10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

LOGO

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2010

OR

 

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

For the transition period from              to             .

COMMISSION FILE NO. 000-49747

FIRST SECURITY GROUP, INC.

(Exact Name of Registrant as Specified in its Charter)

 

Tennessee   58-2461486
(State of Incorporation)  

(I.R.S. Employer

Identification No.)

 

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

(423) 266-2000

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Common Stock, $0.01 par value:

16,418,327 shares outstanding and issued as of November 9, 2010

 

 

 


Table of Contents

 

First Security Group, Inc. and Subsidiary

Form 10-Q

INDEX

 

           Page No.  
PART I.    FINANCIAL INFORMATION   
Item 1.    Financial Statements   
  

Consolidated Balance Sheets - September 30, 2010, December 31, 2009 and September 30, 2009

     1   
  

Consolidated Income Statements - Three months and nine months ended September 30, 2010 and 2009

     3   
  

Consolidated Statement of Stockholders’ Equity - Nine months ended September 30, 2010

     4   
  

Consolidated Statements of Cash Flows - Nine months ended September 30, 2010 and 2009

     5   
  

Notes to Consolidated Financial Statements

     7   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      27   
Item 3.    Quantitative and Qualitative Disclosures about Market Risk      61   
Item 4.    Controls and Procedures      62   
PART II.    OTHER INFORMATION   
Item 1.    Legal Proceedings      63   
Item 1A.    Risk Factors      63   
Item 3.    Defaults Upon Senior Securities      64   
Item 6.    Exhibits      65   
SIGNATURES      66   


Table of Contents

 

PART I - FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

First Security Group, Inc. and Subsidiary

Consolidated Balance Sheets

 

(in thousands)

   September 30,
2010
(unaudited)
     December 31,
2009
(restated)
     September 30,
2009
(unaudited)
 

ASSETS

        

Cash and Due from Banks

   $ 8,545       $ 23,220       $ 14,711   

Federal Funds Sold and Securities Purchased under Agreements to Resell

     —           —           —     
                          

Cash and Cash Equivalents

     8,545         23,220         14,711   
                          

Interest Bearing Deposits in Banks

     224,111         152,616         5,394   
                          

Securities Available-for-Sale

     155,108         143,045         147,175   
                          

Loans Held for Sale

     3,386         1,225         1,001   

Loans

     774,032         950,793         963,294   
                          

Total Loans

     777,418         952,018         964,295   

Less: Allowance for Loan and Lease Losses

     25,320         26,492         25,686   
                          
     752,098         925,526         938,609   
                          

Premises and Equipment, net

     31,891         33,157         33,587   
                          

Intangible Assets

     1,570         1,918         2,012   
                          

Other Assets

     73,068         73,917         61,420   
                          

TOTAL ASSETS

   $ 1,246,391       $ 1,353,399       $ 1,202,908   
                          

(See Accompanying Notes to Consolidated Financial Statements)

 

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First Security Group, Inc. and Subsidiary

Consolidated Balance Sheets

 

(in thousands, except share data)

  September 30,
2010
(unaudited)
    December 31,
2009
(restated)
    September 30,
2009
(unaudited)
 

LIABILITIES AND STOCKHOLDERS’ EQUITY

     

LIABILITIES

     

Deposits

     

Noninterest Bearing Demand

  $ 166,723      $ 151,174      $ 146,820   

Interest Bearing Demand

    65,047        62,429        61,502   

Savings and Money Market Accounts

    170,426        177,543        164,490   

Certificates of Deposit less than $100 thousand

    215,811        244,312        244,127   

Certificates of Deposit of $100 thousand or more

    164,466        207,465        203,533   

Brokered Deposits

    329,731        339,750        198,815   
                       

Total Deposits

    1,112,204        1,182,673        1,019,287   

Federal Funds Purchased and Securities Sold under Agreements to Repurchase

    17,676        17,911        20,463   

Security Deposits

    939        1,376        1,444   

Other Borrowings

    81        94        7,724   

Other Liabilities

    8,645        10,181        8,801   
                       

Total Liabilities

    1,139,545        1,212,235        1,057,719   
                       

STOCKHOLDERS’ EQUITY

     

