic markets, have higher lending limits, offer various services that we do not offer and can better afford and make broader use of media advertising, support services and electronic technology than we do. To offset these competitive disadvantages, we depend on our reputation as being an independent and locally-owned community bank and as having greater personal service, community involvement and ability to make credit and other business decisions quickly and locally.

Lending Activities

We originate loans primarily secured by single and multi-family real estate, residential construction and owner-occupied commercial buildings. In addition, we make loans to small and medium-sized commercial businesses, as well as to consumers for a variety of purposes.

Our loan portfolio at December 31, 2009 was comprised as follows:

 

     Amount    Percentage of
Portfolio
 
     (in thousands, except percentages)  

Loans secured by real estate—

     

Residential 1-4 family

   $ 281,354    29.7

Commercial

     259,819    27.3

Construction

     153,144    16.1

Multi-family and farmland

     37,960    4.0
             
     732,277    77.1

Commercial loans

     146,016    15.3

Consumer installment loans

     48,927    5.1

Leases, net of unearned income

     19,730    2.0

Other

     5,068    0.5
             

Total loans

   $ 952,018    100.0
             

 

6


Table of Contents
Index to Financial Statements

In addition, we have entered into contractual obligations, via lines of credit and standby letters of credit, to extend approximately $185.6 million and $16.1 million, respectively, in credit as of December 31, 2009. We use the same credit policies in making these commitments as we do for our other loans. At December 31, 2009, our contractual obligations to extend credit were comprised as follow:

 

     Amount    Percentage of
Contractual
Obligations
 
     (in thousands, except percentages)  

Contractual obligations secured by real estate—

     

Residential 1-4 family

   $ 63,036    34.0

Commercial

     12,405    6.7

Construction

     33,838    18.2

Multi-family and farmland

     1,822    1.0
             
     111,101    59.9

Commercial loans

     57,406    30.9

Consumer installment loans

     15,333    8.3

Leases, net of unearned income

     —      —  

Other

     1,799    0.9
             

Total contractual obligations

   $ 185,639    100.0
             

Real EstateResidential 1-4 Family. Our residential mortgage loan program primarily originates loans for the purchase of residential property to individuals for other third-party lenders. Residential loans to individuals retained in our loan portfolio primarily consist of first liens on 1-4 family residential mortgages, home equity loans and lines of credit. These loans are generally made on the basis of the borrower’s ability to repay the loan from his or her employment and other income and are secured by residential real estate, the value of which is reasonably ascertainable. We expect that these loan-to-value ratios will be sufficient to compensate for fluctuations in real estate market value and to minimize losses that could result from a downturn in the residential real estate market. We generally do not retain long term, fixed rate residential real estate loans in our portfolio due to interest rate and collateral risks and low levels of profitability.

Real EstateCommercial, Multi-Family and Farmland. We make commercial mortgage loans to finance the purchase of real property as well as loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, including letters of credit, that are also secured by real estate. Commercial mortgage lending typically involves higher loan principal amounts, and the repayment of loans is dependent, in large part, on sufficient income from the properties collateralizing the loans to cover operating expenses and debt service. As a general practice, we require our commercial mortgage loans to be collateralized by well-managed income producing property with adequate margins and to be guaranteed by responsible parties. In addition, a substantial percentage of our commercial mortgage loan portfolio is secured by owner-occupied commercial buildings. We look for opportunities where cash flow from the business located in the owner-occupied building provides adequate debt service coverage and the guarantor’s net worth is centered on assets other than the project we are financing. Our commercial mortgage loans are generally collateralized by first liens on real estate, have fixed or floating interest rates and amortize over a 10 to 20-year period with balloon payments due at the end of one to five years. Payments on loans collateralized by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market.

In underwriting commercial mortgage loans, we seek to minimize our risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition. Our underwriting analysis also includes credit checks, reviews of appraisals and environmental hazards or EPA reports and a review of the financial condition of the borrower. We attempt to limit our risk by analyzing our borrowers’ cash flow and collateral value on an ongoing basis.

 

7


Table of Contents
Index to Financial Statements

Real EstateConstruction. We also make construction and development loans to residential and, to a lesser extent, commercial contractors and developers located within our market areas. Construction loans generally are secured by first liens on real estate and have floating interest rates. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the value of the project is dependent on its successful completion. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, upon the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, there is no assurance that we will be able to recover all of the unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While we have underwriting procedures designed to identify what we believe to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above. We are currently in the process of reducing our exposure to construction and development loans.

CommercialLoans. Our commercial loan portfolio includes loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, as well as letters of credit that are generally secured by collateral other than real estate. Commercial borrowers typically secure their loans with assets of the business, personal guaranties of their principals and often mortgages on the principals’ personal residences. Our commercial loans are primarily made within our market areas and are underwritten on the basis of the commercial borrower’s ability to service the debt from income. In general, commercial loans involve more credit risk than residential and commercial mortgage loans, but less risk than consumer loans. The increased risk in commercial loans is generally due to the type of assets collateralizing these loans. The increased risk also derives from the expectation that commercial loans generally will be serviced from the operations of the business, and those operations may not be successful.

Consumer. We make a variety of loans to individuals for personal, family and household purposes, including secured and unsecured installment and term loans. Consumer loans entail greater risk than other loans, particularly in the case of consumer loans that are unsecured or secured by depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by job loss, divorce, illness or personal hardships.

Leases, Net of Unearned Income. Our commercial lease portfolio includes leases made by our leasing companies, Kenesaw Leasing and J&S Leasing. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery to owner-managed businesses primarily in the trucking and construction industries. The leased property usually serves as collateral for the lease. Our commercial leases are underwritten on the basis of the value of the underlying leased property as well as the basis of the commercial lessee’s ability to service the lease. We anticipate centralizing lease underwriting by March 31, 2010. Commercial leases generally entail greater risks than commercial loans or loans secured by real estate, but less risk than unsecured consumer loans. The increased risk in commercial leases is generally due to the rolling stock nature of the items leased, as well as the illiquid nature of the secondary market for used equipment. The increased risk also derives from the low barriers to entry in the trucking and construction industries. We are currently in the process of reducing our exposure to commercial leases by focusing our efforts on portfolio management of existing relationships instead of new business development.

Credit Risks. The principal economic risk associated with each category of the loans that we make is the creditworthiness of the borrower and the ability of the borrower to repay the loan. General economic conditions and the strength of the services and retail market segments affect borrower creditworthiness. General factors affecting a commercial borrower’s ability to repay include interest rates, inflation and the demand for the commercial borrower’s products and services, as well as other factors affecting a borrower’s customers, suppliers and employees.

 

8


Table of Contents
Index to Financial Statements

Risks associated with real estate loans also include fluctuations in the value of real estate, new job creation trends, tenant vacancy rates and, in the case of commercial borrowers, the quality of the borrower’s management. Consumer loan repayments depend upon the borrower’s financial stability and are more likely to be adversely affected by divorce, job loss, illness and personal hardships.

Lending Policies. Our Board of Directors has established and periodically reviews our bank’s lending policies and procedures. We have established common documentation and standards based on the type of loans among our regions. There are regulatory restrictions on the dollar amount of loans available for each lending relationship. National banking regulations provide that no loan relationship may exceed 15% of a bank’s Tier 1 capital. At December 31, 2009, our legal lending limit was approximately $18.2 million. In addition, we have established a “house” limit of $10 million for each lending relationship. Any loan request exceeding the house limit must be approved by a committee of our Board of Directors. We occasionally sell participation interests in loans to other lenders, primarily when a loan exceeds our house lending limits.

Concentrations. The retail nature of our commercial banking operations allows for diversification of depositors and borrowers, and we believe that our business does not depend upon a single or a few customers. We also do not believe that our credits are concentrated within a single industry or group of related industries.

The economy in our Dalton, Georgia market area is generally dependent upon the carpet industry and changes in construction of residential and commercial establishments. While the Dalton economy is dominated by the carpet and carpet-related industries, we do not have any one customer from whom more than 10% of our revenues are derived. However, we have multiple customers, commercial and retail, that are directly or indirectly affected by, or are engaged in businesses related to the carpet industry that, in the aggregate, have historically provided greater than 10% of our revenues.

The federal banking regulators have issued guidance regarding the risks posed by commercial real estate (CRE) lending concentrations. CRE loans generally include land development, construction loans and loans secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines to help identify institutions that are potentially exposed to significant CRE risk:

 

   

total reported loans for construction, land development and other land represent 100% or more of the institution’s total capital, or

 

   

total commercial real estate loans represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more.

As of December 31, 2009, our total CRE concentration was well below the 300% threshold of the CRE guidance, however, our construction and land development loans represented approximately 114% of the Bank’s total risk-based capital. The primary credit risks associated with this type of lending are underwriting and project risks. Project risks include cost overruns, borrower credit risk, project completion risk, general contractor credit risk, and environmental and other hazard risks. Market risks are risks associated with the sale of the completed residential units. They include affordability risk, which means the risk that borrowers cannot obtain affordable financing, product design risk, and risks posed by competing projects. We have been actively reducing this exposure and anticipate this ratio to be under the 100% threshold of the CRE guidance by March 31, 2010.

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2009, approximately 76.9% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized.

 

9


Table of Contents
Index to Financial Statements

We offer a variety of loan products with payment terms and rate structures that have been designed to meet the needs of our customers within an established framework of acceptable credit risk. Payment terms range from fully amortizing loans that require periodic principal and interest payments to terms that require periodic payments of interest-only with principal due at maturity. Interest-only loans are a typical characteristic in commercial and home equity lines-of-credit and construction loans (residential and commercial). As of December 31, 2009, we had approximately $411.5 million of interest-only loans, which primarily consist of construction and land development loans (27.9%), commercial and industrial loans (21.2%), home equity loans (21.1%) and commercial real estate loans (8.1%). The loans have an average maturity of approximately 18 months or less, with the exception of home equity lines-of-credit which have an average maturity of approximately six and a half years. The interest-only loans are fully underwritten and within our lending policies.

We do not offer, hold or service option adjustable rate mortgages that may expose the borrowers to future increases in repayments in excess of changes resulting solely from increases in the market rate of interest (loans subject to negative amortization).

Deposits

Our principal source of funds for loans and investing in securities is core deposits. We offer a wide range of deposit services, including checking, savings, money market accounts and certificates of deposit. We obtain most of our deposits from individuals and businesses in our market areas. We believe that the rates we offer for core deposits are competitive with those offered by other financial institutions in our market areas. We have also chosen to obtain a portion of our deposits from outside our market through brokered deposits. Our brokered deposits represented 28.7% of total deposits as of December 31, 2009. Other sources of funding include advances from the FHLB, subordinated debt and other borrowings. These other sources enable us to borrow funds at rates and terms, which at times, are more beneficial to us. During the fourth quarter of 2009, we enhanced our liquidity by issuing over $161 million in brokered deposits and placing the excess funds in our interest bearing deposit account at the Federal Reserve Bank of Atlanta. At December 31, 2009, our balance at the Federal Reserve Bank of Atlanta was approximately $148.5 million. This excess cash is available to fund our contractual obligations and prudent investment opportunities.

Other Banking Services

Given client demand for increased convenience and account access, we offer a range of products and services, including 24-hour internet banking, ACH transactions, remote deposit capture, wire transfers, direct deposit, traveler’s checks, safe deposit boxes, and United States savings bonds. We earn fees for most of these services. We also receive ATM transaction fees from transactions performed by our customers participating in a shared network of ATMs and a debit card system that our customers can use throughout Tennessee and Georgia, as well as in other states. Additionally, we offer wealth management services including private client services, financial planning, trust administration, investment management and estate planning services.

Securities

After establishing necessary cash reserves and funding loans, we invest our remaining liquid assets in securities allowed under banking laws and regulations. We invest primarily in obligations of the United States or obligations guaranteed as to principal and interest by the United States, other taxable securities and in certain obligations of states and municipalities. We also invest excess funds in federal funds with our correspondent banks and in our interest bearing account at the Federal Reserve Bank of Atlanta. The sale of federal funds represents a short-term loan from us to another bank. Risks associated with securities include, but are not limited to, interest rate fluctuation, market illiquidity, maturity and concentration.

 

10


Table of Contents
Index to Financial Statements

Seasonality and Cycles

Although we do not consider our commercial banking business to be seasonal, our mortgage banking business is somewhat seasonal, with the volume of home financings, in particular, being lower during the winter months. Additionally, the Dalton, Georgia economy is seasonal and cyclical as a result of its dependence upon the carpet industry and changes in construction of residential and commercial establishments. While the Dalton, Georgia economy is dominated by the carpet and carpet-related industries, we do not have any one customer from whom more than 10% of our revenues are derived. However, we have multiple customers, commercial and retail, that are directly or indirectly affected by, or are engaged in businesses related to the carpet industry that, in the aggregate, have historically provided greater than 10% of our revenues.

Employees

On December 31, 2009, we had 330 full-time employees and 26 part-time employees. We consider our employee relations to be good, and we have no collective bargaining agreements with any employees.

Website Address

Our corporate website address is www.FSGBank.com. From this website, select the “Corporate Info” tab followed by selecting “Investor Relations.” Our filings with the Securities and Exchange Commission (SEC), including but not limited to our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to these reports are available and accessible soon after we file them with the SEC.

 

11


Table of Contents
Index to Financial Statements

SUPERVISION AND REGULATION

Both First Security and FSGBank are subject to extensive state and federal banking regulations that impose restrictions on and provide for general regulatory oversight of their operations. These laws are generally intended to protect depositors, not stockholders. Legislation and regulations authorized by legislation influence, among other things:

 

   

how, when and where we may expand geographically;

 

   

into what product or service market we may enter;

 

   

how we must manage our assets or liabilities; and

 

   

under what circumstances money may or must flow between the parent bank holding company and the subsidiary bank.

Set forth below is an explanation of the major pieces of legislation affecting our industry and how that legislation affects our actions. The following summary is qualified by reference to the statutory and regulatory provisions discussed. Changes in applicable laws or regulations may have a material effect on our business and prospects, and legislative changes and the policies of various regulatory authorities may significantly affect our operations. We cannot predict the effect that fiscal or monetary policies, or new federal or state legislation may have on our business and earnings in the future.

First Security

Because we own all of the capital stock of FSGBank, we are a bank holding company under the Federal Bank Holding Company Act of 1956. As a result, we are primarily subject to the supervision, examination and reporting requirements of the Bank Holding Company Act and the regulations of the Federal Reserve Board.

Acquisitions of Banks. The Bank Holding Company Act requires every bank holding company to obtain the Federal Reserve Board’s prior approval before:

 

   

acquiring direct or indirect ownership or control of any voting shares of any bank if, after the acquisition, the bank holding company will directly or indirectly own or control more than 5% of the bank’s voting shares;

 

   

acquiring all or substantially all of the assets of any bank; or

 

   

merging or consolidating with any other bank holding company.

Additionally, the Bank Holding Company Act provides that the Federal Reserve Board may not approve any of these transactions if it would result in or tend to create a monopoly, substantially lessen competition or otherwise function as a restraint of trade, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve Board is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks concerned. The Federal Reserve Board’s consideration of financial resources generally focuses on capital adequacy, which is discussed below.

Under the Bank Holding Company Act, if we are adequately capitalized and adequately managed, we or any other bank holding company located within Tennessee or Georgia, may purchase a bank located outside of Tennessee or Georgia. Conversely, an adequately capitalized and adequately managed bank holding company located outside of Tennessee or Georgia may purchase a bank located inside Tennessee or Georgia. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in specified concentrations of deposits. Currently, Georgia law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been

 

12


Table of Contents
Index to Financial Statements

incorporated for three years, and Tennessee law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been incorporated for five years. Because FSGBank has been chartered for more than five years, this restriction would not limit our ability to sell.

Change in Bank Control. Subject to various exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with related regulations, require Federal Reserve Board approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of a bank holding company. Control is also presumed to exist, although rebuttable, if a person or company acquires 10% or more, but less than 25%, of any class of voting securities and either:

 

   

the bank holding company has registered securities under Section 12 of the Securities Exchange Act of 1934; or

 

   

no other person owns a greater percentage of that class of voting securities immediately after the transaction.

Our common stock is registered under Section 12 of the Securities Exchange Act of 1934. The regulations provide a procedure for challenging rebuttable presumptions of control.

Permitted Activities. The Bank Holding Company Act has generally prohibited a bank holding company from engaging in activities other than banking or management or controlling banks or other permissible subsidiaries and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those determined by the Federal Reserve Board to be closely related to banking or managing or controlling banks, as to be a proper incident thereto. Provisions of the Gramm-Leach-Bliley Act have expanded the permissible activities of a bank holding company that qualifies as a financial holding company. Under the regulations implementing the Gramm-Leach-Bliley Act, a financial holding company may engage in additional activities that are financial in nature or incidental or complementary to financial activity. Those activities include, among other activities, certain insurance and securities activities.

To qualify to become a financial holding company, FSGBank and any other depository institution subsidiary of First Security must be well capitalized and well managed and must have a Community Reinvestment Act rating of at least “satisfactory.” Additionally, we must file an election with the Federal Reserve Board to become a financial holding company and must provide the Federal Reserve Board with 30 days’ written notice prior to engaging in a permitted financial activity. While we meet the qualification standards applicable to financial holding companies, we have not elected to become a financial holding company at this time.

Support of FSGBank. Under Federal Reserve Board policy, we are expected to act as a source of financial strength for FSGBank and to commit resources to support FSGBank. This support may be required at times when, without this Federal Reserve Board policy, we might not be inclined to provide it. In addition, any capital loans made by us to FSGBank will be repaid only after its deposits and various other obligations are repaid in full. In the unlikely event of our bankruptcy, any commitment by us to a federal bank regulatory agency to maintain the capital of FSGBank will be assumed by the bankruptcy trustee and would be entitled to a priority of payment.

FSGBank

Because FSGBank is chartered as a national bank, it is primarily subject to the supervision, examination and reporting requirements of the National Bank Act and the regulations of the OCC. The OCC regularly examines FSGBank’s operations and has the authority to approve or disapprove mergers, the establishment of branches and similar corporate actions. The OCC also has the power to prevent the continuance or development of unsafe or unsound banking practices or other violations of law. Because FSGBank’s deposits are insured by the FDIC to the maximum extent provided by law, FSGBank is subject to certain FDIC regulations and the FDIC also has

 

13


Table of Contents
Index to Financial Statements

back-up examination and enforcement power over FSGBank. FSGBank is also subject to numerous state and federal statutes and regulations that affect its business, activities and operations.