Preferred Stock – no par value – 10,000,000 shares authorized; 33,000 issued as of September 30, 2010, December 31, 2009 and September 30, 2009

    31,620        31,339        31,248   

Common Stock - $.01 par value - 150,000,000 shares authorized as of September 30, 2010, 50,000,000 shares authorized as of December 31, 2009 and September 30, 2009; 16,418,327 issued as of September 30, 2010, December 31, 2009 and September 30, 2009

    114        114        114   

Paid-In Surplus

    111,550        111,964        111,999   

Common Stock Warrants

    2,006        2,006        2,006   

Unallocated ESOP Shares

    (5,396     (6,193     (6,446

Accumulated Deficit

    (38,789     (4,258     (524

Accumulated Other Comprehensive Income

    5,741        6,192        6,792   
                       

Total Stockholders’ Equity

    106,846        141,164        145,189   
                       

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

  $ 1,246,391      $ 1,353,399      $ 1,202,908   
                       

(See Accompanying Notes to Consolidated Financial Statements)

 

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First Security Group, Inc. and Subsidiary

Consolidated Income Statements

(unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 

(in thousands, except per share data)

   2010     2009     2010     2009  

INTEREST INCOME

        

Loans, including fees

   $ 11,909      $ 14,462      $ 38,090      $ 43,859   

Debt Securities – taxable

     926        1,097        3,010        3,435   

Debt Securities – non-taxable

     335        396        1,062        1,200   

Other

     32        3        371        38   
                                

Total Interest Income

     13,202        15,958        42,533        48,532   
                                

INTEREST EXPENSE

        

Interest Bearing Demand Deposits

     47        45        142        146   

Savings Deposits and Money Market Accounts

     341        384        1,105        1,255   

Certificates of Deposit of less than $100 thousand

     1,131        1,738        3,722        5,687   

Certificates of Deposit of $100 thousand or more

     970        1,530        3,261        4,934   

Brokered Deposits

     2,459        1,225        7,169        4,478   

Other

     119        136        363        395   
                                

Total Interest Expense

     5,067        5,058        15,762        16,895   
                                

NET INTEREST INCOME

     8,135        10,900        26,771        31,637   

Provision for Loan and Lease Losses

     18,415        9,280        26,424        20,469   
                                

NET INTEREST (LOSS) INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES

     (10,280     1,620        347        11,168   
                                

NONINTEREST INCOME

        

Service Charges on Deposit Accounts

     951        1,184        2,999        3,501   

Gain on Sales of Available for Sale Securities, net

     —          —          57        —     

Other

     1,453        1,553        4,210        4,331   
                                

Total Noninterest Income

     2,404        2,737        7,266        7,832   
                                

NONINTEREST EXPENSES

        

Salaries and Employee Benefits

     4,787        4,903        14,438        15,303   

Expense on Premises and Fixed Assets, net of rental income

     1,431        1,493        4,187        4,525   

Impairment of Goodwill

     —          27,156        —          27,156   

Other

     6,294        3,811        15,539        9,731   
                                

Total Noninterest Expenses

     12,512        37,363        34,164        56,715   
                                

LOSS BEFORE INCOME TAX PROVISION

     (20,388     (33,006     (26,551     (37,715

Income Tax Provision (Benefit)

     9,384        (4,877     6,461        (7,326
                                

NET LOSS

     (29,772     (28,129     (33,012     (30,389

Preferred Stock Dividends

     413        412        1,238        1,196   

Accretion on Preferred Stock Discount

     95        90        281        254   
                                

NET LOSS TO COMMON STOCKHOLDERS

   $ (30,280   $ (28,631   $ (34,531   $ (31,839
                                

NET LOSS PER SHARE:

        

Net Loss Per Share - Basic

   $ (1.92   $ (1.84   $ (2.20   $ (2.05

Net Loss Per Share - Diluted

   $ (1.92   $ (1.84   $ (2.20   $ (2.05

Dividends Declared Per Common Share

   $ —        $ 0.01      $ —        $ 0.07   

(See Accompanying Notes to Consolidated Financial Statements)

 

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First Security Group, Inc. and Subsidiary

Consolidated Statement of Stockholders’ Equity

 

          Common Stock                       Accumulated              

(in thousands)

  Preferred
Stock
    Shares     Amount     Paid-In
Surplus
    Common
Stock
Warrants
    Accumulated
Deficit
    Other
Comprehensive

Income
    Unallocated
ESOP Shares
    Total  

Balance – December 31, 2009 (restated)

  $ 31,339        16,418      $ 114      $ 111,964      $ 2,006      $ (4,258   $ 6,192      $ (6,193   $ 141,164   

Comprehensive Income:

                 

Net Loss (unaudited)

              (33,012         (33,012

Change Unrealized Gain:

                 

Securities Available-for-Sale, net of tax and reclassification adjustments (unaudited)

                563          563   

Fair Value of Derivatives, net of tax and reclassification adjustments (unaudited)

                (1,014       (1,014
                       

Total Comprehensive Loss

                    (33,463
                       

Accretion of Discount Associated with Preferred Stock (unaudited)

    281                (281         —     

Preferred Stock Dividend (unaudited)

              (1,238         (1,238

Stock-based Compensation, net of forfeitures (unaudited)

          73                73   

ESOP Allocation (unaudited)

          (487           797        310   
                                                                       

Balance – September 30, 2010 (unaudited)

  $ 31,620        16,418      $ 114      $ 111,550      $ 2,006      $ (38,789   $ 5,741      $ (5,396   $ 106,846   
                                                                       

(See Accompanying Notes to Consolidated Financial Statements)

 

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First Security Group, Inc. and Subsidiary

Consolidated Statements of Cash Flow

(unaudited)

 

     Nine Months Ended September 30,  

(in thousands)

   2010     2009  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net Loss

   $ (33,012   $ (30,389

Adjustments to Reconcile Net Loss to Net Cash (Used in) Provided by Operating Activities -

    

Provision for Loan and Lease Losses

     26,424        20,469   

Amortization, net

     751        513   

Impairment of Goodwill

     —          27,156   

Deferred Tax Asset Valuation Allowance

     17,432        —     

Stock-Based Compensation

     73        274   

ESOP Compensation

     310        469   

Depreciation

     1,372        1,582   

Net Gain on Sale of Premises and Equipment

     (17     (2

Loss on Sale of Other Real Estate and Repossessions, net

     550        71   

Write-down of Other Real Estate and Repossessions

     2,715        507   

Gain on Sale of Available-for-Sale Securities, net

     (57     —     

Accretion of Fair Value Adjustment, net

     (79     (140

Accretion of Cash Flow Swaps

     —          (528

Accretion of Terminated Cash Flow Swaps

     (1,532     (1,252

Changes in Operating Assets and Liabilities -

    

Loans Held for Sale

     (2,164     608   

Interest Receivable

     584        142   

Other Assets

     (12,243     (4,318

Interest Payable

     (1,291     (2,463

Other Liabilities

     (1,639     (715
                

Net Cash (Used in) Provided by Operating Activities

     (1,823     11,984   
                

CASH FLOWS FROM INVESTING ACTIVITIES

    

Net Change in Interest Bearing Deposits in Banks

     (71,495     (4,476

Activity in Available-for-Sale-Securities -

    