Branching. National banks are required by the National Bank Act to adhere to branching laws applicable to state banks in the states in which they are located. Under both Tennessee and Georgia law, FSGBank may open branch offices throughout Tennessee or Georgia with the prior approval of the OCC. In addition, with prior regulatory approval, FSGBank may acquire branches of existing banks located in Tennessee or Georgia. FSGBank and any other national or state-chartered bank generally may branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. Tennessee and Georgia law, with limited exceptions, currently permit branching across state lines through interstate mergers.

Under the Federal Deposit Insurance Act, states may “opt-in” and allow out-of-state banks to branch into their state by establishing a new start-up branch in the state. Tennessee has opted in and therefore, any out-of-state bank can establish a start-up branch in Tennessee as long as that state’s banking law would also allow Tennessee banks to establish start-up branches in that state. Therefore, FSGBank may establish start-up branches in any state that would allow a Tennessee bank to do the same.

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, the federal banking regulators have established five capital categories in which all institutions are placed: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.

As a bank’s capital condition deteriorates, federal banking regulators are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. The three most significant categories, however, are well capitalized, adequately capitalized, and undercapitalized. At December 31, 2009, FSGBank was categorized as well capitalized.

A “well capitalized” bank is one that is not subject to any written agreement, order or capital directive to meet and maintain a specific capital level for any capital measure, and that maintain a total risk-based capital ratio of at least 10%, a tier 1 risk-based capital ratio of at least 6% and a tier 1 leverage ratio of at least 5%. Generally, a classification as well capitalized will place a bank outside of the regulatory zone for purposes of prompt corrective action. However, a well capitalized bank may be reclassified as “adequately capitalized” based on criteria other than capital, if the federal regulator determines that a bank requires certain remedial action.

An “adequately capitalized” bank is one that maintains a total risk-based capital ratio of at least 8%, a tier 1 risk-based capital ratio of at least 4% and a tier 1 leverage ratio of at least 4%. A bank that is adequately capitalized is prohibited from directly or indirectly accepting, renewing or rolling over any brokered deposits, absent applying for and receiving a waiver from the FDIC, and is subject to rate restrictions on the level of interest that it can pay on deposits. In addition, an adequately capitalized bank may be required by its federal regulator to comply with operating restrictions similar to those placed on undercapitalized banks.

An “undercapitalized” bank is one that fails to meet the required minimum level for any capital measure required to be deemed adequately capitalized. A bank that reaches the undercapitalized level is subject to enhanced monitoring by federal regulators, restrictions on asset growth, acquisitions, branching and engaging in new lines of business, and is required to submit a capital restoration plan. In addition, an undercapitalized institution is subject to discretionary safeguards whereby the primary federal regulator can:

 

   

prohibit capital distributions;

 

   

prohibit payment of management fees to a controlling person;

 

14


Table of Contents
Index to Financial Statements
   

require sale of securities, or, if grounds for conservatorship or receivership exist, direct the bank to merge or be acquired;

 

   

restrict affiliate transactions;

 

   

restrict or prohibit all activities that are determined to pose an excessive risk to the bank;

 

   

require the institution to elect new directors, dismiss directors or senior executive officer or employ qualified senior executive officers to improve management;

 

   

prohibit the acceptance of deposits from correspondent banks;

 

   

require prior approval of capital distributions by holding companies;

 

   

require holding company divestiture of the bank, bank divestiture of subsidiaries, and/or holding company divestiture of other affiliates;

 

   

require the bank to take any other action the federal regulator determines will “better achieve” prompt corrective action objectives;

 

   

prohibit material transactions outside the usual course of business;

 

   

prohibit amending the bylaws/charter of the bank;

 

   

prohibit any material changes in accounting methods; and

 

   

prohibit golden parachute payments, excessive compensation and bonuses.

FDIC Insurance Assessments. FSGBank’s deposits are insured by the Deposit Insurance Fund (the “DIF”) of the FDIC up to the amount permitted by law. FSGBank is thus subject to FDIC deposit insurance premium assessments. The FDIC uses a risk-based assessment system that assigns insured depository institutions to one of four risk categories based on three primary sources of information—supervisory risk ratings for all institutions, financial ratios for most institutions, including FSGBank, and long-term debt issuer ratings for large institutions that have such ratings. In February 2009, the FDIC issued new risk based assessment rates that took effect April 1, 2009. For insured depository institutions in the lowest risk category, the annual assessment rate ranges from 7 to 24 cents for every $100 of domestic deposits. For institutions assigned to higher risk categories, the new assessment rates range from 17 to 77.5 cents per $100 of domestic deposits. These ranges reflect a possible downward adjustment for unsecured debt outstanding and possible upward adjustments for secured liabilities and, in the case of institutions outside the lowest risk category, brokered deposits.

The FDIC’s assessment rates are intended to result in a reserve ratio of at least 1.15%. As of December 31, 2008, the ratio had fallen well below this floor. The FDIC is required to return the DIF to its statutorily mandated minimum reserve ratio of 1.15% within eight years. On September 30, 2009, the FDIC collected a one-time special assessment of five basis points of an institution’s assets minus tier 1 capital as of June 30, 2009. The amount of the special assessment could not exceed ten basis points times the institution’s assessment base for the second quarter 2009. On November 12, 2009, the FDIC adopted a final rule that required nearly all FDIC-insured depositor-institutions to prepay their DIF assessments for the fourth quarter of 2009 and for the next three years. This prepayment did not affect FSGBank’s net income. The FDIC has indicated that the prepayment of DIF assessments would be in lieu of additional special assessments.

The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of The Financing Corporation (FICO). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and in 2009 ranged from 1.02 cents to 1.14 cents per $100 of assessable deposits. These assessments will continue until the debt matures in 2017 through 2019.

The FDIC may, without further notice-and-comment rulemaking, adopt rates that are higher or lower than the stated base assessment rates, provided that the FDIC cannot (i) increase or decrease the total rates from one

 

15


Table of Contents
Index to Financial Statements

quarter to the next by more than three basis points, or (ii) deviate by more than three basis points from the stated assessment rates. The FDIC has proposed maintaining current assessment rates through December 31, 2010, followed by a uniform increase in risk-based assessment rates of three basis points effective January 1, 2011.

The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, or condition imposed by the FDIC.

FDIC Temporary Liquidity Guarantee Program. On October 14, 2008, the FDIC announced that its Board of Directors, under the authority to prevent “systemic risk” in the U.S. banking system, approved the Temporary Liquidity Guarantee Program (“TLGP”). The purpose of the TLGP is to strengthen confidence and encourage liquidity in the banking system. The TLGP is composed of two components, the Debt Guarantee Program and the Transaction Account Guarantee Program, and institutions had the opportunity, prior to December 5, 2008, to opt out of either or both components of the TLGP.

The Debt Guarantee Program: Under the TLGP, the FDIC guarantees certain newly issued senior unsecured debt issued through October 31, 2009 by participating financial institutions. Neither First Security nor FSGBank issued any debt guaranteed by the FDIC under the Debt Guarantee component of the TLGP.

The Transaction Account Guarantee Program: Under the TLGP, the FDIC fully guarantees funds in non-interest bearing deposit accounts held at participating FDIC-insured institutions, regardless of dollar amount. The temporary guarantee originally was scheduled to expire at the end of 2009. On August 26, 2009, the FDIC extended the program through June 30, 2010. During the original period, the FDIC imposed a 10 basis point annual rate surcharge will be applied to noninterest-bearing transaction deposit amounts over $250,000. For the extension period, this surcharge will be between 15 and 25 basis points on an annualized basis. Institutions will not be assessed on amounts that are otherwise insured. FSGBank did not opt out of the original or extension periods of the Transaction Account Guarantee component of the TLGP.

Community Reinvestment Act. The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their respective jurisdictions, the federal banking regulators shall evaluate the record of each financial institution in meeting the credit needs of its local community, including low and moderate-income neighborhoods. These facts are also considered in evaluating mergers, acquisitions and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on FSGBank. Additionally, we must publicly disclose the terms of various Community Reinvestment Act-related agreements.

Allowance for Loan and Lease Losses. The Allowance for Loan and Lease Losses (ALLL) represents one of the most significant estimates in our financial statements and regulatory reports. Because of its significance, we have developed a system by which we develop, maintain and document a comprehensive, systematic and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses. The “Interagency Policy Statement on the Allowance for Loan and Lease Losses” issued on December 13, 2006, encourages all banks to ensure controls are in place to consistently determine the ALLL in accordance with GAAP, FSGBank’s stated policies and procedures, management’s best judgment and relevant supervisory guidance. Consistent with supervisory guidance, we maintain a prudent and conservative, but not excessive, ALLL, that is at a level that is appropriate to cover estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio. The allowance for loan and lease losses, and our methodology for calculating the allowance, are fully described in Note 1 to our consolidated financial statements under “Allowance for Loan and Lease Losses” on page 93, and in the “Management’s Discussion and Analysis—Statement of Financial Condition—Allowance for Loan and Lease Losses” section on pages 61 through 67.

 

16


Table of Contents
Index to Financial Statements

Commercial Real Estate Lending. Our lending operations may be subject to enhanced scrutiny by federal banking regulators based on our concentration of commercial real estate loans. On December 6, 2006, the federal banking regulators issued final guidance to remind financial institutions of the risk posed by commercial real estate (“CRE”) lending concentrations. CRE loans generally include land development, construction loans and loans secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines for its examiners to help identify institutions that are potentially exposed to significant CRE risk and may warrant greater supervisory scrutiny:

 

   

total reported loans for construction, land development and other land represent 100% or more of the institution’s total capital, or

 

   

total commercial real estate loans represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more.

As of December 31, 2009, our total CRE concentration was well below the 300% threshold of the CRE guidance, however, our construction and land development loans represented approximately 114% of the Bank’s total risk-based capital. We have been actively reducing this exposure and anticipate this ratio to be under the 100% threshold of the CRE guidance by March 31, 2010.

Other Regulations. Interest and other charges collected or contracted for by FSGBank are subject to state usury laws and federal laws concerning interest rates. FSGBank’s loan operations are also subject to federal laws applicable to credit transactions, such as the:

 

   

Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 

   

Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 

   

Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;

 

   

Fair Credit Reporting Act of 1978, as amended by the Fair and Accurate Credit Transactions Act, governing the use and provision of information to credit reporting agencies, certain identify theft protections, and certain other credit disclosures;

 

   

Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

   

National Flood Insurance Act and Flood Disaster Protection Act, requiring flood insurance to extend or renew certain loans in flood plains;

 

   

Real Estate Settlement Procedures Act, requiring certain disclosures concerning loan closing costs and escrows, and governing transfers of loan servicing and the amounts of escrows, in connection with loans secured by one-to-four family residential properties;

 

   

Soldiers’ and Sailors’ Civil Relief Act of 1940, as amended, governing the repayment terms of, and property rights underlying, secured obligations of currently on active duty with the United States military;

 

   

Talent Amendment in the 2007 Defense Authorization Act, establishing a 36% annual percentage rate ceiling, which includes a variety of charges including late fees, for consumer loans to military service members and their dependents;

 

   

lending restrictions and limitations set forth in sections 22(g) and 22(h) of the Federal Reserve Act regarding loans and other extensions of credit made to executive officers, directors, principal stockholders and other insiders; and

 

17


Table of Contents
Index to Financial Statements
   

rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

FSGBank’s deposit operations are also subject to federal laws applicable to depository accounts, such as the:

 

   

Truth in Savings Act, requiring certain disclosures for consumer deposit accounts;

 

   

Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;

 

   

Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve Board to implement that act, governing automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; and

 

   

rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

As part of the overall conduct of the business, First Security and FSGBank must comply with:

 

   

privacy and data security laws and regulations at both the federal and state level; and

 

   

anti-money laundering laws, including the USA Patriot Act.

Capital Adequacy

The Federal Reserve and the OCC require that First Security and FSGBank meet certain minimum ratios of capital to assets in order to conduct their activities. Two measures of regulatory capital are used in calculating these ratios—tier 1 capital and total capital. Tier 1 capital generally includes common equity, retained earnings, a limited amount of qualifying preferred stock, and qualifying minority interests in consolidated subsidiaries, reduced by goodwill and certain other intangible assets, such as core deposit intangibles, and certain other assets. Total capital generally consists of tier 1 capital plus a limited amount of the allowance for loan and lease losses, preferred stock that did not qualify as tier 1 capital, certain types of subordinated debt and a limited amount of other items.

Two of FSGBank’s capital ratios are intended to reflect a cushion against credit risk and are the result of the division of tier 1 capital and of total capital, respectively, by the asset total weighted for risk. Certain assets, such as cash and Treasury securities, have a zero risk weight. Others, such as commercial and consumer loans, often have a 100% risk weight. Some assets may be assigned to risk weight categories ranging between 0% and 100%. Certain off-balance sheet assets also are included in total risk-weighted assets.

Another key ratio intended to assess capital adequacy is the leverage ratio, which is derived by dividing tier 1 capital by the average total of all on-balance sheet assets for any given period. In this calculation, assets are not risk-weighted. Assets deducted from regulatory capital, such as goodwill and other intangible assets, are also excluded from the asset base used to calculate capital ratios.

The minimum regulatory capital ratios for both First Security and FSGBank are generally 8% for total capital, 4% for tier 1 capital and 4% for leverage. To be eligible to be classified as “well capitalized,” FSGBank must generally maintain a total capital ratio of 10% or greater, a tier 1 capital ratio of 6% or greater, and a leverage ratio of 5% or more and not be subject to a formal action to maintain higher ratios. The current capital levels of FSGBank qualify it for well capitalized status. FSGBank expects the OCC may require FSGBank to maintain a total capital ratio of 12% or greater and a leverage ratio of 9% or greater, both of which are currently satisfied.

The OCC, the Federal Reserve, and the FDIC have authority to compel or restrict certain actions if FSGBank’s capital should fall below adequate capital standards as a result of operating losses, or if its regulators

 

18


Table of Contents
Index to Financial Statements

otherwise determine that it has insufficient capital. Among other matters, the corrective actions may include, but are not limited to, requiring FSGBank to enter into informal or formal enforcement orders, including memoranda of understanding, written agreements, supervisory letters, commitment letters, and consent or cease and desist orders to take corrective action and refrain from unsafe and unsound practices; removing officers and directors; and assessing civil monetary penalties; and taking possession of and closing and liquidating FSGBank.

The regulatory capital framework under which First Security and FSGBank operate is in a period of change with likely legislation or regulation that will revise the current standards and very likely increase capital requirements for the entire banking industry, including First Security and FSGBank. The resulting capital requirements are yet to be determined. First Security and FSGBank are now governed by a set of capital rules that the Federal Reserve and the OCC have had in place since 1988, with some subsequent amendments and revisions. These rules are popularly known as “Basel I.” Before the current financial crisis began to have a dramatic effect on the banking industry, the U.S. regulators had participated in an effort by the Basel Committee on Banking Supervision to develop Basel II. Basel II provides several options for determining capital requirements for credit and operational risk. In December 2007, the agencies adopted a final rule implementing Basel II’s “advanced approach” for “core banks”—U.S. banking organizations with over $250 billion in banking assets or on-balance-sheet foreign exposures of at least $10 billion. For other banking organizations, including First Security and FSGBank, the U.S. banking agencies proposed a rule in July 2008 that would have enabled these organizations to adopt the Basel II “standardized approach.” The proposed rule has not been finalized. As a result of the financial crisis that has adversely affected global credit markets and increases in credit, liquidity, interest rate and other risks, in September 2009, the Treasury issued principles for stronger capital and liquidity standards for banking firms, which included recommendations for higher capital standards for all banking organizations to be implemented as part of a broader reconsideration of international risk-based capital standards developed by Basel II.

Payment of Dividends

First Security is a legal entity separate and distinct from FSGBank. The principal sources of First Security’s cash flow, including cash flow to pay dividends to its stockholders, are dividends and management fees that FSGBank pays to its sole stockholder, First Security. Statutory and regulatory limitations apply to FSGBank’s payment of dividends to First Security as well as to First Security’s payment of dividends to its stockholders.

FSGBank is required by federal law to obtain prior approval of the OCC for payments of dividends if the total of all dividends declared by FSGBank’s Board of Directors in any year will exceed (1) the total of FSGBank’s net profits for that year, plus (2) FSGBank’s retained net profits of the preceding two years, less any required transfers to surplus.

When First Security received a capital investment from the Treasury under the CPP on January 9, 2009, we became subject to additional limitations on the payment of dividends. These limitations require, among other things, that (i) all dividends for the securities purchased under the CPP be paid before other dividends can be paid and (ii) the Treasury must approve any increases in quarterly common dividends above five cents per share for three years following the Treasury’s investment.

The payment of dividends by First Security and FSGBank may also be affected by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. In addition, the OCC may require, after notice and a hearing, that FSGBank stop or refrain from engaging in any practice it considers unsafe or unsound. The federal banking agencies have indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act of 1991, a depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

 

19


Table of Contents
Index to Financial Statements

On February 24, 2009, the Federal Reserve clarified its guidance on dividend policies for bank holding companies through the publication of a Supervisory Letter. As part of the letter, the Federal Reserve encouraged bank holding companies, particularly those that had participated in the CPP, to consult with the Federal Reserve prior to dividend declarations, and redemption and repurchase decisions even when not explicitly required to do so by federal regulations. The Federal Reserve has indicated that CPP recipients, such as First Security, should consider and communicate in advance to regulatory staff how a company’s proposed dividends, capital repurchases and capital redemptions are consistent with First Security’s obligation to eventually redeem the securities held by the Treasury. This new guidance is largely consistent with prior regulatory statements encouraging bank holding companies to pay dividends out of net income and to avoid dividends that could adversely affect the capital needs or minimum regulatory capital ratios of the bank holding company and its subsidiary bank.

Restrictions on Transactions with Affiliates

First Security and FSGBank are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:

 

   

a bank’s loans or extensions of credit to affiliates;

 

   

a bank’s investment in affiliates;

 

   

assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve Board;

 

   

loans or extensions of credit to third parties collateralized by the securities or obligations of affiliates; and

 

   

a bank’s guarantee, acceptance or letter of credit issued on behalf of an affiliate.

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. FSGBank must also comply with other provisions designed to avoid the taking of low-quality assets.

First Security and FSGBank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibit an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

FSGBank is also subject to restrictions on extensions of credit to their executive officers, directors, principal stockholders and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

Limitations on Senior Executive Compensation

On October 22, 2009, the Federal Reserve Board issued proposed guidance designed to help ensure that incentive compensation policies at banking organizations do not encourage excessive risk-taking or undermined the safety and soundness of the organization. In connection with the proposed guidance, the Federal Reserve Board announced that it will review First Security’s incentive compensation arrangements as part of the regular, risk-focused supervisory process. The Federal Reserve Board may take enforcement action against a banking organization if its incentive compensation arrangement or related risk management, control, or governance processes pose a risk to the safety and soundness of the organization and the organization is not taking prompt and effective measures to correct the deficiencies.

 

20


Table of Contents
Index to Financial Statements

Due to First Security’s participation in the CPP, First Security is also subject to additional executive compensation limitations. For example, First Security must:

 

   

ensure that its senior executive incentive compensation packages do not encourage excessive risk;

 

   

subject senior executive compensation to “clawback” if the compensation was based on inaccurate financial information or performance metrics;

 

   

prohibit any golden parachute payments to senior executive officers; and

 

   

agree not to deduct more than $500,000 for a senior executive officer’s compensation.

Proposed Legislation and Regulatory Action

New regulations and statutes are regularly proposed that contain wide-ranging potential changes to the structures, regulations and competitive relationships of financial institutions operating and doing business in the United States. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.

Effect of Governmental Monetary Policies

Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve Board affect the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. We cannot predict the nature or impact of future changes in monetary and fiscal policies.

 

Item 1A. Risk Factors

An investment in our common stock involves risks. If any of the following risks or other risks, which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed. In such a case, the trading price of our common stock could decline, and you may lose all or part of your investment. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements.

RISKS ASSOCIATED WITH OUR BUSINESS

We have incurred operating losses and cannot assure you that we will be profitable in the future.

We incurred a net loss available to common stockholders of $35.0 million, or $2.25 per share, for the year ended December 31, 2009, due primarily to goodwill impairment and credit losses and associated costs, including a significant provision for loan losses. Although we have taken steps to reduce our credit exposure, we likely will continue to have a higher than normal level of non-performing assets and charge-offs into 2010, which would continue to adversely impact our overall financial condition and results of operations.

We may experience increased delinquencies and credit losses, which could have a material adverse effect on our capital, financial condition and results of operations.

Like other lenders, we face the risk that our customers will not repay their loans. A customer’s failure to repay us is usually preceded by missed monthly payments. In some instances, however, a customer may declare bankruptcy prior to missing payments, and, following a borrower filing bankruptcy, a lender’s recovery of the

 

21


Table of Contents
Index to Financial Statements

credit extended is often limited. Since our loans are secured by collateral, we may attempt to seize the collateral when and if customers default on their loans. However, the value of the collateral may not equal the amount of the unpaid loan, and we may be unsuccessful in recovering the remaining balance from our customers. Rising delinquencies and rising rates of bankruptcy in our market area generally and among our customers specifically can be precursors of future charge-offs and may require us to increase our allowance for loan and lease losses. Higher charge-off rates and an increase in our allowance for loan and lease losses may hurt our overall financial performance if we are unable to increase revenue to compensate for these losses and may also increase our cost of funds.

Our allowance for loan and lease losses may not be adequate to cover actual losses, and we may be required to materially increase our allowance, which may adversely affect our capital, financial condition and results of operations.

We maintain an allowance for loan and lease losses, which is a reserve established through a provision for loan losses charged to expenses, which represents management’s best estimate of probable credit losses that have been incurred within the existing portfolio of loans. The allowance for loan and lease losses and our methodology for calculating the allowance are fully described in Note 1 to our consolidated financial statements under “Allowance for Loan and Lease Losses” on page 93, and in the “Management’s Discussion and Analysis—Statement of Financial Condition—Allowance for Loan and Lease Losses” section on pages 61 through 67. In general, an increase in the allowance for loan and lease losses results in a decrease in net income, and possibly risk-based capital, and may have a material adverse effect on our capital, financial condition and results of operations.

The allowance, in the judgment of management, is established to reserve for estimated loan losses and risks inherent in the loan portfolio. The determination of the appropriate level of the allowance for loan and lease losses involves a high degree of subjectivity and requires us to make significant estimates of current credit risks using existing qualitative and quantitative information, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in the allowance for loan and lease losses. In addition, bank regulatory agencies periodically review our allowance for loan and lease losses and may require an increase in the provision for loan losses or the recognition of additional loan charge offs, based on judgments that are different than those of management. As we are consistently adjusting our loan portfolio and underwriting standards to reflect current market conditions, we can provide no assurance that our methodology will not change, which could result in a charge to earnings.

We continually reassess the creditworthiness of our borrowers and the sufficiency of our allowance for loan and lease losses as part of FSGBank’s credit functions. Our allowance for loan and lease losses increased from 1.72% of total loans at December 31, 2008 to 2.78% at December 31, 2009. We recorded a provision for loan losses during the year ended December 31, 2009 of approximately $25.3 million, which was significantly higher than in previous periods. We charged-off approximately $16.2 million in loans, net of recoveries, during the year ended December 31, 2009, which was also significantly higher than in previous periods. We will likely experience additional classified loans and non-performing assets in the foreseeable future, as well as related increases in loan charge-offs, as the deterioration in the credit and real estate markets causes borrowers to default. Further, the value of the collateral underlying a given loan, and the realizable value of such collateral in a foreclosure sale, likely will be negatively affected by the current downturn in the real estate market, and therefore may result in an inability to realize a full recovery in the event that a borrower defaults on a loan. Any additional non-performing assets, loan charge-offs, increases in the provision for loan losses or the continuation of aggressive charge-off policies or any inability by us to realize the full value of underlying collateral in the event of a loan default, will negatively affect our business, financial condition, and results of operations and the price of our securities. Further, there can be no assurance that our allowance for loan and lease losses at December 31, 2009 will be sufficient to cover future credit losses.

 

22


Table of Contents
Index to Financial Statements

We make and hold in our portfolio a significant number of land acquisition and development and construction loans, which pose more credit risk than other types of loans typically made by financial institutions.

We offer land acquisition and development, and construction loans for builders and developers, and as of December 31, 2009, we had $153.2 million in such loans outstanding, representing 113.9% of FSGBank’s total risk-based capital. These land acquisition and development, and construction loans are more risky than other types of loans. The primary credit risks associated with land acquisition and development and construction lending are underwriting and project risks. Project risks include cost overruns, borrower credit risk, project completion risk, general contractor credit risk, and environmental and other hazard risks. Approximately $153.1 million of this portfolio consists of loans for which the related property is neither pre-sold nor pre-leased, which creates additional market risks. Market risks are risks associated with the sale of the completed residential units. They include affordability risk, which means the risk that borrowers cannot obtain affordable financing, product design risk, and risks posed by competing projects. There can be no assurance that losses in our land acquisition and development and construction loan portfolio will not exceed our reserves, which could adversely impact our earnings. Given the current environment, the non-performing loans in our land acquisition and development and construction portfolio are likely to increase during 2010, and these non-performing loans could result in a material level of charge-offs, which will negatively impact our capital and earnings.

If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2009, approximately 76.9% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized. As a result, if we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

The amount of our OREO may increase significantly, resulting in additional losses, and costs and expenses that will negatively affect our operations.

At December 31, 2008, we had a total of $7.1 million of OREO, and at December 31, 2009, we had a total of $16.0 million of OREO, reflecting a $8.9 million increase over the past twelve months. This increase in OREO is due, among other things, to the continued deterioration of the residential real estate market and the tightening of the credit market. As the amount of OREO increases, our losses, and the costs and expenses to maintain the real estate likewise increase. Due to the on-going economic downturn, the amount of OREO may continue to increase in the coming months. Any additional increase in losses, and maintenance costs and expenses due to OREO may have material adverse effects on our business, financial condition, and results of operations. Such effects may be particularly pronounced in a market of reduced real estate values and excess inventory, which may make the disposition of OREO properties more difficult, increase maintenance costs and expenses, and may reduce our ultimate realization from any OREO sales.

We are seeking additional senior officers, but our ability to attract and retain the best key employees may be limited by the need for regulatory non-objection and the restrictions that we must place on the compensation of those employees.

We are currently seeking to externally hire or otherwise reassign qualified individuals to fill senior positions in credit administration and commercial lending and to fill our vacant Chief Operating Officer position. We are currently required to notify the OCC ninety days in advance of employing any senior executive officer or changing the responsibilities of a senior executive officer. This requirement could prevent us from hiring the

 

23


Table of Contents
Index to Financial Statements

individuals of our choosing, could discourage potential applicants, or otherwise delay our ability to fill these positions. We are also generally prohibited from entering into, amending, or renewing any agreement that provides for golden parachute payments to an institution-affiliated party or from making such golden parachute payments, absent approval from the OCC and written concurrence of the FDIC. In addition, as a participant in the CPP, we are subject to specified limits on the compensation we can pay to certain senior executive officers. The limitations, which include restrictions on bonus and other incentive compensation payable to First Security’s senior executive officers, a prohibition on any “golden parachute” payments and a “clawback” of any bonus that was based on materially inaccurate financial data or other performance metric, could limit our ability to attract and retain the best executive officers because other competing employers may not be subject to these limitations. If this were to occur, our business and results of operations could be adversely affected.

Our use of appraisals in deciding whether to make a loan on or secured by real property or how to value such loan in the future may not accurately describe the net value of the real property collateral that we can realize.

In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and, as real estate values in our market area have experienced changes in value in relatively short periods of time, this estimate might not accurately describe the net value of the real property collateral after the loan has been closed. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize an amount equal to the indebtedness secured by the property. The valuation of the property may negatively impact the continuing value of such loan and could adversely affect our operating results and financial condition.

We will realize additional future losses if the proceeds we receive upon liquidation of non-performing assets are less than the fair value of such assets.

We have announced a strategy to manage our non-performing assets aggressively, a portion of which may not be currently identified. Non-performing assets are recorded on our financial statements at fair value, as required under GAAP, unless these assets have been specifically identified for liquidation, in which case they are recorded at the lower of cost or estimated net realizable value. In current market conditions, we are likely to realize additional future losses if the proceeds we receive upon dispositions of non-performing assets are less than the recorded fair value of such assets.

Negative publicity about financial institutions, generally, or about First Security or FSGBank, specifically, could damage First Security’s reputation and adversely impact its liquidity, business operations or financial results.

Reputation risk, or the risk to our business from negative publicity, is inherent in our business. Negative publicity can result from the actual or alleged conduct of financial institutions, generally, or First Security or FSGBank, specifically, in any number of activities, including leasing and lending practices, corporate governance, and actions taken by government regulators in response to those activities. Negative publicity can adversely affect our ability to keep and attract customers and can expose us to litigation and regulatory action, any of which could negatively affect our liquidity, business operations or financial results.

If we are unable to increase our share of deposits in our market, we may need to accept out-of-market brokered deposits, the costs of which may be higher than expected, and which may not be available to us.

We can offer no assurance that we will be able to maintain or increase our market share of deposits in our highly competitive service area. If we are unable to do so, we may be forced to accept increased amounts of out of market brokered deposits. As of December 31, 2009, we had approximately $339.8 million in out of market deposits, including brokered certificates of deposit, brokered money market accounts and CDARS®, which

 

24


Table of Contents
Index to Financial Statements

represented approximately 28.7% of our total deposits. The cost of out of market and brokered deposits may exceed the cost of deposits in our local market. In addition, the cost of out of market brokered deposits can be volatile, and if we are unable to access these markets or if our costs related to out of market brokered deposits increases, our liquidity and ability to support demand for loans could be adversely affected. Finally, should we become subject to a formal regulatory order requiring specific capital levels, we would be designated as adequately capitalized and would be barred from accepting new or renewing existing brokered deposits without a regulatory waiver, which may not be obtained and could have an adverse effect on our liquidity.

Increases in our expenses and other costs, including those related to centralizing our credit functions, could adversely affect our financial results.

Our expenses and other costs, such as operating expenses and hiring new employees to enhance our credit and underwriting administration, directly affect our earnings results. In light of the extremely competitive environment in which we operate, and because the size and scale of many of our competitors provides them with increased operational efficiencies, it is important that we are able to successfully manage such expenses. We are aggressively managing our expenses in the current economic environment, but as our business develops, changes or expands, and as we hire additional personnel, additional expenses can arise. Other factors that can affect the amount of our expenses include legal and administrative cases and proceedings, which can be expensive to pursue or defend. In addition, changes in accounting policies can significantly affect how we calculate expenses and earnings.

Changes in the interest rate environment could reduce our net interest income, which could reduce our profitability.

As a financial institution, our earnings significantly depend on our net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Therefore, any change in general market interest rates, including changes in the Federal Reserve Board’s fiscal and monetary policies, affects us more than non-financial institutions and can have a significant effect on our net interest income and total income. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets and liabilities. As a result, an increase or decrease in market interest rates could have material adverse effects on our net interest margin and results of operations.

In addition, we cannot predict whether interest rates will continue to remain at present levels. Changes in interest rates may cause significant changes, up or down, in our net interest income. Depending on our portfolio of loans and investments, our results of operations may be adversely affected by changes in interest rates. In addition, any significant increase in prevailing interest rates could adversely affect our mortgage banking business because higher interest rates could cause customers to request fewer refinancings and purchase money mortgage originations.

Adverse market conditions, future losses or increased capital requirements may require us to raise additional capital in the future to support our operations, but that capital may not be available when it is needed or it could be dilutive to our existing stockholders, which could adversely affect our financial condition and our results of operations.

We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations, which may require us to maintain capital in excess of published regulatory standards for a “well-capitalized” institution. We currently anticipate the OCC will require FSGBank to maintain a tier 1 leverage ratio of at least 9.0% and a total risk-based capital ratio of at least 12.0%. We anticipate that our capital resources will be sufficient to satisfy these capital requirements for the foreseeable future. However, adverse market conditions in our area could require us to raise additional capital in the future.

 

25


Table of Contents
Index to Financial Statements

In addition, in the future, we may need to raise additional capital to comply with commitments made to our regulators or a new regulatory capital framework such as a new proposal for risk-based capital standards developed by federal or international regulatory groups. As a result of the financial crisis that has adversely affected global credit markets and increases in credit, liquidity, interest rate and other risks, in September 2009, the Treasury issued principles for stronger capital and liquidity standards for banking firms, which included recommendations for higher capital standards for all banking organizations to be implemented as part of a broader reconsideration of international risk-based capital standards developed by the Basel Committee on Banking Supervision (“Basel II”). Any new capital framework is likely to affect the cost and availability of different types of credit. U.S. banking organizations are likely to be required to hold higher levels of capital and could incur increased compliance costs; it is unclear, at this time, if similar increases in capital standards will be incorporated into a revised Basel II proposal that would be adopted by international financial institutions. Any of these developments, including increased capital requirements, could require us to raise additional capital.

Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. If we need to raise additional capital, there is no guarantee that we will be able to borrow funds or successfully raise capital at all or on terms that are favorable or otherwise not dilutive to existing stockholders. If we cannot raise additional capital when needed, our ability to operate or expand our business could be materially impaired. Further, should FSGBank come under a regulatory directive to maintain elevated capital levels or otherwise fail to maintain sufficient capital to meet the regulatory standards for a “well-capitalized” institution, it could prohibit us from directly or indirectly accepting, renewing or rolling over any brokered deposits, absent applying for and receiving a waiver from the FDIC, which could adversely affect FSGBank’s liquidity and/or operating results.

We face strong competition from larger, more established competitors that may inhibit our ability to compete and expose us to greater lending risks.

The banking business is highly competitive, and we experience strong competition from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other financial institutions, which operate in our primary market areas and elsewhere.

We compete with these institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established and much larger financial institutions. While we believe we can and do successfully compete with these other financial institutions in our markets, we may face a competitive disadvantage as a result of our smaller size and lack of geographic diversification.

Our ability to diversify our economic risks is limited by our own local markets and economies. We lend primarily to individuals and to small to medium-sized businesses, which may expose us to greater lending risks than those of banks lending to larger, better capitalized businesses with longer operating histories. As an example, our market area in northern Georgia is highly dependent on the home furnishings and carpet industry centered near Dalton, Georgia. Because of the downturn in residential construction, this industry has suffered a business decline, which has adversely affected the performance of our operations in Dalton and surrounding areas. As a community bank, we are less able to spread the risk of unfavorable local economic conditions than larger or more regional banks. Moreover, we cannot give any assurance that we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.

Although we compete by concentrating our marketing efforts in our primary market area with local advertisements, personal contacts and greater flexibility in working with local customers, we can give no assurance that this strategy will be successful.

 

26


Table of Contents
Index to Financial Statements

Our agreement with the Treasury under the CPP is subject to unilateral change by the Treasury, which could adversely affect our business, financial condition, and results of operations.

Under the CPP, the Treasury may unilaterally amend the terms of its agreement with us in order to comply with any changes in federal law. We cannot predict the effects of any of these changes and of the associated amendments. It is possible, however, that any such amendment could have a material impact on us or our operations.

The costs and effects of litigation, investigations or similar matters, or adverse facts and developments related thereto, could materially affect our business, operating results and financial condition.

We may be involved from time to time in a variety of litigation, investigations or similar matters arising out of our business. Our insurance may not cover all claims that may be asserted against it and indemnification rights to which we are entitled may not be honored, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation. Should the ultimate judgments or settlements in any litigation or investigation significantly exceed our insurance coverage, they could have a material adverse effect on our business, financial condition and results of operations. In addition, premiums for insurance covering the financial and banking sectors are rising. We may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms or at historic rates, if at all.

Changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance could materially affect our business, operating results and financial condition.

We are subject to various taxing jurisdictions where we conduct business. We assess the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintain tax accruals consistent with our evaluation. This evaluation incorporates assumptions and estimates that involve a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our operating results.

Currently, we expect to fully realize our deferred tax assets. However, continued losses may require a partial or full valuation allowance against our deferred tax assets. Such a change could have a material impact on our operating results.

Environmental liability associated with lending activities could result in losses.

In the course of our business, we may foreclose on and take title to properties securing our loans. If hazardous substances are discovered on any of these properties, we may be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site, even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses and may materially limit the use of properties that we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Our loan policies require certain due diligence of high risk industries and properties with the intention of lowering our risk of a non-performing loan and/or foreclosed property.