Maturities, Prepayments, and Calls

     46,685        21,624   

Sales

     14,762        —     

Purchases

     (73,002     (26,826

Loan Originations and Principal Collections, net

     134,191        19,205   

Proceeds for Interim Settlements of Cash Flow Swaps, net

     —          938   

Proceeds for Termination of Cash Flow Swaps

     —          5,778   

Proceeds from Sale of Premises and Equipment

     17        16   

Proceeds from Sales of Other Real Estate and Repossessions

     8,086        6,720   

Additions to Premises and Equipment

     (106     (1,406

Capital Improvements to Repossessions and Other Real Estate

     (1,273     (355
                

Net Cash Provided by Investing Activities

     57,865        21,218   
                

CASH FLOWS FROM FINANCING ACTIVITIES

    

Net Decrease in Deposits

     (70,469     (57,002

Net Decrease in Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

     (235     (19,573

Net (Decrease) Increase of Other Borrowings

     (13     4,947   

Proceeds from Issuance of Preferred Stock and Common Stock Warrants

     —          33,000   

Repurchase of Common Stock for 401(k) and ESOP Plan

     —          (1,023

Dividends Paid on Preferred Stock

     —          (990

Dividends Paid on Common Stock

     —          (1,072
                

Net Cash Used in Financing Activities

     (70,717     (41,713
                

NET CHANGE IN CASH AND CASH EQUIVALENTS

     (14,675     (8,511

CASH AND CASH EQUIVALENTS - beginning of period

     23,220        23,222   
                

CASH AND CASH EQUIVALENTS - end of period

   $ 8,545      $ 14,711   
                

(See Accompanying Notes to Consolidated Financial Statements)

 

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     Nine Months Ended September 30,  

(in thousands)

   2010      2009  

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES

     

Transfers to Foreclosed Properties and Repossessions

   $ 18,781       $ 17,103   

SUPPLEMENTAL SCHEDULE OF CASH FLOWS

     

Interest Paid

   $ 17,053       $ 19,358   

Income Taxes Paid

   $ 128       $ 539   

(See Accompanying Notes to Consolidated Financial Statements)

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of financial condition and the results of operations have been included. All such adjustments were of a normal recurring nature, except for the deferred tax valuation allowance as discussed in Note 11.

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

Operating results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010 or any other period. These interim financial statements should be read in conjunction with the Company’s latest annual consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

NOTE 2 – RESTATEMENT

Subsequent to filing the June 30, 2010 Quarterly Report on Form 10-Q and a change in personnel responsible for the Company’s other real estate owned, the Company determined that certain write-downs associated with other real estate owned (OREO) were not recorded in the appropriate accounting periods. Upon completion of the Company’s internal review, the primary regulator of the Company’s wholly-owned subsidiary bank, FSGBank, N.A. (Bank), verified the findings as part of its ongoing annual safety and soundness examination. The Bank has been requested to file amended Call Reports with the FDIC and the Company to file amended FR Y-9C and FR Y-9LP reports with the Federal Reserve, for December 31, 2009, March 31, 2010 and June 30, 2010 to reflect the findings.

On October 28, 2010, the Company’s Audit/Corporate Governance Committee determined that the previously issued audited consolidated financial statements for the year ended December 31, 2009 (contained in the Company’s Annual Report on Form 10-K filed March 16, 2010, and subsequently amended by that certain Amendment No. 1 to the Annual Report on Form 10-K filed on April 30, 2010) and the previously issued unaudited consolidated financial statements for the quarters ended March 31, 2010 and June 30, 2010 (contained in the Company’s Quarterly Reports on Form 10-Q filed, respectively, on May 10, 2010 and August 8, 2010) should no longer be relied upon. The restatements to these consolidated financial statements reflect the appropriate timing and recognition of charge-offs and write-downs associated with other real estate owned. While the changes were not quantitatively material, the restatements ensure consistency with the Company’s publicly available financial information.

For the period ended December 31, 2009, the Company determined that additional OREO write-downs totaling $616 thousand and additional OREO charge-offs totaling $89 thousand were improperly reflected in future periods. The December 31, 2009 Form 10-K/A (Amendment No. 2) will properly reflect these items as well as an increase in the provision for loan and lease losses of $89 thousand to return the allowance for loan and lease losses to the previously reported balance. The tax benefit associated with the additional expenses totaled $270 thousand. The net impact on these items increased the net loss available to common stockholders by $435 thousand from the previously reported net loss of $34,974 thousand to $35,409 thousand.

For the three-month period ended March 31, 2010, the Company previously reported no OREO write-downs. The Company’s policies require an appraisal to determine the initial fair value of the property at the time of foreclosure. An updated appraisal is required on at least an annual basis. The Company’s internal review determined that 15 properties were subject to new appraisals during the first quarter of 2010; however, all 15 appraisals were received subsequent to March 31, 2010. These findings were consistent with the properties due for a new appraisal during the fourth quarter of 2009; ten of the twelve appraisals due in the fourth quarter were received in the second quarter of 2010. The other two appraisals were received during the fourth quarter but the associated write-downs were not recorded. Accordingly, March 31, 2010 Form 10-Q/A will only reflect changes to the December 31, 2009 and March 31, 2010 consolidated balance sheets.

For the three-month period ended June 30, 2010, the Company previously reported $1,337 thousand in write-downs to OREO/repossessions. Of this amount, $292 thousand were inappropriately accounted for in this reporting period. These write-downs have been included in the above restatements. Additionally, the Company’s internal review determined that a charge-off of $89 thousand and a write-down of $24 thousand were not properly reported in the three months ended June 30, 2010. The June 30, 2010 Form 10-Q/A will reflect the changes described above, including the tax effects thereof, as well as an additional $89 thousand in provision for loan and lease losses to return the allowance to the previously reported balance.

For the three months ended September 30, 2010, the Company’s internal review identified $526 thousand of write-downs that were associated with prior periods. These have been reclassified in the above restatements. As the Company’s internal review was completed prior to filing the September 30, 2010 quarterly report on Form 10-Q, no restatement is required for this period.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

The following table provides the previously reported and the restated amounts included in the restatements:

 

     Previously
Reported as of
December 31,
2009
    Anticipated
Restatement
Adjustments
    Restated as
of December 31,
2009
 
     (in thousands)  

Changes to the Consolidated Balance Sheet

      

Other Assets

   $ 74,352      $ (435   $ 73,917   

Accumulated Deficit

   $ (3,823   $ (435   $ (4,258

Changes to the Consolidated Income Statements

      

Provision for Loan and Lease Losses

   $ 25,315      $ 89      $ 25,404   

Other Non-Interest Expense

   $ 14,938      $ 617      $ 15,555   

Income Tax (Benefit) Provision

   $ (7,982   $ (271   $ (8,253

Net (Loss) Income Available to Common Shareholders

   $ (34,974   $ (435   $ (35,409
     Previously
Reported as of
March 31,
2010
    Anticipated
Restatement
Adjustments
    Restated as
of March 31,
2010
 
     (in thousands)  

Changes to the Consolidated Balance Sheet

      

Other Assets

   $ 80,539      $ (435   $ 80,104   

Accumulated Deficit

   $ (5,442   $ (435   $ (5,877
     Previously
Reported as of
June 30,

2010
    Anticipated
Restatement
Adjustments
    Restated as
of June 30,
2010
 
     (in thousands)  

Changes to the Consolidated Balance Sheet

      

Other Assets

   $ 80,313      $ (365   $ 79,948   

Accumulated Deficit

   $ (8,144   $ (365   $ (8,509

Changes to the Consolidated Income Statements for the three months ended June 30, 2010

      

Provision for Loan and Lease Losses

   $ 3,544      $ 90      $ 3,634   

Other Non-Interest Expense

   $ 5,907      $ (203   $ 5,704   

Income Tax Benefit

   $ (1,812   $ 43      $ (1,769

Net Loss Available to Common Shareholders

   $ (2,702   $ 70      $ (2,632

NOTE 3. OPERATIONAL AND REGULATORY MATTERS

The Company continues to operate in a difficult environment and has been significantly impacted by the unprecedented credit and economic market turmoil, as well as the recessionary economy. Deterioration in the Tennessee and Georgia commercial and residential real estate markets and related declines in property values in those markets has had a negative impact on our operating results since the latter half of 2008.