 

27


Table of Contents
Index to Financial Statements

RISKS RELATED TO RECENT MARKET, LEGISLATIVE AND REGULATORY EVENTS

We may become subject to supervisory actions and/or enhanced regulation that could have an additional material negative effect on our business, operating flexibility, financial condition and the value of our common stock. In addition, addressing regulatory concerns in this market environment will require significant time and attention from our management team, which may increase our costs, impede the efficiency of our internal business processes and adversely affect our profitability in the near-term.

Under federal and state laws and regulations pertaining to the safety and soundness of insured depository institutions, the Federal Reserve (for bank holding companies), the OCC (for national banks) and, separately, the FDIC (as the insurer of bank deposits), have the authority to compel or restrict certain actions on our part if they determine that we have insufficient capital or are otherwise operating in a manner that may be deemed to be inconsistent with safe and sound banking practices. Under this authority, our bank regulators can require us to enter into informal or formal enforcement orders, including board resolutions, memoranda of understanding, written agreements and consent or cease and desist orders, pursuant to which we would be required to take identified corrective actions to address cited concerns and to refrain from taking certain actions. For additional information relating to the extensive regulation, supervision and legislation that govern most aspects of our operations and limit the businesses in which we engage, please see “Supervision and Regulation” on page 12.

In light of declining asset quality and earnings, and the risks associated with liquidity and concentrations of credit, in the fourth quarter of 2009, we committed to the OCC to undertake certain actions to improve FSGBank’s liquidity and funds management, capital adequacy, and credit risk management. We are currently required to notify the OCC ninety days in advance of adding or replacing a member of the board of directors, employing any senior executive officer, or changing the responsibilities of any senior executive officer so that the person would assume a different executive position, and are generally prohibited from entering into, amending, or renewing any agreement that provides for golden parachute payments to an institution-affiliated party or from making such golden parachute payments, absent approval from the OCC and written concurrence of the FDIC. The adoption and implementation of these plans and policies will require significant time and attention from our management team, which may increase our costs, including additional personnel costs, impede the efficiency of our internal business processes and adversely affect our profitability in the near-term.

No assurances can be given that these actions will be sufficient to satisfy the OCC, and we may make additional commitments to the OCC in the future. We believe it is likely that the OCC will enter into some form of enforcement action with FSGBank, and we anticipate that FSGBank will be required to maintain a tier 1 leverage ratio of at least 9.0% and a total risk-based capital ratio of at least 12.0%. Any enforcement action is likely to formalize these commitments and may impose additional obligations and limitations on FSGBank. If our regulators were to take such an enforcement action, then we could, among other things, become subject to significant restrictions on our ability to develop any new business, as well as restrictions on our existing business, we could be required to raise additional capital, dispose of certain assets and liabilities within a prescribed period of time, and/or hire additional personnel to strengthen our credit and underwriting functions. Further, should FSGBank come under a regulatory directive to maintain elevated capital levels or otherwise fail to maintain sufficient capital to meet the regulatory standards for a “well-capitalized” institution, it could prohibit us from directly or indirectly accepting, renewing or rolling over any brokered deposits, absent applying for and receiving a waiver from the FDIC, which could adversely affect FSGBank’s liquidity and/or operating results. The terms of any such supervisory action that goes beyond the steps we have already taken could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock.

A continuation of the current economic downturn in the housing market and the homebuilding industry and in our markets generally could adversely affect our financial condition, results of operations or cash flows.

Our long-term success depends upon the growth in population, income levels, deposits and housing starts in our primary market areas. If the communities in which FSGBank operate do not grow, or if prevailing economic

 

28


Table of Contents
Index to Financial Statements

conditions locally or nationally are unfavorable, our business may not succeed. The unpredictable economic conditions we have faced over the last 24 months have had an adverse effect on the quality of our loan portfolio and our financial performance. Economic recession over a prolonged period or other economic problems in our market areas could have a material adverse impact on the quality of the loan portfolio and the demand for our products and services. Future adverse changes in the economies in our market areas may have a material adverse effect on our financial condition, results of operations or cash flows. Further, the banking industry in Tennessee and Georgia is affected by general economic conditions such as inflation, recession, unemployment and other factors beyond our control.

Since the third quarter of 2007, the residential construction and commercial development real estate markets have experienced a variety of difficulties and changed economic conditions. As a result, there has been substantial concern and publicity over asset quality among financial institutions due in large part to issues related to subprime mortgage lending, declining real estate values and general economic concerns. As of December 31, 2009, our non-performing assets had increased to $65.4 million, or 4.83% of our total assets, as compared to $27.3, or 2.14% as of December 31, 2008. Furthermore, the housing and the residential mortgage markets continue to experience a variety of difficulties and changed economic conditions.

The homebuilding and residential mortgage industry has experienced a significant and sustained decline in demand for new homes and a decrease in the absorption of new and existing homes available for sale in various markets. Our customers who are builders and developers face greater difficulty in selling their homes in markets where these trends are more pronounced. Consequently, we are facing increased delinquencies and non-performing assets as these builders and developers are forced to default on their loans with us. We do not know when the housing market will improve, and accordingly, additional downgrades, provisions for loan losses and charge-offs related to our loan portfolio may occur. If market conditions continue to deteriorate, our non-performing assets may continue to increase and we may need to take additional valuation adjustments on our loan portfolios and real estate owned as we continue to reassess the market value of our loan portfolio, the losses associated with the loans in default and the net realizable value of real estate owned.

The results of our stress test may be incorrect and may not accurately predict the impact on our financial condition if the economy were to continue to deteriorate.

Bank regulatory authorities, in connection with the Supervisory Capital Assessment Program, or “SCAP,” recently administered a stress or SCAP test to the nation’s 19 largest banks. The SCAP test is based on a 2-year cumulative loan loss assumption that represents two scenarios, a “baseline” scenario that assumed a consensus forecast for certain economic variables and a “more adverse” than expected scenario to project a more significant downturn. These scenarios are not forecasts or projections of expected loan losses.

While bank regulatory authorities have not administered a SCAP test to our loan portfolio (both loans held for investment and loans held for sale), we, in conjunction with a third-party consultant, have completed a stress test of our loan portfolio to determine the potential effects on our capital as a result of the persistence of the economic factors identified in the SCAP test and to assess the potential exposure for increased non-performing assets. The analysis was designed to approximate the SCAP test, with specific adjustments based on more current economic data reflective of the market areas in which our loans are located. In December 2009, our consultant reported that First Security would need to raise approximately $200 thousand to satisfy current regulatory well capitalized standards at December 31, 2010 assuming First Security experienced credit losses projected by the “more adverse” scenario of the stress test. The review also found we would need to raise approximately $31.4 million to satisfy these standards if it repaid all TARP funds. In the event that the OCC requires FSGBank to maintain a tier 1 leverage ratio of at least 9.0% and a total risk-based capital ratio of at least 12.0%, we would need to raise approximately $22.8 million to satisfy these standards, assuming that TARP funds are not repaid.

The results of these stress tests involve many assumptions about the economy and future loan losses and default rates, and may not accurately reflect the impact on our financial condition if the economy does not

 

29


Table of Contents
Index to Financial Statements

improve or continues to deteriorate. While we believe that appropriate assumptions have been applied in performing the stress test, these assumptions may prove to be incorrect. In addition, the results of our stress test may not be comparable to the results of stress tests performed and publicly released by Treasury, and the results of this test may not be the same as if the test had been performed by Treasury. Moreover, the results of the stress test may not accurately reflect the impact on us if economic conditions are materially different than our assumptions. Any continued deterioration of the economy could result in credit losses significantly higher than those predicted by our internal stress test, which in turn would adversely affect our financial condition and capital levels.

Negative developments in the financial industry, and the domestic and international credit markets may adversely affect our operations and results.

Negative developments during 2008 in the global credit and derivative markets resulted in uncertainty in the financial markets in general with the expectation of the general economic downturn continuing into 2010. As a result of this “credit crunch,” commercial as well as consumer loan portfolio performances have deteriorated at many institutions and the competition for deposits and quality loans has increased significantly. Global securities markets, and bank holding company stock prices in particular, have been negatively affected, as has the ability of banks and bank holding companies to raise capital or borrow in the debt markets. If these negative trends continue, our business operations and financial results may be negatively affected.

We may be required to pay significantly higher FDIC premiums or remit special assessments that could adversely affect our earnings.

A downgrade in our regulatory condition, along with our current level of brokered deposits, could cause our assessment to materially increase. In addition, market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. As a result, the entire industry may be required to pay significantly higher premiums or additional special assessments that could adversely affect our earnings. It is possible that the FDIC may impose additional special assessments in the future as part of its restoration plan.

Future legislation could harm our competitive position.

Congress is considering additional proposals to substantially change the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies. Such legislation may change existing banking statutes and regulations, as well as our current operating environment significantly. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand our permissible activities, or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether new legislation will be enacted and, if enacted, the effect that it, or any regulations, would have on our business, financial condition, or results of operations.

RISKS ASSOCIATED WITH AN INVESTMENT IN OUR COMMON STOCK

The trading volume of our common stock is less than that of other larger financial services companies.

Although our common stock is traded on the Nasdaq Global Select Market, the trading volume of our common stock is less than that of other larger financial services companies. For the public trading market for our common stock to have the desired characteristics of depth, liquidity and orderliness requires the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause our stock price to fall more than would otherwise be expected if the trading volume of our common stock were commensurate with the trading volumes of the common stock of other financial services companies.

 

30


Table of Contents
Index to Financial Statements

Tennessee law and our charter limit the ability of others to acquire us.

Various anti-takeover protections for Tennessee corporations are set forth in the Tennessee Business Corporation Act, the Business Combination Act, the Control Share Acquisition Act, the Greenmail Act and the Investor Protection Act. Because our common stock is registered with the SEC under the Securities Exchange Act of 1934, the Business Combination Act automatically applies to us unless our stockholders adopt a charter or bylaw amendment which expressly excludes us from the anti-takeover provisions of the Business Combination Act two years prior to a proposed takeover. Our Board of Directors has no present intention of recommending such charter or bylaw amendment.

These statutes have the general effect of discouraging, or rendering more difficult, unfriendly takeover or acquisition attempts. Such provisions could be beneficial to current management in an unfriendly takeover attempt but could have an adverse effect on stockholders who might wish to participate in such a transaction.

Our future operating results may be below securities analysts’ or investors’ expectations, which could cause our stock price to decline.

We may be unable to generate significant revenues or grow at the rate expected by securities analysts or investors. In addition, our costs may be higher than we, securities analysts or investors expect. If we fail to generate sufficient revenues or our costs are higher than we expect, our results of operations will suffer, which in turn could cause our stock price to decline.

Our operating results in any particular period may not be a reliable indication of our future performance. In some future quarters, our operating results may be below the expectations of securities analysts or investors. If this occurs, the price of our common stock will likely decline.

We have elected to defer the dividend payment on our Series A Preferred Stock for the first quarter of 2010; as a result, we are unable to pay dividends on our common stock until we pay all dividends in arrears on the Series A Preferred Stock.

On January 27, 2010, our Board of Directors elected to suspend the dividend on our common stock and elected to defer the dividend payment on our Series A Preferred Stock for the first quarter of 2010. We may not pay dividends on common stock unless all dividends have been paid on the securities issued to the Treasury under the CPP; having deferred the first quarter 2010 dividend payment, we are prohibited on paying any future dividends on our common stock until all dividends payable to the Treasury under the CPP have been paid in full.

Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our Board of Directors may deem relevant. The holders of our common stock are entitled to receive dividends when, and if declared by our Board of Directors out of funds legally available for that purpose. As part of our consideration to pay future cash dividends, we intend to retain adequate funds from future earnings to support the development and growth of our business. In addition, our ability to pay dividends is restricted by federal policies and regulations. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. Further, our principal sources of funds to pay dividends are cash dividends and management fees that we receive from FSGBank.

The CPP also restricts our ability to increase the amount of quarterly dividends on common stock above $0.05 per share, which potentially limits your opportunity for gain on your investment.

 

31


Table of Contents
Index to Financial Statements

The Series A Preferred Stock issued to the Treasury impacts net income available to our common stockholders and our earnings per share.

On January 9, 2009, we issued senior preferred stock (the “Series A Preferred Stock”) to the Treasury in an aggregate amount of $33 million, along with a warrant to purchase 823,627 shares of common stock (the “Warrant”). As long as shares of our Series A Preferred Stock issued under the CPP are outstanding, no dividends may be paid on our common stock unless all dividends on the Series A Preferred Stock have been paid in full. Additionally, for so long as the Treasury owns shares of the Series A Preferred Stock, we are not permitted to pay cash dividends in excess of $0.05 per share per quarter on our common stock for three years without the Treasury’s consent. The dividends declared on shares of our Series A Preferred Stock will reduce the net income available to common stockholders and our earnings per common share. Additionally, issuance of the Warrant, in conjunction with the issuance of the Series A Preferred Stock, may be dilutive to our earnings per share. The shares of First Security’s Series A Preferred Stock will also receive preferential treatment in the event of liquidation, dissolution or winding up.

We can provide no assurances as to when the Series A Preferred Stock can be redeemed and the Warrant can be repurchased.

Subject to consultation with our banking regulators, we intend to repurchase the Series A Preferred Stock and the Warrant issued to the Treasury when we believe the credit metrics in our loan portfolio have improved for the long-term and the overall economy has rebounded. However, there can be no assurance when the Series A Preferred Stock and the Warrant can be repurchased, if at all. Until such time as the Series A Preferred Stock and the Warrant are repurchased, we will remain subject to the terms and conditions of those instruments, which, among other things, require us to obtain regulatory approval to repurchase or redeem common stock or our other preferred stock or increase the dividends on our common stock over $0.05 per share, except in limited circumstances. Further, our continued participation in the CPP subjects us to increased regulatory and legislative oversight, including with respect to executive compensation. These new oversight and legal requirements under the CPP, as well as any other requirement that the Treasury could adopt in the future, may have unforeseen or unintended adverse effects on the financial services industry as a whole, and particularly on CPP participants such as ourselves.

Holders of the Series A Preferred Stock have rights that are senior to those of our common stockholders.

The shares of Series A Preferred Stock that we have issued to the Treasury is senior to our shares of common stock, and holders of the Series A Preferred Stock have certain rights and preferences that are senior to holders of our common stock. The restrictions on our ability to declare and pay dividends to common stockholders are discussed immediately above. In addition, we and our subsidiaries may not purchase, redeem or otherwise acquire for consideration any shares of our common stock unless we have paid in full all accrued dividends on the Series A Preferred Stock for all prior dividend periods, other than in certain circumstances. Furthermore, the Series A Preferred Stock is entitled to a liquidation preference over shares of our common stock in the event of liquidation, dissolution or winding up.

Holders of the Series A Preferred Stock may, under certain circumstances, have the right to elect two directors to our Board of Directors.

In the event that we fail to pay dividends on the Series A Preferred Stock for an aggregate of six quarterly dividend periods or more (whether or not consecutive), we must increase the authorized number of directors then constituting our Board of Directors by two. Holders of the Series A Preferred Stock, together with the holders of any outstanding parity stock with the same voting rights, will be entitled to elect the two additional members of the Board of Directors at the next annual meeting (or at a special meeting called for this purpose) and at each subsequent annual meeting until all accrued and unpaid dividends for all past dividend periods have been paid in full.

 

32


Table of Contents
Index to Financial Statements

Holders of the Series A Preferred Stock have limited voting rights.

Except in connection with the election of directors to our Board of Directors as discussed immediately above and as otherwise required by law, holders of the Series A Preferred Stock have limited voting rights. In addition to any other vote or consent of stockholders required by law or our amended and restated charter, the vote or consent of holders owning at least 66 2/3% of the shares of Series A Preferred Stock outstanding is required for (1) any authorization or issuance of shares ranking senior to the Series A Preferred Stock; (2) any amendment to the rights of the Series A Preferred Stock that adversely affects the rights, preferences, privileges or voting power of the Series A Preferred Stock; or (3) consummation of any merger, share exchange or similar transaction unless the shares of Series A Preferred Stock remain outstanding or are converted into or exchanged for preference securities of the surviving entity other than us and have such rights, preferences, privileges and voting power as are not materially less favorable than those of the holders of the Series A Preferred Stock.

 

Item 1B. Unresolved Staff Comments

There are no written comments from the Commission staff regarding our periodic or current reports under the Act which remain unresolved.

 

Item 2. Properties

During 2009, we conducted our business primarily through our corporate headquarters located at 531 Broad Street, Chattanooga, Hamilton County, Tennessee.

 

33


Table of Contents
Index to Financial Statements

We believe that our banking offices are in good condition, are suitable to our needs and, for the most part, are relatively new. The following table summarizes pertinent details of our owned or leased branch, loan production and leasing offices.