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

Operational Matters

The Company’s financial statements are presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has experienced losses from operations during the last two years that raise possible doubt as to its ability to continue as a going concern. The Company’s ability to continue as a going concern is contingent upon its ability to devise and successfully execute a management plan to develop profitable operations, satisfy the requirements of the regulatory actions detailed below, and lower the level of problem assets to an acceptable level.

Management has developed strategic and capital plans, which include, but are not limited to: (1) reorganizing management into a line of business structure, (2) restructuring credit and lending functions with new policies and centralized processes, (3) reducing adversely classified assets, (4) maintaining a Tier 1 leverage capital ratio of not less than 9%, (5) maintaining a total risk-based capital ratio of not less than 13%, (6) maintaining an adequate allowance for loan losses and (7) actively working to maintain appropriate liquidity while reducing reliance on non-core sources of funding.

The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the possible inability of the Company to continue as a going concern.

Regulatory Matters

First Security Group, Inc.

On September 7, 2010, the Company entered into a Written Agreement (Agreement) with the Federal Reserve Bank of Atlanta (Federal Reserve), the Company’s primary regulator. The Agreement is designed to enhance the Company’s ability to act as a source of strength to the Bank.

The Agreement prohibits the Company from declaring or paying dividends without prior written consent of the Federal Reserve. The Company is also prohibited from taking dividends, or any other form of payment representing a reduction of capital, from the Bank without prior written consent.

Within 60 days of the Agreement, the Company is required to submit to the Federal Reserve a written plan designed to maintain sufficient capital at the Company and the Bank.

On September 14, 2010, the Company filed a current report on Form 8-K describing the Agreement. The Form 8-K also provides the final, executed Agreement.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

FSGBank, N.A.

On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order (Order), FSGBank, the Company’s wholly-owned subsidiary, consented and agreed to the issuance of a Consent Order by the Office of the Comptroller of the Currency (OCC), the Bank’s primary regulator.

The Bank and the OCC agreed as to the areas of the Bank’s operations that warrant improvement and a plan for making those improvements. The Order required the Bank to develop and submit written strategic and capital plans covering at least a three-year period. The Bank is required to review and revise various policies and procedures, including those associated with concentration management, the allowance for loan and lease losses, liquidity management, criticized asset, loan review and credit.

Within 120 days of the effective date of the Order, the Bank is required to achieve and thereafter maintain total capital at least equal to 13 percent of risk-weighted assets and Tier 1 capital at least equal to 9 percent of adjusted total assets. As of September 30, 2010, the first financial reporting period subsequent to the 120 day requirement, the Bank’s total capital to risk-weighted assets was 12.93 percent and the Tier 1 capital to adjusted total assets was 7.43 percent. The Bank has notified the OCC of the non-compliance.

During the third quarter of 2010, the OCC requested additional information and clarifications to the Bank’s submitted strategic and capital plans. The Bank is currently preparing the response and anticipates submitting the response during the fourth quarter of 2010.

Because the Order established specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Order. As an adequately capitalized institution, the Bank may not pay interest on deposits that are more than 75 basis points above the rate applicable to the applicable market of the Bank as determined by the FDIC. Additionally, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.

On April 29, 2010, the Company filed a current report on Form 8-K describing the Order and the Bank’s actions to date. The Form 8-K also provides the final, executed Order.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

NOTE 4 – COMPREHENSIVE INCOME

Comprehensive income is a measure of all changes in equity, not only reflecting net income but certain other changes as well. The following table presents the comprehensive income for the three and nine month periods ended September 30, 2010 and 2009, respectively.

 

     Three Months Ended     Nine Months Ended  
     September 30,     September 30,  
     2010     2009     2010     2009  
     (in thousands)  

Net loss

   $ (29,772   $ (28,129   $ (33,012   $ (30,389
                                

Other comprehensive income (loss)

        

Available-for-sale securities

        

Unrealized net gain on securities arising during the period

     794        2,432        911        2,789   

Tax expense related to unrealized net gain

     (270     (827     (310     (948

Reclassification adjustments for realized gain included in net income

     —          —          (57     —     

Tax expense related to gain realized in net income

     —          —          19        —     
                                

Unrealized gain on securities, net of tax

     524        1,605        563        1,841   
                                

Derivative cash flow hedges

        

Unrealized gain on derivatives arising during the period

     41        —          —          312   

Tax expense related to unrealized gain

     (14     —          —          (106

Reclassification adjustments for realized gain included in net income

     (485     (614     (1,537     (1,765

Tax expense related to gain realized in net income

     165        209        523        600   
                                

Unrealized loss on derivatives, net of tax

     (293     (405     (1,014     (959
                                

Other comprehensive income (loss), net of tax

     231        1,200        (451     882   
                                

Comprehensive loss, net of tax

   $ (29,541   $ (26,929   $ (33,463   $ (29,507
                                

NOTE 5 – EARNINGS PER SHARE

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

 

     Three Months Ended     Nine Months Ended  
     September 30,     September 30,  
     2010     2009     2010     2009  
     (in thousands, except per share data)  

Net loss available to common stockholders

   $ (30,280   $ (28,631   $ (34,531   $ (31,839
                                

Denominator:

        

Weighted average common shares outstanding

     15,785        15,543        15,717        15,539   

Equivalent shares issuable upon exercise of stock options

     —          —          —          —     
                                

Weighted average diluted shares outstanding

     15,785        15,543        15,717        15,539   
                                

Net loss per share:

        

Basic

   $ (1.92   $ (1.84   $ (2.20   $ (2.05
                                

Diluted

   $ (1.92   $ (1.84   $ (2.20   $ (2.05
                                

For the three and nine months ended September 30, 2010, the weighted average stock options, stock warrants and restricted stock awards that were anti-dilutive totaled 1,892 thousand and 1,930 thousand, respectively, compared to 1,311 thousand and 1,361 thousand for the same periods in 2009. Anti-dilutive options and awards are not included in the computation of diluted earnings per share under the treasury stock method.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

NOTE 6 – SECURITIES

Investment Securities by Type

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

 

     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Fair Value  
     (in thousands)  

Securities available-for-sale

           

September 30, 2010

           

Debt securities—

           

Federal agencies

   $ 27,787       $ 386       $ —         $ 28,173   

Mortgage-backed

     86,876         2,978         —           89,854   

Municipals

     35,326         1,690         10         37,006   

Other

     127         —           52         75   
                                   

Total

   $ 150,116       $ 5,054       $ 62       $ 155,108   
                                   

Securities available-for-sale

           

December 31, 2009

           

Debt securities—

           

Federal agencies

   $ 17,226       $ 144       $ 16       $ 17,354   

Mortgage-backed

     80,338         3,225         477         83,086   

Municipals

     41,216         1,373         66         42,523   

Other

     126         —           44         82   
                                   

Total

   $ 138,906       $ 4,742       $ 603       $ 143,045   
                                   

Securities available-for-sale

           

September 30, 2009

           

Debt securities—

           

Federal agencies

   $ 20,262       $ 138       $ 1       $ 20,399   

Mortgage-backed

     80,765         3,202         559         83,408   

Municipals

     41,479         1,801         3         43,277   

Other

     126         —           35         91   
                                   

Total

   $ 142,632       $ 5,141       $ 598       $ 147,175   
                                   

Proceeds from sales of securities available-for-sale totaled $14,762 thousand for the nine months ended September 30, 2010. Gross realized gains from sales of securities were $368 thousand for the nine months ended September 30, 2010. Gross realized losses were $311 thousand for the nine months ended September 30, 2010. There were no sales of securities during the nine months ended September 30, 2009.