 

Office Address

   Date Opened    Owned/    Square
Footage
   Use of
Office

401 South Thornton Avenue

Dalton, Whitfield County, Georgia

   September 17, 1999    Owned    16,438    Branch

1237 North Glenwood Avenue

Dalton, Whitfield County, Georgia

   September 17, 1999    Owned    3,300    Branch

761 New Highway 68

Sweetwater, Monroe County, Tennessee

   June 26, 2000    Owned    3,000    Branch

1740 Gunbarrel Road

Chattanooga, Hamilton County, Tennessee

   July 3, 2000    Leased    3,400    Branch

4227 Ringgold Road

East Ridge, Hamilton County, Tennessee

   July 28, 2000    Leased    3,400    Branch

817 Broad Street

Chattanooga, Hamilton County, Tennessee

   June 26, 2000    Leased    4,050    Branch

835 South Congress Parkway

Athens, McMinn County, Tennessee

   November 6, 2000    Owned    3,400    Branch

4535 Highway 58

Chattanooga, Hamilton County, Tennessee

   May 7, 2001    Owned    3,400    Branch

820 Ridgeway Avenue

Signal Mountain, Hamilton County, Tennessee

   May 29, 2001    Owned    2,500    Branch

2709 Chattanooga Road, Suite 5

Rocky Face, Whitfield County, Georgia

   June 4, 2001    Leased    2,400    Branch

1409 Cowart Street

Chattanooga, Hamilton County, Tennessee

   October 22, 2001    Building Owned

Land Leased

   1,000    Branch

9217 Lee Highway

Ooltewah, Hamilton County, Tennessee

   July 8, 2002    Owned    3,400    Branch

2905 Maynardville Highway

Maynardville, Union County, Tennessee

   July 20, 2002    Owned    12,197    Branch

216 Maynardville Highway

Maynardville, Union County, Tennessee

   July 20, 2002    Leased    2,000    Branch

2918 East Walnut Avenue

Dalton, Whitfield County, Georgia

   March 31, 2003    Owned    10,337    Branch

715 South Thornton Avenue

Dalton, Whitfield County, Georgia

   March 31, 2003    Building Owned

Land Leased

   4,181    Branch

2270 Highway 72 N

Loudon, Loudon County, Tennessee

   June 30, 2003    Owned    1,860    Branch

35 Poplar Springs Road

Ringgold, Catoosa County, Georgia

   July 14, 2003    Owned    3,400    Branch

167 West Broadway Boulevard

Jefferson City, Jefferson County, Tennessee

   October 14, 2003    Owned    3,743    Branch

 

34


Table of Contents
Index to Financial Statements

Office Address

   Date Opened    Owned/    Square
Footage
   Use of
Office

705 East Broadway

Lenoir City, Loudon County, Tennessee

   October 27, 2003    Owned    3,610    Branch

301 North Main Street

Sweetwater, Monroe County, Tennessee

   December 4, 2003    Owned    4,650    Branch

215 Warren Street

Madisonville, Monroe County, Tennessee

   December 4, 2003    Owned    8,456    Branch

405 Highway 165

Tellico Plains, Monroe County, Tennessee

   December 4, 2003    Owned    3,565    Branch

155 North Campbell Station Road

Knoxville, Knox County, Tennessee

   March 2, 2004    Building Owned

Land Leased

   3,743    Branch

4215 Highway 411

Madisonville, Monroe County, Tennessee

   March 15, 2004    Owned    472    Branch

1013 South Highway 92

Dandridge, Jefferson County, Tennessee

   April 5, 2004    Owned    3,500    Branch

307 Lovell Road

Knoxville, Knox County, Tennessee

   August 16, 2004    Building Owned

Land Leased

   3,500    Branch

1111 Northshore Drive, Suite S600

Knoxville, Knox County, Tennessee

   October 1, 2004    Leased    9,867    Loan &
Leasing

1111 Northshore Drive, Suite P-100

Knoxville, Knox County, Tennessee

   July 25, 2005    Leased    1,105    Branch

307 Hull Avenue

Gainesboro, Jackson County, Tennessee

   August 31, 2005    Owned    9,662    Branch

6766 Granville Highway

Granville, Jackson County, Tennessee

   August 31, 2005    Owned    2,880    Branch

3261 Jennings Creek Highway

Whitleyville, Jackson County, Tennessee

   August 31, 2005    Building Owned

Land Leased

   1,368    Branch

340 South Jefferson Avenue

Cookeville, Putnam County, Tennessee

   August 31, 2005    Owned    3,220    Branch

376 West Jackson Street

Cookeville, Putnam County, Tennessee

   August 31, 2005    Owned    14,780    Branch

301 Keith Street SW

Cleveland, Bradley County, Tennessee

   October 31, 2005    Leased    3,072    Branch

3895 Cleveland Road

Varnell, Whitfield County, Georgia

   November 11, 2005    Owned    1,860    Branch

531 Broad Street

Chattanooga, Hamilton County, Tennessee

   December 11, 2006    Owned    39,700    Branch &
Headquarters

614 West Main Street

Algood, Putnam County, Tennessee

   April 10, 2007    Owned    1,936    Branch

52 Mouse Creek Road

Cleveland, Bradley County, Tennessee

   May 14, 2007    Owned    1,256    Branch

5188 Highway 153

Hixson, Hamilton County, Tennessee

   May 22, 2009    Owned    4,194    Branch

 

35


Table of Contents
Index to Financial Statements

As of December 31, 2009, we owned one additional plot of land. The vacant lot is located at 1020 South Highway 92, Dandridge, Jefferson County, Tennessee (1.0 acres). The lot is currently available for sale. We originally purchased, or a predecessor institution purchased, this site for bank purposes.

We ceased operations at 2424 Roswell Road, Suite 6A, Marietta, Cobb County, Georgia, in August 2008. We are still leasing the office and plan to reopen when market conditions improve.

We are not aware of any environmental problems with the properties that we own or lease that would be material, either individually, or in the aggregate, to our operations or financial condition.

 

Item 3. Legal Proceedings

While we are from time to time a party to various legal proceedings arising in the ordinary course of our business, management believes, after consultation with legal counsel, that there are no proceedings threatened or pending against us that will, individually or in the aggregate, have a material adverse affect on our business or consolidated financial condition, except as described below.

During 2009, Lloyd L. Montgomery, III, our former President and Chief Operating Officer, filed a $2.3 million wrongful termination arbitration claim against us. On January 19, 2010, we settled this claim for $500 thousand. The settlement amount was fully accrued as of December 31, 2009.

 

Item 4. [Reserved]

 

36


Table of Contents
Index to Financial Statements

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Since August 10, 2005, our common stock has been traded on the Nasdaq Global Select Market under the symbol FSGI. On March 15, 2010, there were 1,137 registered holders of record of our common stock. The high and low prices per share were as follows:

 

Quarter

   High    Low    Dividend

2009

        

4th Quarter

   $ 3.91    $ 1.82    $ 0.01

3rd Quarter

     4.10      3.35      0.01

2nd Quarter

     4.54      3.25      0.01

1st Quarter

     5.14      2.80      0.05

2008

        

4th Quarter

   $ 7.94    $ 4.37    $ 0.05

3rd Quarter

     7.95      5.94      0.05

2nd Quarter

     9.70      5.57      0.05

1st Quarter

     9.25      7.06      0.05

It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries. For a foreseeable period of time, our principal source of cash will be dividends and management fees paid by FSGBank to us. There are certain restrictions on these payments imposed by federal banking laws, regulations and authorities.

The declaration and payment of dividends on our common stock will depend upon our earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, our ability to service any equity or debt obligations senior to our common stock and other factors deemed relevant by our Board of Directors. On January 27, 2010, our Board of Directors elected to suspend the dividend on our common stock and elected to defer the dividend payment on our Series A Preferred Stock for the first quarter of 2010. In light of this action, we make no assurance that we will pay any dividends in the future. We may not pay dividends on our common stock unless all dividends have been paid on the securities issued to the Treasury under the CPP; having deferred the first quarter 2010 dividend payment, we are prohibited on paying any future dividends on our common stock until all dividends payable to the Treasury under the CPP have been paid in full. The CPP also restricts our ability to increase the amount of quarterly dividends on common stock above $0.05 per share, which potentially limits your opportunity for gain on your investment.

On November 28, 2007, our Board of Directors authorized a plan to repurchase up to 500,000 shares of our common stock in open market transactions, with the specific timing and amount of repurchases based on market conditions, securities law limitations, and other factors. All repurchases are made with our cash resources, and may be suspended or discontinued at any time without prior notice. On April 21, 2008, this repurchase program was suspended. As of the suspension date, we had repurchased 358 thousand shares at a weighted average price of $7.82.

On July 23, 2008, our Board of Directors approved a loan, which was subsequently amended on January 28, 2009, in the amount of $12.7 million from First Security Group, Inc. to 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 within the 401(k) and ESOP Plan. As of December 31, 2009, the plan held 768,787 unallocated shares at a weighted average price of $8.04. The purchase program concluded on December 31, 2009.

 

37


Table of Contents
Index to Financial Statements

The following table presents information regarding purchases by First Security and the affiliated purchasers of our common stock during the fourth quarter of 2009.

 

Period

  Total Number of
Shares Purchased
  Average Price Paid
per Share
  Total Number of
Shares Purchased
as Part of Publicly
Announced Plans
or Programs
  Maximum Number
of Shares that May
Yet Be Purchased
Under the Plans or
Programs
 

October 1, 2009—October 31, 2009

  —     $ —     —     N/A 1 

November 1, 2009—November 30, 2009

  —     $ —     —     N/A 1 

December 1, 2009—December 31, 2009

  —     $ —     —     —     
           

Total

  —       —    
           

 

1

The 401(k) and ESOP may purchase an unspecified number of shares up to a purchase cost of $12.7 million, of which $8.7 million was still available at the conclusion of the program on December 31, 2009.

LOGO

 

     Period Ending

Index

   12/31/04    12/31/05    12/31/06    12/31/07    12/31/08    12/31/09

First Security Group, Inc.

   100.00    117.15    140.21    111.30    58.81    31.01

NASDAQ Composite

   100.00    101.37    111.03    121.92    72.49    104.31

SNL Bank NASDAQ

   100.00    96.95    108.85    85.45    62.06    50.34

SNL Southeast Bank

   100.00    102.36    120.03    90.42    36.60    36.75

 

38


Table of Contents
Index to Financial Statements
Item 6. Selected Financial Data

Our selected financial data is presented below as of and for the years ended December 31, 2005 through 2009. The selected financial data presented below as of December 31, 2009 and 2008 and for each of the years in the three-year period ended December 31, 2009, are derived from our audited financial statements and related notes included in this Annual Report on Form 10-K and should be read in conjunction with the consolidated financial statements and related notes, along with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 45. The selected financial data as of December 31, 2007, 2006 and 2005 and for the two years ended December 31, 2006 have been derived from our audited financial statements that are not included in this Annual Report on Form 10-K. Certain of the measures set forth below are non-GAAP financial measures under the rules and regulations promulgated by the SEC. For a discussion of management’s reasons to present such data and a reconciliation to GAAP, please see “GAAP Reconciliation and Management Explanation for Non-GAAP Financial Measures” on page 41.

 

     As of and for the Years Ended December 31,
     2009     2008    2007    2006    2005
     (in thousands, except per share amounts and full-time
equivalent employees)

Earnings:

             

Net interest income

   $ 42,209      $ 45,227    $ 48,922    $ 47,982    $ 40,441

Provision for loan and lease losses

   $ 25,315      $ 15,753    $ 2,155    $ 2,184    $ 2,922

Non-interest income

   $ 10,335      $ 11,682    $ 11,300    $ 10,617    $ 8,847

Non-interest expense

   $ 68,231      $ 40,382    $ 41,441    $ 40,017    $ 35,373

Dividends and accretion on preferred stock

   $ 1,954      $ —      $ —      $ —      $ —  

Net (loss) income available to common stockholders, before extraordinary items

   $ (34,974   $ 1,361    $ 11,356    $ 11,112    $ 7,396

Extraordinary items, net of tax

   $ —        $ —      $ —      $ —      $ 2,175
                                   

Net (loss) income available to common stockholders

   $ (34,974   $ 1,361    $ 11,356    $ 11,112    $ 9,571
                                   

Earnings—Normalized

             

Non-interest expense, excluding goodwill impairment

   $ 41,075      $ 40,382    $ 41,441    $ 40,017    $ 35,373

Net (loss) income available to common stockholders before extraordinary items, excluding goodwill impairment

   $ (10,212   $ 1,361    $ 11,356    $ 11,112    $ 7,396

Per Share Data:

             

Net (loss) income before extraordinary items, basic

   $ (2.25   $ 0.08    $ 0.67    $ 0.64    $ 0.51

Net (loss) income, basic

   $ (2.25   $ 0.08    $ 0.67    $ 0.64    $ 0.65

Net (loss) income before extraordinary items, diluted

   $ (2.25   $ 0.08    $ 0.66    $ 0.63    $ 0.50

Net (loss) income, diluted

   $ (2.25   $ 0.08    $ 0.66    $ 0.63    $ 0.64

Cash dividends declared on common shares

   $ 0.08      $ 0.20    $ 0.20    $ 0.13    $ 0.03

Book value per common share

   $ 6.72      $ 8.78    $ 8.80    $ 8.15    $ 7.84

Tangible book value per common share

   $ 6.60      $ 6.98    $ 6.99    $ 6.39    $ 6.00

Per Share Data—Normalized:

             

Net (loss) income before extraordinary items, excluding goodwill impairment, basic

   $ (0.66   $ 0.08    $ 0.67    $ 0.64    $ 0.51

Net (loss) income before extraordinary items, excluding goodwill impairment, diluted

   $ (0.66   $ 0.08    $ 0.66    $ 0.63    $ 0.50

 

39


Table of Contents
Index to Financial Statements
     As of and for the Years Ended December 31,  
     2009     2008     2007     2006     2005  
     (in thousands, except per share amounts and full-time equivalent
employees)
 

Performance Ratios:

          

Return on average assets1

     -2.78     0.11     0.97     1.03     0.83

Return on average common equity1

     -25.60     0.92     7.75     7.91     6.88

Return on average tangible assets1

     -2.83     0.11     1.00     1.06     0.85

Return on average tangible common equity1

     -30.62     1.15     9.81     10.22     8.45

Net interest margin, taxable equivalent

     3.75     4.07     4.79     5.09     5.15

Efficiency ratio

     129.85     70.96     68.81     68.29     71.77

Non-interest income to net interest income and non-interest income

     19.67     20.53     18.76     18.12     17.95

Performance Ratios—Normalized:

          

Return on average assets, excluding goodwill impairment1

     -0.81     0.11     0.97     1.03     0.83

Return on average common equity, excluding goodwill impairment1

     -7.48     0.92     7.75     7.91     6.88

Return on average tangible assets, excluding goodwill impairment1

     -0.83     0.11     1.00     1.06     0.85

Return on average tangible common equity, excluding goodwill impairment1

     -8.94     1.15     9.81     10.22     8.45

Capital & Liquidity:

          

Total equity to total assets

     10.46     11.30     12.19     12.82     13.30

Tangible equity to tangible assets

     10.33     9.20     9.93     10.33     10.51

Tangible common equity to tangible assets

     8.01     9.20     9.93     10.33     10.51

Tier 1 risk-based capital ratio

     12.72     9.85     10.76     12.04     12.09

Total risk-based capital ratio

     13.98     11.10     11.81     13.10     13.23

Tier 1 leverage ratio

     10.62     8.74     9.74     10.50     10.62

Dividend payout ratio

     nm        239.02     30.06     19.50     4.61

Total loans to total deposits

     80.50     93.99     105.59     91.93     86.90

Asset Quality:

          

Net charge-offs

   $ 16,184      $ 9,300      $ 1,129      $ 2,215      $ 2,374   

Net loans charged-off to average loans

     1.66     0.93     0.12     0.28     0.36

Non-accrual loans

   $ 45,454      $ 18,453      $ 3,372      $ 2,653      $ 1,314   

Other real estate owned

   $ 16,017      $ 7,145      $ 2,452      $ 1,982      $ 1,552   

Repossessed assets

   $ 3,881      $ 1,680      $ 1,834      $ 2,231      $ 1,891   

Non-performing assets (NPA)

   $ 65,352      $ 27,278      $ 7,658      $ 6,866      $ 4,757   

NPA to total assets

     4.83     2.14     0.63     0.61     0.46

Loans 90 days past due

   $ 4,524      $ 2,706      $ 2,289      $ 1,325      $ 1,042   

NPA + loans 90 days past due to total assets

     5.16     2.35     0.82     0.72     0.56

Non-performing loans (NPL)

   $ 49,978      $ 21,159      $ 5,661      $ 3,978      $ 2,356   

NPL to total loans

     5.25     2.09     0.59     0.47     0.31

Allowance for loan and lease losses to total loans

     2.78     1.72     1.15     1.18     1.35

Allowance for loan and lease losses to NPL

     53.01     82.16     193.53     250.63     429.58

 

40


Table of Contents
Index to Financial Statements
     As of and for the Years Ended December 31,
     2009    2008    2007    2006    2005
    

(in thousands, except per share amounts and full-time

equivalent employees)

Period End Balances:

              

Loans

   $ 952,018    $ 1,011,584    $ 953,105    $ 847,593    $ 748,659

Intangible assets

   $ 1,918    $ 29,560    $ 30,356    $ 31,341    $ 32,463

Assets

   $ 1,353,834    $ 1,276,227    $ 1,211,955    $ 1,129,803    $ 1,040,692

Deposits

   $ 1,182,673    $ 1,076,286    $ 902,629    $ 922,001    $ 861,507

Common stockholders’ equity

   $ 110,260    $ 144,244    $ 147,693    $ 144,788    $ 138,389

Total stockholders’ equity

   $ 141,599    $ 144,244    $ 147,693    $ 144,788    $ 138,389

Common stock market capitalization

   $ 39,075    $ 75,860    $ 150,640    $ 204,796    $ 171,950

Full-time equivalent employees

     347      361      371      369      358

Common shares outstanding

     16,418      16,420      16,775      17,762      17,654

Average Balances:

              

Loans

   $ 977,758    $ 997,371    $ 904,490    $ 796,866    $ 657,928

Intangible assets

   $ 22,382    $ 29,948    $ 30,838    $ 31,699    $ 19,924

Earning assets

   $ 1,150,337    $ 1,132,962    $ 1,041,078    $ 960,966    $ 799,109

Assets

   $ 1,258,663    $ 1,258,469    $ 1,165,948    $ 1,081,375    $ 866,946

Deposits

   $ 1,057,090    $ 956,994    $ 924,587    $ 887,319    $ 734,869

Common stockholders’ equity

   $ 136,599    $ 148,655    $ 146,582    $ 140,467    $ 107,499

Total stockholders’ equity

   $ 166,804    $ 148,655    $ 146,582    $ 140,467    $ 107,499

Common shares outstanding, basic—wtd

     15,550      16,021      16,959      17,315      14,618

Common shares outstanding, diluted—wtd

     15,550      16,143      17,293      17,680      14,910

 

1

Performance ratios are calculated using net (loss) income available to common shareholders, before extraordinary items, and excluding the goodwill impairment.

GAAP Reconciliation and Management Explanation for Non-GAAP Financial Measures

The information set forth above contains certain financial information determined by methods other than in accordance with GAAP. Management uses these “non-GAAP” measures in their analysis of First Security’s performance. Non-GAAP measures typically adjust GAAP performance measures to exclude the effects of charges, expenses and gains related to the consummation of mergers and acquisitions and costs related to the integration of merged entities. These non-GAAP measures may also exclude other significant gains, losses or expenses that are unusual in nature and not expected to recur. Since these items and their impact on our performance are difficult to predict, management believes presentations of financial measures excluding the impact of these items provide useful supplemental information that is important for a proper understanding of the operating results of our core business. Additionally, management utilizes measures involving a tangible basis which exclude the impact of intangible assets such as goodwill and core deposit intangibles. As these assets are normally created through acquisitions and not through normal recurring operations, management believes that the exclusion of these items presents a more comparable assessment of the aforementioned measures on a recurring basis.

Specifically, management uses “non-interest expense, excluding goodwill impairment,” “net (loss) income available to common stockholders before extraordinary items, excluding goodwill impairment, net of tax,” “net (loss) income before extraordinary items, excluding goodwill impairment per share,” “return on average common equity,” “return on average tangible assets,” “return on average tangible common equity,” “return on average assets, excluding goodwill impairment,” “return on average common equity, excluding goodwill impairment,” “return on average tangible assets, excluding goodwill impairment,” and “return on average tangible common equity, excluding goodwill impairment.” Our management uses these non-GAAP measures in its analysis of First Security’s performance, as further described below.

 

   

“Non-interest expense, excluding goodwill impairment” is defined as non-interest expense reduced by the effect of goodwill impairment. “Net (loss) income available to common stockholders before

 

41


Table of Contents
Index to Financial Statements
 

extraordinary items, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax. “Net (loss) income before extraordinary items, excluding goodwill impairment per share” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by total common shares outstanding. Our management includes these measures because it believes that they are important when measuring First Security’s performance exclusive of the effects of impairment of goodwill. As of September 30, 2009, the annual assessment of goodwill indicated a full impairment of goodwill; accordingly, no further goodwill remains on the books of First Security. The goodwill impairment is a one-time, non-cash accounting adjustment that has no effect on First Security’s cash flows, liquidity, tangible capital, or ability to conduct business and as such, management believes excluding this charge is appropriate to properly measure First Security’s performance. These three non-GAAP financial measures exclude the effect of the goodwill impairment on the most comparable GAAP measures: non-interest expense (to measure the overall level of First Security’s recurring non-interest related expenses); net (loss) income available to common stockholders before extraordinary items (to reflect the recurring overall net income available to stockholders collectively); and net (loss) income before extraordinary items per share (to reflect the recurring overall net income available to stockholders on a per share basis).

 

   

“Return on average common equity” is defined as annualized earnings for the period divided by average equity reduced by average preferred stock. Our management includes this measure in addition to return on average equity, the most comparable GAAP measure, because it believes that it is important when measuring First Security’s performance exclusive of the effects of First Security’s outstanding preferred stock, which has a fixed return, and that this measure is important to many investors in First Security’s common stock.

 

   

“Return on average tangible assets” is defined as annualized earnings for the period divided by average assets reduced by average goodwill and other intangible assets. “Return on average tangible common equity” is defined as annualized earnings for the period divided by average equity reduced by average preferred stock and average goodwill and other intangible assets. Our management includes these measures because it believes that they are important when measuring First Security’s performance exclusive of the effects of goodwill and other intangibles recorded in First Security’s historic acquisitions, exclusive of the effects of First Security’s outstanding preferred stock, which has a fixed return, and these measures are used by many investors as part of their analysis of First Security’s performance.

 

   

“Return on average assets, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average assets. “Return on average common equity, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average equity reduced by average preferred stock. “Return on average tangible assets, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average assets reduced by average goodwill and other intangible assets. “Return on average tangible common equity, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average equity reduced by average preferred stock and average goodwill and other intangible assets. The most comparable GAAP measure for each of these measures is return on average assets. Our management includes these measures because it believes that they are important when measuring First Security’s performance exclusive of the effects of impairment of goodwill. As of September 30, 2009, the annual assessment of goodwill indicated a full impairment of goodwill; accordingly, no further goodwill remains on the books of First Security. The goodwill impairment is a one-time, non-cash accounting adjustment that has no effect on First Security’s cash flows, liquidity, tangible capital, or ability to conduct business and as such, management believes excluding this charge is necessary to properly measure First Security’s performance.

 

42


Table of Contents
Index to Financial Statements

These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. The following table provides a more detailed analysis of these non-GAAP performance measures.

 

    As of and for the Years Ended December 31,  
    2009     2008     2007     2006     2005  
    (in thousands, except per share data)  

Return on average assets

    -2.78     0.11     0.97     1.03     0.83

Effect of intangible assets

    -0.05     —          0.03     0.03     0.02
                                       

Return on average tangible assets

    -2.83     0.11     1.00     1.06     0.85
                                       

Return on average assets

    -2.78     0.11     0.97     1.03     0.83

Effect of goodwill impairment

    1.97     —          —          —          —     
                                       

Return on average assets, excluding goodwill impairment

    -0.81     0.11     0.97     1.03     0.83

Effect of average intangible assets

    -0.02     —          0.03     0.03     0.02
                                       

Return on average tangible assets, excluding goodwill impairment

    -0.83     0.11     1.00     1.06     0.85
                                       

Return on average common equity

    -25.60     0.92     7.75     7.91     6.88

Effect of goodwill impairment

    18.12     —          —          —          —     
                                       

Return on average common equity, excluding goodwill impairment

    -7.48     0.92     7.75     7.91     6.88

Effect on average intangible assets

    -1.46     0.23     2.06     2.32     1.57
                                       

Return on average tangible common equity, excluding goodwill impairment

    -8.94     1.15     9.81     10.22     8.45
                                       

Total equity to total assets

    10.46     11.30     12.19     12.82     13.30

Effect of intangible assets

    -0.13     -2.10     -2.26     -2.49     -2.79
                                       

Tangible equity to tangible assets

    10.33     9.20     9.93     10.33     10.51
                                       

Effect of preferred stock

    -2.32     —          —          —          —     
                                       

Tangible common equity to tangible assets

    8.01     9.20     9.93     10.33     10.51
                                       

Non-interest expense

  $ 68,231      $ 40,382      $ 41,441      $ 40,017      $ 35,373   

Effect of goodwill impairment

    (27,156     —          —          —          —     
                                       

Non-interest expense, excluding goodwill impairment

  $ 41,075      $ 40,382      $ 41,441      $ 40,017      $ 35,373   
                                       

Net (loss) income available to common stockholders

  $ (34,974   $ 1,361      $ 11,356      $ 11,112      $ 9,571   

Extraordinary gain, net of tax

    —          —          —          —          (2,175

Effect of goodwill impairment, net of $2,394 tax effect

    24,762        —          —          —          —     
                                       

Net (loss) income available to common stockholders before extraordinary gain, excluding goodwill impairment

  $ (10,212   $ 1,361      $ 11,356      $ 11,112      $ 7,396   
                                       

Total stockholders’ equity

  $ 141,599      $ 144,244      $ 147,693      $ 144,788      $ 138,389   

Effect of preferred stock

    (31,339     —          —          —          —     
                                       

Common stockholders’ equity

  $ 110,260      $ 144,244      $ 147,693      $ 144,788      $ 138,389   
                                       

Average assets

  $ 1,258,663      $ 1,258,469      $ 1,165,948      $ 1,081,375      $ 866,946   

Effect of average intangible assets

    22,382        29,948        30,838        31,699        19,924   
                                       

Average tangible assets

  $ 1,236,281      $ 1,228,521      $ 1,135,110      $ 1,049,676      $ 847,022   
                                       

 

43


Table of Contents
Index to Financial Statements
    As of and for the Years Ended December 31,  
    2009     2008     2007     2006     2005  
    (in thousands, except per share data)  

Average total stockholders’ equity

  $ 166,804      $ 148,655      $ 146,582      $ 140,467      $ 107,499   

Effect of average preferred stock

    (30,205     —          —          —          —     
                                       

Average common stockholders’ equity

    136,599        148,655        146,582        140,467        107,499   
                                       

Effect of average intangible assets

    (22,382     (29,948     (30,838     (31,699     (19,924
                                       

Average tangible common stockholders’ equity

  $ 114,217      $ 118,707      $ 115,744      $ 108,768      $ 87,575   
                                       

Per Share Data

         

Book value per common share

  $ 6.72      $ 8.78      $ 8.80      $ 8.15      $ 7.84   

Effect of intangible assets

    (0.12     (1.80     (1.81     (1.76     (1.84
                                       

Tangible book value per common share

  $ 6.60      $ 6.98      $ 6.99      $ 6.39      $ 6.00   
                                       

Net (loss) income before extraordinary items, basic

  $ (2.25   $ 0.08      $ 0.67      $ 0.64      $ 0.51   

Effect of goodwill impairment, net of tax

    1.59        —          —          —          —     
                                       

Net (loss) income before extraordinary items, excluding goodwill impairment, basic

  $ (0.66   $ 0.08      $ 0.67      $ 0.64      $ 0.51   
                                       

Net (loss) income before extraordinary items, diluted

  $ (2.25   $ 0.08      $ 0.66      $ 0.63      $ 0.50   

Effect of goodwill impairment, net of tax

    1.59        —          —          —          —     
                                       

Net (loss) income before extraordinary items, excluding goodwill impairment, diluted

  $ (0.66   $ 0.08      $ 0.66      $ 0.63      $ 0.50   
                                       

 

44


Table of Contents
Index to Financial Statements
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation

The following is management’s discussion and analysis (MD&A) which should be read in conjunction with “Selected Financial Data” and our consolidated financial statements and notes included in this Annual Report on Form 10-K. The discussion in this Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report. Our actual results could differ materially from those discussed in this Annual Report on Form 10-K.

Year Ended December 31, 2009

The following discussion and analysis sets forth the major factors that affected First Security’s financial condition as of December 31, 2009 and 2008, and results of operations for the three years ended December 31, 2009 as reflected in the audited financial statements.

Overview

CPP Investment

On January 9, 2009, as part of the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP), we agreed to issue and sell, and the Treasury agreed to purchase (1) 33,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock (Preferred Shares), Series A, having a liquidation preference of $1,000 per share and (2) a ten-year warrant to purchase up to 823,627 shares of our common stock, $0.01 par value, at an exercise price of $6.01 per share, for an aggregate purchase price of $33 million in cash. The Preferred Shares qualify as Tier 1 capital and pay 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.

Market Conditions

Most indicators point toward the overall U.S economy transitioning to a gradual recovery period over the balance of 2010. Some economists have indicated that the future recovery may bring with it few new jobs. However, our market received positive news, when, on July 15, 2008, the Volkswagen Group of America, Inc. announced plans to build a $1 billion automobile production facility in Chattanooga, Tennessee. More recently, Volkswagen officials announced a supplier park that could hold 15 or more companies that will be built adjacent to the primary production facility. Additionally, in February 2009, Wacher Chemie AG announced plans to construct a new hyperpure polycrystalline silicon facility in Cleveland, Tennessee. The Wacher investment is also expected to be around $1 billion and will produce silicon that is used by the solar and semiconductor industries.

The Volkswagen plant will bring about 2,000 direct jobs, including approximately 400 white-collar jobs, and up to 12,000 indirect jobs to the region. The Wacher plant is expected to add approximately 500 new jobs. We believe the positive economic impact on Chattanooga and the surrounding region will be significant and it may stabilize and possibly increase real estate values and enhance economic activity within our market area.

While the economic recession has resulted in higher unemployment across the country, our market areas benefit from more stable rates of employment. Our major market areas of Chattanooga and Knoxville have a lower unemployment rate of 8.8% and 8.3%, respectively (as of November 2009, the most recent available data), than the national and Tennessee rates of 10.0% and 10.0%, respectively. The economy of the Dalton, Georgia MSA is primarily centered on the carpet and floor-covering industries. With the decline in housing starts and

 

45


Table of Contents
Index to Financial Statements

overall economy, Dalton has been the most negatively impacted region in our footprint. The unemployment rate in the Dalton MSA is 12.7% (as of November 2009) as compared to the Georgia rate of 9.8%. For the Chattanooga and Knoxville MSAs, the number of unemployed workers is decreasing and, as of November 2009, has declined by 12.0% in Chattanooga and 13.1% in Knoxville since the peak in June 2009. We anticipate these positive employment trends to continue into 2010.

Our market area has also benefited from a relatively stable housing market. According to the National Association of REALTORS, the median sales prices of existing single-family homes declined only 5.0% and 5.2% for the Chattanooga and Knoxville MSAs, respectively, from 2008 to 2009 compared to 11.9% for the nation and 8.7% for the census region identified as the South. While real estate values may continue to decline, we are hopeful that housing prices will remain above the state and national levels due to the significant economic investments being made in our market.

Financial Results

As of December 31, 2009, we had total consolidated assets of $1.4 billion, total loans of $952.0 million, total deposits of $1.2 billion and stockholders’ equity of $141.6 million. In 2009, our net loss available to common stockholders was $35.0 million, resulting in net loss of $2.25 per share (basic and diluted). During 2009, we recognized a goodwill impairment of $27.2 million, or $24.8 million after-tax. Excluding the goodwill impairment, our net loss available to common stockholders was $10.2 million, or $0.66 per share (basic and diluted). The goodwill impairment represents a one-time, non-cash accounting adjustment and has no impact on cash flows, liquidity, tangible capital or our ability to conduct business.

As of December 31, 2008, we had total consolidated assets of $1.3 billion, total loans of $1.0 billion, total deposits of $1.1 billion and stockholders’ equity of approximately $144.2 million. In 2008, our net income was $1.4 million, resulting in basic and diluted net income of $0.08 per share.

Net interest income for 2009 declined by $3.0 million primarily as a result of the reductions to the target federal funds rate by the Federal Reserve Board that began in September 2007 and ended in December 2008. The weighted average target fund rate for 2008 was 1.76% compared to 0.25% for 2009. The provision for loan and lease losses increased $9.6 million as a result of declining asset quality and general economic conditions. Noninterest income decreased by $1.3 million, primarily a result of lower deposit fees and lower mortgage loan and related fee income. Noninterest expense, excluding the goodwill impairment of $27.2 million, marginally increased 1.7%, or $693 thousand. Full-time equivalent employees were 347 at December 31, 2009, compared to 361 at December 31, 2008.

Our efficiency ratio, excluding the goodwill impairment, increased to 78.2% in 2009 versus 70.1% in 2008 and 68.8% in 2007. The efficiency ratio for 2009 increased as a result of the combined $4.4 million decline in net interest income and noninterest income and the increase in noninterest expense. We anticipate our efficiency ratio to stabilize and begin to improve during the second half of 2010 as we focus on enhancing revenue while reducing certain overhead expenses. However, the stabilization and possible improvement of our efficiency ratio in second half 2010 is contingent on both macro-economic factors, such as changes to the federal funds target rate, and micro-economic factors, such as local unemployment and real estate values.

Net interest margin in 2009 was 3.75%, or 32 basis points lower, compared to the prior period of 4.07%. The net interest margin of our peer group (as reported on the December 31, 2009 Uniform Bank Performance Report) was 3.50% and 3.68% for 2009 and 2008, respectively. During 2008 and into 2009, our margin continued to decline to a low of 3.63% for the first quarter of 2009. As loan yields stabilized after the final December 2008 federal funds rate cut and deposit rates continued to reprice at lower market rates, our margin began to trend upward during the second and third quarters of 2009. The issuance of over $161.1 million in brokered deposits in the fourth quarter reversed this trend as the margin in the fourth quarter of 2009 was 3.67%. We anticipate our margin to decline during the first half of 2010 before stabilizing during the second half of 2010. Our expectations are dependent on our ability to raise core deposits, our loan and deposit pricing, and any possible actions by the Federal Reserve Board to the target federal funds rate.

 

46


Table of Contents
Index to Financial Statements

Strategic Initiatives

During 2009 and into 2010, we initiated a set of strategic initiatives to position us appropriately for both short-term stability and long-term success. The following are the primary initiatives with associated target dates for implementation:

 

Strategic Initiative

  

Current and/or Potential Impact

   Actual/Expected
Implementation

Capital

     

•    CPP participation

   Received $33 million in Preferred Stock capital    1st quarter 2009

•    Capital stress test

  

Outsourced a SCAP capital stress test to assist in capital planning

   4th quarter 2009

Liquidity

     

•    Liquidity enhancement

  

Increased longer term brokered deposits and excess cash to fund future contractual obligations and prudent investments

   1st quarter 2010

Asset Quality

     

•    Asset Quality Committee

  

Created board-level committee to focus on asset quality

   1st quarter 2009

•    OREO sales team

   Dedicated resources to exclusively sell OREO    1st quarter 2009

•    Loan review department expansion

  

Added resources to increase frequency and coverage of the review of our portfolio

   4th quarter 2009

•    Extensive loan review

   Outsourced an extensive loan review prior to year-end 2009    4th quarter 2009

Credit Administration

     

•    Lines of business

  

Credit functions aligned by retail and commercial lines of business with dedicated credit officers and staff supporting each portfolio

   4th quarter 2009

•    Loan underwriting centralization

  

Ensures consistency in underwriting, pricing, loan structure and policy compliance

   2nd quarter 2010

•    Collections centralization

  

Dedicated collections department created to focus on collection of past due loans and recovery of prior charge-offs

   2nd quarter 2010

•    Loan document preparation centralization

  

Operational efficiencies and reduction of loan policy exceptions

   2nd quarter 2010

The above initiatives are discussed in additional detail throughout MD&A.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our significant accounting policies are described in Note 1, “Accounting Policies,” to the consolidated financial statements and are integral to understanding MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that we reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.

 

47


Table of Contents
Index to Financial Statements

Allowance for Loan and Lease Losses

The allowance for loan and lease losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan and lease losses and reduced through loan and lease charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that we exercise judgment to estimate an appropriate allowance. Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact our net income as a result of the change in the provision for loan and lease losses. Refer to the “Provision for Loan and Lease Losses” and “Allowance” sections within MD&A for a discussion of our methodology of establishing the allowance as well as Note 1 to our notes to the consolidated financial statements.

Estimates of Fair Value

Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Our available-for-sale securities and held for sale loans are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a non-recurring basis. We use fair value on a non-recurring basis for other real estate owned, repossessions and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.

Fair value is the price that could be received to sell as asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that we make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate our assessments regarding assumptions that market participants would use in pricing the asset or the liability.

Changes in fair value could materially impact our financial results. Refer to Note 17, “Fair Value Measurements” in the notes to our consolidated financial statements for a discussion of our methodology of calculating fair value.

Goodwill

Our 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. Impairment is a condition that exists when the carrying amount of goodwill exceeds its implied fair value. As more fully described below, we recorded a full goodwill impairment during 2009.

Income Taxes

We are subject to various taxing jurisdictions where we conduct business and we estimate income tax expense based on amounts that we expect to owe to these jurisdictions. We evaluate the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income.

 

48


Table of Contents
Index to Financial Statements

The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and are reported in other liabilities or other assets, respectively, in our consolidated balance sheets. We assess the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintain tax accruals consistent with our evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results.

We periodically evaluate our uncertain tax positions and estimate the appropriate level of tax reserves related to each of these positions. Additionally, we evaluate our deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 12, “Income Taxes,” in the notes to our consolidated financial statements as well as the Income Taxes section of MD&A for more information.

Results of Operations

We reported a net loss available to common stockholders for 2009 of $35.0 million versus net income for 2008 of $1.4 million and net income for 2007 of $11.4 million. In 2009, net loss per share was $2.25 (basic and diluted) on approximately 15.6 million weighted average shares outstanding. Excluding the goodwill impairment of $24.8 million after-tax, or $27.2 million before-tax, our net loss was $10.2 million, or $0.66 per share (basic and diluted) for 2009. In 2008, the net income of $1.4 million resulted in net income of $0.08 per share (basic and diluted) on approximately 16.0 million weighted average basic shares and 16.1 million weighted average diluted shares. In 2007, the net income of $11.4 million resulted in basic net income per share of $0.67 on approximately 17.0 million shares and diluted net income per share of $0.66 on approximately 17.3 million weighted average shares outstanding.

Net income available to common shareholders in 2009 was significantly below the 2008 level predominately as a result of the goodwill impairment and higher provision expense. Declining margins also resulted in lower net interest income. As of December 31, 2009, we had 39 banking offices, including the headquarters, one leasing/loan production office and 347 full time equivalent employees.

 

49


Table of Contents
Index to Financial Statements

The following table summarizes the components of income and expense and the changes in those components for the past three years.

 

    Condensed Consolidated Statements of Income
For the Years Ended December 31,
 
    2009     Change
From
Prior
Year
    Percent
Change
    2008     Change
From
Prior
Year
    Percent
Change
    2007   Change
From
Prior
Year
    Percent
Change
 
    (in thousands, except percentages)  

Interest income

  $ 64,007      $ (12,081   (15.9 )%    $ 76,088      $ (7,435   (8.9 )%    $ 83,523   $ 8,396      11.2

Interest expense

    21,798        (9,063   (29.4 )%      30,861        (3,740   (10.8 )%      34,601     7,456      27.5
                                                               

Net interest income

    42,209        (3,018   (6.7 )%      45,227        (3,695   (7.6 )%      48,922     940      2.0

Provision for loan and lease losses

    25,315        9,562      60.7     15,753        13,598      631.0     2,155     (29   (1.3 )% 
                                                               

Net interest income after provision for loan and lease losses

    16,894        (12,580   (42.7 )%      29,474        (17,293   (37.0 )%      46,767     969      2.1

Noninterest income

    10,335        (1,347   (11.5 )%      11,682        382      3.4     11,300     683      6.4

Noninterest expense

    68,231        27,849      69.0     40,382        (1,059   (2.6 )%      41,441     1,424      3.6
                                                               

Net (loss) income before income taxes

    (41,002     (41,776   (5,397.4 )%      774        (15,852   (95.3 )%      16,626     228      1.4

Income tax (benefit) provision

    (7,982     (7,395   1,259.8     (587     (5,857   (111.1 )%      5,270     (16   (0.3 )% 
                                                               

Net (loss) income

    (33,020     (34,381   (2,526.2 )%      1,361        (9,995   (88.0 )%      11,356     244      2.2

Preferred stock dividends and discount accretion

    1,954        1,954      100.0     —          —        —          —       —        —     
                                                               

Net (loss) income available to common stockholders

  $ (34,974   $ (36,335   (2,669.7 )%    $ 1,361      $ (9,995   (88.0 )%    $ 11,356   $ 244      2.2
                                                               

Further explanation, with year-to-year comparisons of the income and expense, is provided below.

Net Interest Income

Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. In 2009, net interest income was $42.2 million, or 6.7% less than the 2008 level of $45.2 million, which was 7.6% less than the 2007 level of $48.9 million.

The level of net interest income is determined primarily by the average balances (volume) of interest earning assets and the various rate spreads between our interest earning assets and our funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest earning assets and interest bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits.

 

50


Table of Contents
Index to Financial Statements

The following table summarizes net interest income on a fully tax-equivalent basis and average yields and rates paid for the years ended December 31, 2009, 2008 and 2007.

Average Consolidated Balance Sheets and Net Interest Analysis

Fully Tax-Equivalent Basis

 

    For the Years Ended,  
    2009     2008     2007  
    Average
Balance
    Income/
Expense
  Yield/
Rate
    Average
Balance
    Income/
Expense
  Yield/
Rate
    Average
Balance
    Income/
Expense
  Yield/
Rate
 
    (in thousands, except percentages)  
    (fully tax-equivalent basis)  

ASSETS

                 

Earning assets:

                 

Loans, net of unearned income1,2

  $ 977,758      $ 57,784   5.91   $ 997,371      $ 69,863   7.00   $ 904,490      $ 77,309   8.55

Debt securities—taxable

    98,797        4,613   4.67     89,711        4,647   5.18     90,093        4,545   5.04

Debt securities—non-taxable 2

    43,134        2,457   5.70     42,780        2,452   5.73     43,489        2,493   5.73

Federal funds sold and other earning assets

    30,648        72   0.23     3,100        49   1.58     3,005        134   4.46
                                                           

Total earning assets

    1,150,337        64,926   5.64     1,132,962        77,011   6.80     1,041,077        84,481   8.11
                                         

Allowance for loan losses

    (20,582         (12,030         (10,452    

Intangible assets

    22,382            29,948            30,838       

Cash & due from banks

    15,292            23,280            25,841       

Premises & equipment

    33,753            34,429            35,799       

Other assets

    57,481            49,880            42,845       
                                   

Total assets

  $ 1,258,663          $ 1,258,469          $ 1,165,948       
                                   

LIABILITIES AND STOCKHOLDERS’ EQUITY

                 

Interest bearing liabilities:

                 

NOW accounts

  $ 61,501      $ 190   0.31   $ 62,911      $ 327   0.52   $ 63,983      $ 536   0.84

Money market accounts

    126,219        1,567   1.24     103,137        2,139   2.07     100,206        2,875   2.87

Savings deposits

    35,986        101   0.28     35,120        146   0.42     35,851        293   0.82

Time deposits less than $100 thousand

    244,912        7,183   2.93     256,664        10,549   4.11     265,099        13,021   4.91

Time deposits > $100 thousand

    203,052        6,265   3.09     214,705        9,310   4.34     216,732        11,147   5.14

Brokered CDs and CDARS®

    157,717        5,317   3.37     121,736        4,735   3.89     76,635        3,711   4.84

Brokered money markets and NOWs

    77,683        653   0.84     4,975        74   1.49     —          —     —  

Federal funds purchased

    335        4   1.19     23,710        689   2.91     3,304        173   5.24

Repurchase agreements

    20,828        498   2.39     34,513        835   2.42     27,260        734   2.69

Other borrowings

    1,723        20   1.16     78,108        2,057   2.63     45,683        2,111   4.62
                                                           

Total interest bearing liabilities

    929,956        21,798   2.34     935,579        30,861   3.30     834,753        34,601   4.15
                                         

Net interest spread

    $ 43,128   3.30     $ 46,150   3.50     $ 49,880   3.96
                             

Noninterest bearing demand deposits

    150,020            157,746            166,081       

Accrued expenses and other liabilities

    11,883            16,489            18,532       

Stockholders’ equity

    160,376            144,622            146,873       

Accumulated other comprehensive gain (loss)

    6,428            4,033            (291    
                                   

Total liabilities and stockholders’ equity

  $ 1,258,663          $ 1,258,469          $ 1,165,948       
                                   

Impact of noninterest bearing sources and other changes in balance sheet composition

      0.45       0.57       0.83
                             

Net interest margin

      3.75       4.07       4.79
                             

 

51


Table of Contents
Index to Financial Statements

 

1

Nonaccrual loans have been included in the average balance. Only the interest collected on such loans has been included as income.

 

2

Interest income from securities and loans includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for all years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $919 thousand, $923 thousand and $958 thousand for the three years ended December 31, 2009, 2008 and 2007.

The following table shows the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amounts of the change in each category.

Change in Interest Income and Expense on a Tax Equivalent Basis

 

     2009 compared to 2008 increase
(decrease) in interest income and
expense due to changes in:
    2008 compared to 2007 increase
(decrease) in interest income and
expense due to changes in:
 
     Volume     Rate     Total     Volume     Rate     Total  
     (in thousands)  

Earning assets:

            

Loans, net of unearned income

   $ (1,561   $ (10,518   $ (12,079   $ 7,939      $ (15,385   $ (7,446

Debt Securities—taxable

     457        (491     (34     (19     121        102   

Debt Securities—non-taxable

     14        (9     5        (41     —          (41

Federal funds sold and other earning assets

     434        (411     23        4        (89     (85
                                                

Total earning assets

     (656     (11,429     (12,085     7,883        (15,353     (7,470
                                                

Interest bearing liabilities:

            

NOW accounts

     (8     (129     (137     (6     (203     (209

Money market accounts

     472        (1,044     (572     84        (820     (736

Savings deposits

     3        (48     (45     (6     (141     (147

Time deposits less than $100 thousand

     (511     (2,855     (3,366     (414     (2,058     (2,472

Time deposits > $100

     (529     (2,516     (3,045     (104     (1,733     (1,837

Brokered CDs and CDARS®

     1,383        (801     582        2,184        (1,160     1,024   

Brokered money market accounts

     1,078        (499     579        74        —          74   

Federal funds purchased

     (679     (6     (685     1,068        (552     516   

Repurchase agreements

     (332     (5     (337     195        (94     101   

Other borrowings

     (2,012     (25     (2,037     1,498        (1,552     (54
                                                

Total interest bearing liabilities

     (1,135     (7,928     (9,063     4,573        (8,313     (3,740
                                                

Increase (decrease) in net interest income

   $ 479      $ (3,501   $ (3,022   $ 3,310      $ (7,040   $ (3,730
                                                

Net Interest Income—Volume and Rate Changes

Interest income in 2009 was $64.0 million, a 16% decrease over the 2008 level of $76.1 million, which was a 9% decrease over the 2007 level of $83.5 million. For 2009, average interest-earning assets increased 2% to $1.2 billion. However, the associated increase in earnings from the higher volumes was offset by the decline in the yields of earning assets and a shift in earning assets, as discussed in additional detail below. The decrease in interest income from 2007 to 2008 was due to the impact of the reductions in yields exceeding the impact of the increases in the volume of earning assets. Average loans in 2009 were $977.8 million, a decrease of $19.6 million, or 2%. Average taxable debt securities increased $9.1 million, or 10%. Other earning assets increased $27.5 million to $30.6 million. The largest component of other earning assets is our interest bearing account at the Federal Reserve Bank of Atlanta that averaged $23.0 million during 2009. This account yields approximately 25 basis points. The increase in average taxable debt securities and other earning assets was funded by the

 

52


Table of Contents
Index to Financial Statements

reductions in loans and increases in brokered deposits. The impact on interest income from the decline in average loans fully offset the increases in the other categories of earning assets. The total impact on interest income from changes in volume was a reduction of $656 thousand comparing 2009 to 2008.

The reduction in yield of average earnings assets reduced interest income by $11.4 million, accounting for 95% of the total decline, on a fully tax equivalent basis from 2008 to 2009. The tax equivalent yield on earning assets decreased 116 basis points in 2009 to 5.64% from 6.80% in 2008, which was 131 basis points lower than 2007. The reduction in yield on loans for 2009 was 109 basis points, which was a result of the full impact of the 2008 cuts in the federal funds rate. From September 2007 to December 2008, the Federal Reserve Board reduced the target federal funds rate by 500 basis points to a target rate of 0.25%. Throughout the last twenty-four months, we had an asset sensitive balance sheet, which means that earning assets reprice faster than interest bearing liabilities and thus interest income declines faster than interest expense in a declining rate environment.

Total interest expense was $21.8 million in 2009 compared to $30.9 million in 2008 and $34.6 million in 2007. Interest expense for 2009 decreased due to the reduced cost of funds as well as reduced volumes of interest bearing liabilities. Interest expense for 2008 decreased due to the reduced cost of funds despite the additional volumes of interest bearing liabilities. Average interest bearing liabilities declined by $5.6 million, or 1%, to $930.0 million for 2009 compared to 2008. During 2009, we replaced non-deposit liabilities, primarily short-term other borrowings, with long-term brokered deposits. Average interest bearing liabilities, excluding average deposits, declined by $113.4 million while average brokered deposits increased $108.7 million. In-market certificates of deposits declined by $23.4 million, or 5%, while money markets increased $23.1 million, or 22%. The total impact on the changes in volume of average interest bearing liabilities was a decline in interest expense of $1.1 million. Comparing 2008 to 2007, average interest bearing liabilities increased $100.8 million, or 12%, to $935.6 million. During 2008, average brokered deposits increased by $49.7 million, or 65%, average other borrowings increased by $32.4 million, or 71%, and average Federal Funds purchased increased by $20.4 million from $3.3 million to $23.7 million. These increases in non-core deposits were primarily used to fund our loan growth for 2008.

The reduction of costs on interest bearing liabilities reduced interest expense by $7.9 million, accounting for 87% of the total change of $9.1 million comparing 2008 to 2009. Deposit pricing, especially for time deposits, typically lags changes in the target federal funds rate, and therefore we realized a consistent but gradual reduction in our costs of deposits throughout 2009. The average rate paid on interest bearing liabilities for 2009 decreased by 96 basis points from 3.30% to 2.34%. Beginning in the second half of 2008 and continuing into 2009, we decided to fortify our balance sheet and improve our contingent funding plans so we significantly reduced our overnight borrowings and replaced them with brokered deposits. During the fourth quarter of 2009, we took advantage of historically low rates and further extended our brokered CD ladder. We issued approximately $161.1 million of brokered CDs during the fourth quarter of 2009 with a weighted average maturity of 41 months and weighted average rate of 2.72%. The bulk of these funds were placed in our interest-bearing account at the Federal Reserve Bank of Atlanta. These funds will serve as excess liquidity to fund contractual obligations or prudent investments. Comparing 2007 to 2008, the average rate paid on average interest bearing liabilities decreased 85 basis points to 3.30% from 4.15%. Our rate decreases in 2008 were a reflection of the market conditions.

We expect average loans to continue to decline in 2010 while all other earnings assets increase or are comparable to the 2009 levels. The average yield on loans in 2010 should be comparable to 2009 while the overall yield on earning assets may decline in 2010 due to the increase in interest-bearing cash and the associated lower yield. We expect average interest bearing liabilities to be comparable with a shift from average other borrowings to average brokered CDs. Rates paid on deposits are expected to be consistent with 2009 rates.

Net Interest Income—Net Interest Spread and Net Interest Margin

The banking industry uses two key ratios to measure relative profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The net interest rate spread does

 

53


Table of Contents
Index to Financial Statements

not consider the impact of noninterest bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest bearing deposits in earning assets.

First Security’s net interest rate spread (on a tax equivalent basis) was 3.30% in 2009, 3.50% in 2008 and 3.96% in 2007, while the net interest margin (on a tax equivalent basis) was 3.75% in 2009, 4.07% in 2008 and 4.79% in 2007. The decrease in the net interest spread and net interest margin for 2009 was primarily due to the full-year impact of the 2008 Federal Reserve Board cuts to the target federal funds rate, partially offset by the repricing of our deposits. The 2008 decline from 2007 was also due to the Federal Reserve Board rate cuts. During 2008, approximately 47% of our loans repriced simultaneously with changes to an associated index (such as Prime, which is driven by the target federal funds rate), while only approximately 11% of our liabilities repriced simultaneously. As such, the 2008 target rate reductions by the Federal Reserve Board had an immediate negative impact on our net interest spread and net interest margin. Additionally, a decline in average noninterest bearing deposits for 2009 contributed an additional 12 basis points to the reduction in net interest margin. For 2009, noninterest bearing deposits contributed 45 basis points to the net interest margin, as compared to 57 basis points during 2008.

In October 2007, we entered into cash flow swaps with a $50 million total notional value. The swaps exchanged a portion of our Prime-based variable rate payments for fixed rate payments. The fixed rate was appropriately 7.72%. On March 26, 2009, we elected to terminate the interest rate swaps for $5.8 million due to increasing counterparty credit risk. By terminating the swaps, we locked in the gain, which is accreting into interest income over the remaining life of the originally hedged items. The 2009 terminated swaps, combined with swaps we terminated in 2007, added approximately $2.3 million to interest income in 2009. For 2010, we estimate the terminated swaps will add approximately $2.0 million to interest income.

We anticipate our net interest spread and net interest margin to decline during the first half of 2010 before stabilizing or increasing in the second half of 2010. The anticipated decline is associated with the negative spread created in the fourth quarter of 2009 by issuing brokered deposits and placing the bulk of the proceeds in our interest-bearing account at the Federal Reserve Bank of Atlanta. The stabilization for the second half of 2010 depends on multiple factors, including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, and any possible further action by the Federal Reserve Board to adjust the target federal funds rate.

Provision for Loan and Lease Losses

The provision for loan and lease losses charged to operations during 2009 increased $9.6 million to $25.3 million compared to $15.8 million in 2008 and $2.2 million in 2007. Net charge-offs totaled $16.2 million for 2009, $9.3 million for 2008 and $1.1 million for 2007. Net charge-offs as a percentage of average loans were 1.66% in 2009, 0.93% in 2008 and 0.12% in 2007 and our Bank’s peer group averages (as reported in the December 31, 2009 Uniform Bank Performance Report) were 1.48%, 0.80% and 0.24% in 2009, 2008 and 2007, respectively.

The increase in our provision for loan and lease losses in 2009 relative to 2008 was a result of our analysis of inherent risks in the loan portfolio in relation to the portfolio’s growth, the level of impaired, past due, charged-off, classified and non-performing loans, as well as increased environmental risk factors due to the general economic conditions. During 2009, we significantly increased our allowance for loan and lease losses from 1.72% of total loans as of December 31, 2008 to 2.78% of total loans as of December 31, 2009. The provision expense associated with this reserve-building was approximately $10.1 million. As of December 31, 2009, we determined our allowance of $26.5 million was adequate to provide for credit losses, which we describe more fully below in the Allowance for Loan and Lease Loss section of MD&A.

We will continue to provide provision expense to maintain an allowance level adequate to absorb known and estimated losses inherent in our loan portfolio. As the determination of provision expense is a function of the adequacy of the allowance for loan and lease losses, we cannot reasonably estimate the provision expense for

 

54


Table of Contents
Index to Financial Statements

2010. Furthermore, the provision expense could materially increase or decrease in 2010 depending on a number of factors, including, among others, the level of net charge-offs, the amount of classified loans and the value of collateral associated with impaired loans.

Noninterest Income

Total noninterest income for 2009 was $10.3 million compared to $11.7 million in 2008 and $11.3 million in 2007. The following table presents the components of noninterest income for years ended December 31, 2009, 2008 and 2007.

Noninterest Income

 

     For the Years Ended  
     2009    Percent
Change
    2008    Percent
Change
    2007  
     (in thousands, except percentages)  

Non-sufficient funds (NSF) fees

   $ 3,550    (14.1 )%    $ 4,135    0.3   $ 4,123   

Service charges on deposit accounts

     1,092    (5.0 )%      1,149    6.8     1,076   

Point-of-sale (POS) fees

     1,126    7.2     1,050    11.2     944   

Mortgage loan and related fees

     1,025    (29.0 )%      1,443    (9.5 )%      1,594   

Bank-owned life insurance income

     1,006    4.0     967    6.9     905   

Net gain (loss) on sales of available-for-sale securities

     —      (100.0 )%      146    186.9     (168

Other-than-temporary impairment of securities

     —      —       —      100.0     (584

Other income

     2,536    (9.2 )%      2,792    (18.1 )%      3,410   
                                  

Total noninterest income

   $ 10,335    (11.5 )%    $ 11,682    3.4   $ 11,300   
                                  

Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including non-sufficient funds (NSF) fees, were $4.6 million, or 45% of total noninterest income for 2009, compared with $5.3 million, or 45% of total noninterest income for 2008, and $5.2 million, or 46% for 2007.

Point-of-sale fees increased 7.2% to $1.1 million in 2009 compared to 2008. POS fees are primarily generated when our customers use their debit cards for retail purchases. We anticipate POS fees to continue to grow as customer trends show increased use of debit cards.

Mortgage loan and related fees for 2009 were $1.0 million, compared to $1.4 million in 2008 and $1.6 million in 2007. As discussed in Note 18 to our consolidated financial statements, we began electing the fair value option under applicable accounting guidance to our held for sale loan originations in February 2008. This election impacted the timing and recognition of origination fees and costs, as well as the value of the servicing rights. The recognition of the income is now concurrent with the origination of the loan. We believe the fair value option improves financial reporting by better aligning the underlying economic changes in value of the loans and related hedges to the reported results. Additionally, the election eliminates the complexities and inherent difficulties of achieving hedge accounting.

Our process to originate and sell a conforming mortgage in the secondary market typically takes 30 to 60 days from the date of mortgage origination to the date the mortgage is sold to an investor in the secondary market. Due to the normal processing time, we will have a certain amount of held for sale loans at any time. We sell these loans with the right to service the loan being released to the purchaser for a fee. Mortgages originated for sale in the secondary markets totaled $61.1 million for 2009, $67.0 million in 2008 and $80.1 million in 2007. Mortgages sold in the secondary market totaled $61.5 million for 2009, $69.8 million and $83.3 million in 2007. We do not originate sub-prime loans. For 2010, we expect mortgage loan income to be consistent or decline as the volume of refinancing stabilizes or declines should mortgage rates remain consistent or increase.

 

55


Table of Contents
Index to Financial Statements

Bank-owned life insurance income increased to $1.0 million compared to $967 thousand for 2008 and $905 thousand for 2007. The Company is the owner and beneficiary of these contracts. The income generated by the cash value of the insurance policies accumulates on a tax-deferred basis and is tax free to maturity. Additionally, the insurance death benefit will be a tax free payment to the Company. This tax-advantaged asset enables us to provide benefits to our employees. On a fully tax equivalent basis, the weighted average interest rate earned on the policies was 6.1% during 2009.

During 2009, we did not sell any available-for-sale securities. During 2008, we sold approximately $13.1 million in senior unsecured debt issued by Freddie Mac and Fannie Mae for a gain of $146 thousand. During 2007, we de-leveraged a portion of our balance sheet by selling approximately $27.0 million in investment securities to pay down our overnight borrowings. This transaction eliminated negative spread. Due to the timing of the sale, the loss on the transaction is reflected through two line items. The other-than-temporary impairment charge represents the loss position of the sold securities as of March 31, 2007. The loss on sale of securities in 2007 represents the change in value of the sold securities from April 1, 2007 until the date of sale.

Other income for 2009 was $2.5 million, compared to the 2008 level of $2.8 million and the 2007 level of $3.4 million. The components of other income primarily consist of ATM fee income, trust fee income, underwriting revenue, safe deposit box fee income and gains on sales of other real estate, repossessions, leased equipment and premises and equipment. Gains on sales declined $127 thousand and trust fees declined $39 thousand in 2009 compared to 2008. We anticipate our fee income to be consistent or to increase in 2010.

Noninterest Expense

Total noninterest expense for 2009 was $68.2 million, compared to $40.4 million in 2008 and $41.4 million in 2007. Noninterest expense for 2009 included a full impairment to goodwill of $27.2 million. Excluding this one-time, non-cash expense, noninterest expense for 2009 was $41.1 million. For 2009, increases in FDIC insurance, professional fees and other expenses offset the savings in salaries and benefits and other expense categories. The following table represents the components of noninterest expense for the years ended December 31, 2009, 2008 and 2007.

Noninterest Expense

 

     For the Years Ended
     2009    Percent
Change
    2008    Percent
Change
    2007
     (in thousands, except percentages)

Salaries and benefits

   $ 20,246    (6.2 )%    $ 21,577    (5.5 )%    $ 22,836

Occupancy

     3,418    (2.5 )%      3,505    2.2     3,429

Furniture and equipment

     2,473    (19.2 )%      3,059    (9.4 )%      3,378

Professional fees

     2,127    22.0     1,744    10.6     1,577

FDIC insurance

     1,866    196.7     629    182.1     223

Data processing

     1,445    (1.2 )%      1,463    4.6     1,399

Losses and write-downs on other real estate owned, repossessions, fixed assets and other assets

     1,308    (1.9 )%      1,334    (5.5 )%      1,411

Impairment of goodwill

     27,156    100.0     —      —       —  

Intangible asset amortization

     485    (39.1 )%      796    (19.2 )%      985

Communications

     716    (0.6 )%      720    (1.9 )%      734

Printing and supplies

     399    (3.2 )%      412    (20.9 )%      521

Advertising

     278    (25.3 )%      372    (18.4 )%      456

Other expense

     6,314    32.3     4,771    6.2     4,492
                                

Total noninterest expense

   $ 68,231    69.0   $ 40,382    (2.6 )%    $ 41,441
                                

 

56


Table of Contents
Index to Financial Statements

Total salaries and benefits decreased $1.3 million, or 6%, in 2009 as compared to 2008. The decrease in salaries and benefits is primarily related to fewer full-time equivalent employees and a reduction in stock option expense. As of December 31, 2009, we had 39 full service banking offices and one leasing/loan production facility with 347 full-time equivalent employees. As of December 31, 2008, we had 39 full service banking offices and three leasing offices with 361 full-time equivalent employees; as of December 31, 2007, we had 40 full service banking offices and five leasing offices with 371 full-time equivalent employees. As discussed in the Asset Quality section of MD&A, we are adding additional employees in the credit administration and loan review departments and anticipate hiring additional positions in 2010. The future increase in salary and benefits will be partially offset through various cost savings, including personnel reductions.

Total occupancy expense for 2009 decreased by 3% compared with 2008, which was 2% more than total occupancy expense in 2007. The decrease in 2009 was due to cost saving initiatives at our branch locations. The increase in 2008 was primarily due to higher utility costs and higher property taxes. As of December 31, 2009, we leased nine facilities and the land for five branches. As a result, occupancy expense is higher than if we owned these facilities, including the real estate, but conversely, we have been able to deploy the capital into earning assets rather than capital expenditures for facilities.

Furniture and equipment, communication, advertising, and printing and supplies expense decreased both in 2009 and 2008 due to cost controls implemented.

Professional fees increased by $383 thousand, or 22%, from 2008 to 2009, and increased by $167 thousand, or 11%, from 2007 to 2008. The increase in 2009 is primarily due to additional legal costs associated with the higher levels of non-performing assets and the arbitration settlement, described further below, as well as a fourth quarter 2009 third-party loan review, as more fully described in the Asset Quality and Non-performing Assets section of MD&A. Professional fees also include fees related to investor relations, outsourcing compliance and information technology audits and a portion of internal audit to Professional Bank Services, as well as external audit, tax services and legal and accounting advice related to, among other things, foreclosures, lending activities, employee benefit programs and potential acquisitions. The increase in 2008 was primarily due to additional legal costs associated with the higher levels of nonperforming assets. We anticipate professional fees to be consistent or lower for 2010.

The premium paid for FDIC deposit insurance increased $1.2 million to $1.9 million in 2009 compared to 2008. The expense in 2008 and 2007 was $629 thousand and $223 thousand. For 2009, we recorded a $560 thousand charge for the FDIC special assessment that was paid on September 30, 2009. The remaining increase is due to an across-the-board increase in the FDIC’s assessment calculation, which became effective in 2009 as well as our participation in the Temporary Liquidity Guarantee Program (TLGP), which is funded through add-on premium fees.

During the fourth quarter of 2009, the FDIC approved a rule mandating all banks prepay deposit premium insurance assessments for the three year period ending December 31, 2012. The total prepayment amount factored in an estimated five percent annual growth rate in the deposit base as well as a uniform three basis point increase in the assessment rate effective January 1, 2011. No additional cash payments or refunds are required or issued until the later of the date the prepayment is exhausted or December 30, 2014. The FDIC indicated that it intends the prepayment option to eliminate the need for additional special assessments. On December 31, 2009, we prepaid $6.0 million to the FDIC. The payment did not adversely impact our liquidity.

Data processing expense were consistent from 2008 to 2009. The monthly fees associated with data processing are typically based on transaction volume.

Losses and write-downs on other real estate owned, repossessions, fixed assets and other assets decreased $26 thousand, or 2%, from 2008 to 2009. The decrease is primarily related to fewer write-downs on other real

 

57


Table of Contents
Index to Financial Statements

estate owned. Write-downs on other real estate totaled $334 thousand in 2009 compared to $707 thousand in 2008. Losses and write-downs for 2010 are dependent on multiple factors, including the volume of nonperforming assets, as well as changes in the associated market value of those assets.

Our 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. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Accounting guidance requires us to estimate the fair value in making the assessment of impairment at least annually. We engaged an independent valuation firm to assist in computing the fair value estimate for the goodwill as of September 30, 2009. The firm utilizes two separate valuation methodologies and compares the results of each methodology in order to determine the fair value of the goodwill associated with our prior acquisitions. 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 results of the third-party goodwill assessment for 2009 indicated a full impairment and therefore we recorded a $27.2 million goodwill impairment as of September 30, 2009. The impairment was primarily a result of the continuing economic downtown and its implication on bank valuations. The one-time, non-cash accounting adjustment has no impact on cash flows, liquidity, tangible capital or our ability to conduct business. Additionally, as goodwill is excluded from regulatory capital, the impairment has no impact on the regulatory capital ratios of First Security or FSGBank, both of which remain “well capitalized” under regulatory requirements.

Intangible asset amortization decreased by $311 thousand, or 39%, in 2009 as compared to 2008 and decreased $189 thousand, or 19%, in 2008 compared to 2007. For 2009, core deposit intangible expense declined by $117 thousand compared to 2008. During 2008, a non-compete agreement and a license fee agreement fully amortized, resulting in a combined $194 thousand decline in 2009 expense compared to 2008. The core deposit intangible assets amortize on an accelerated basis over an estimated useful life of ten years. The following table represents our anticipated intangible asset amortization over the next five years, excluding new acquisitions, if any.

 

     2010    2011    2012    2013    2014
     (in thousands)

Core deposit intangible amortization expense

   $ 465    $ 444    $ 382    $ 270    $ 196

Other expense increased by $1.5 million, or 32%, for 2009 compared to 2008 and increased $279 thousand, or 6%, in 2008 compared to 2007. The increase in 2009 is primarily associated with the $500 thousand arbitration settlement, described below, as well as higher expenses associated with repossessed assets and foreclosed properties, including but not limited to maintenance and repairs, back-taxes and storage costs. The increase in 2008 primarily relates to increases in expenses associated with repossessed assets and other real estate owned.

On January 19, 2010, we settled the $2.3 million arbitration claim involving the April 15, 2009 termination of employment of Lloyd L. Montgomery, III, our former President and Chief Operating Officer. The settlement agreed to pay Mr. Montgomery $500 thousand. The settlement amount was accrued in other expense during 2009. Through the settlement agreement, both parties agreed to release all claims against one another and to dismiss the arbitration claim with prejudice. The settlement agreement also provides that Mr. Montgomery’s confidentiality and non-solicitation obligations under his employment agreement shall remain in effect.

 

58


Table of Contents
Index to Financial Statements

Income Taxes

We recorded income tax benefit of $8.0 million in 2009 compared to a benefit of $587 thousand in 2008 and a tax expense of $5.3 million in 2007. For 2009, our tax-exempt income from municipal securities and bank-owned life insurance was approximately $2.6 million. The goodwill impairment included $20.2 million that was not deductible for tax purposes. Excluding these non-taxable items, our pre-tax 2009 net loss would decrease to approximately $23.4 million, resulting in an effective tax rate of approximately 34%.

At December 31, 2009, we evaluated our significant uncertain tax positions. Under the “more-likely-than-not” threshold guidelines, we believe we have identified all significant uncertain tax benefits. We 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 uncertain 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 income tax expense in our consolidated financial statements. During 2009, we accrued $1.1 million for an uncertain tax position and approximately $155 thousand in associated interest and penalties.

At December 31, 2009, we have no valuation allowance associated with our deferred tax assets. In evaluating our deferred tax assets, we use all available information, both quantitative and qualitative. A valuation allowance is required when it is “more-likely-than-not” that some or all of the deferred tax assets will not be realized. At December 31, 2009, we have a deferred tax asset of $7.1 million.

Statement of Financial Condition

Our total assets were $1.4 billion at December 31, 2009, an increase of $77.6 million, or 6%, over 2008. The growth occurred in the fourth quarter of 2009, during which total assets increased by over $150 million, as we enhanced our liquidity and locked-in longer term and historically low-cost brokered deposits. At year-end, the excess funds of nearly $150 million were maintained in our interest-bearing account at the Federal Reserve Bank of Atlanta. The increase in deposits was partially offset by a decline in loans and increase in the allowance for loan and lease losses. During 2010, we anticipate funding prudent investment opportunities through growth in core deposits or with our existing cash reserves.

Loans

Our active efforts to reduce certain credit exposures and their related balance sheet risk, as well as the effects of the economic recession, resulted in declining loan balances during 2009.

Total loans declined $59.6 million, or 6%, comparing year-end 2009 to year-end 2008. During 2009, we actively reduced our exposure to construction and land development loans by $41.5 million, or 21%, and commercial leases by $11.1 million, or 36% compared to December 31, 2008. Most other loan categories declined during 2009 as a result of the economic recession. Commercial real estate loans increased by $25.2 million, or 11%, during 2009. A majority of this growth was in owner-occupied commercial real estate.

During 2008, loan demand was solid for the first three quarters before softening in the fourth quarter due to the recession. Total loans increased 6% from year-end 2007 to year-end 2008. The increase in loans in 2008 is primarily attributable to residential 1-4 family loans increasing $34.1 million, or 13%, commercial real estate increasing $22.7 million, or 11%, and commercial loans increasing $19.9 million, or 14%, compared to 2007.

We will continue to extend prudent loans to credit-worthy consumers and businesses during 2010. However, due to the current economic environment, we anticipate our loans may remain stable or possibly decline in the near term. Funding of future loans may be restricted by our ability to raise core deposits, although we may use our current cash reserves, as necessary and appropriate. Loan growth may also be restricted by the necessity for us to maintain appropriate capital levels, as well as adequate liquidity.

 

59


Table of Contents
Index to Financial Statements

The following table presents a summary of the loan portfolio by category for the last five years.

Loans Outstanding

 

    As of December 31,  
    2009     Percent
Change
    2008     Percent
Change
    2007     Percent
Change
    2006     Percent
Change
    2005  
    (in thousands, except percentages)  

Loans secured by real estate-

                 

Residential 1-4 family

  $ 281,354      (5.1 )%    $ 296,454      13.0   $ 262,373      6.7   $ 246,005      11.4   $ 220,760   

Commercial

    259,819      10.7     234,630      10.7     211,931      29.4     163,836      10.6     148,172   

Construction

    153,144      (21.3 )%      194,603      (10.1 )%      216,583      27.7     173,652      48.0     117,352   

Multi-family and farmland

    37,960      10.8     34,273      91.6     17,887      (12.9 )%      20,544      (7.4 )%      22,194   
                                                               
    732,277      (3.6 )%      759,960      7.2     708,774      17.3     604,037      18.8     508,478   

Commercial loans

    146,016      (7.5 )%      157,906      14.4     138,015      13.7     121,385      11.4     108,974   

Consumer loans

    48,927      (16.1 )%      58,296      (7.7 )%      63,156      (6.9 )%      67,858      4.9     64,694   

Leases, net of unearned income

    19,730      (36.1 )%      30,873      (25.8 )%      41,587      (20.1 )%      52,039      (17.7 )%      63,205   

Other

    5,068      11.4     4,549      189.2     1,573      (30.8 )%      2,274      (31.3 )%      3,308   
                                                               

Total loans

    952,018      (5.9 )%      1,011,584      6.1     953,105      12.4     847,593      13.2     748,659   

Allowance for loan and lease losses

    (26,492   52.4     (17,385   58.7     (10,956   9.9     (9,970   (1.5 )%      (10,121
                                                               

Net loans

  $ 925,526      (6.9 )%      994,199      5.5   $ 942,149      12.5   $ 837,623      13.4   $ 738,538   
                                                               

Substantially all of our loans are to customers located in Georgia and Tennessee, in our immediate markets. We believe that we are not dependent on any single customer or group of customers whose insolvency would have a material adverse effect on operations. We also believe that the loan portfolio is diversified among loan collateral types, as noted by the following table.

Loans by Collateral Type

 

    As of December 31,  
    2009   % of
Loans
    2008   % of
Loans
    2007   % of
Loans
    2006   % of
Loans
    2005   % of
Loans
 
    (in thousands, expect percentages)  

Secured by real estate:

                   

Construction and land development

  $ 153,144   16.1   $ 194,603   19.2   $ 216,583   22.7   $ 173,652   20.5   $ 117,352   15.7

Farmland

    12,077   1.3     11,470   1.1     6,870   0.7     10,243   1.2     12,799   1.7

Home equity lines of credit

    88,770   9.3     88,708   8.8     80,326   8.4 %&n