At September 30, 2010, December 31, 2009 and September 30, 2009, federal agencies, municipals and mortgage-backed securities with a carrying value of $28,949 thousand, $12,600 thousand and $14,973 thousand, respectively, were pledged to secure public deposits. At September 30, 2010, December 31, 2009 and September 30, 2009, the carrying amount of securities pledged to secure repurchase agreements was $20,095 thousand, $26,472 thousand and $33,596 thousand, respectively. At September 30, 2010, securities of $5,899 thousand were pledged to the Federal Reserve Bank of Atlanta to secure the Company’s daytime correspondent transactions.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

Maturity of Securities

The following table presents the amortized cost and fair value of debt securities by contractual maturity at September 30, 2010.

 

     Amortized
Cost
    Fair
Value
 
     (in thousands)  

Within 1 year

   $ 1,865      $ 1,890   

Over 1 year through 5 years

     33,734        34,574   

5 years to 10 years

     23,060        24,082   

Over 10 years

     4,581        4,708   
                
     63,240        65,254   

Mortgage-backed securities

     86,876        89,854   
                

Total

   $ 150,116      $ 155,108   
                

Impairment Analysis

The following table shows the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2010, December 31, 2009 and September 30, 2009.

 

    Less than 12 months     12 months or greater     Totals  
    Fair
Value
    Unrealized
Losses
    Fair
Value
    Unrealized
Losses
    Fair
Value
    Unrealized
Losses
 
    (in thousands)  

September 30, 2010

           

Federal agencies

  $ —        $ —        $ —        $ —        $ —        $ —     

Mortgage-backed

    —          —          —          —          —          —     

Municipals

    —          —          392        10        392        10   

Other

    —          —          75        52        75        52   
                                               

Totals

  $ —        $ —        $ 467      $ 62      $ 467      $ 62   
                                               

December 31, 2009

           

Federal agencies

  $ 1,982      $ 16      $ —        $ —        $ 1,982      $ 16   

Mortgage-backed

    2,375        6        3,086        471        5,461        477   

Municipals

    1,404        31        617        35        2,021        66   

Other

    —          —          82        44        82        44   
                                               

Totals

  $ 5,761      $ 53      $ 3,785      $ 550      $ 9,546      $ 603   
                                               

September 30, 2009

           

Federal agencies

  $ 1,370      $ 1      $ —        $ —        $ 1,370      $ 1   

Mortgage-backed

    —          —          4,574        559        4,574        559   

Municipals

    —          —          650        3        650        3   

Other

    —          —          91        35        91        35   
                                               

Totals

  $ 1,370      $ 1      $ 5,315      $ 597      $ 6,685      $ 598   
                                               

As of September 30, 2010, the Company performed an impairment assessment of the securities in its portfolio that had an unrealized loss to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) the Company intends to sell the security, (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized costs basis or (3) the Company does not expect to recover the security’s entire amortized cost basis, even if the Company does not intend to sell. Additionally, accounting guidance requires that for impaired securities that the Company does not intend to sell and/or that it is not more-likely-than-not that the Company will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses,

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.

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

As of September 30, 2010, gross unrealized losses in the Company’s portfolio totaled $62 thousand, compared to $603 thousand as of December 31, 2009 and $598 thousand as of September 30, 2009. The unrealized losses in municipal securities are primarily due to widening credit spreads and changes in interest rates subsequent to purchase. The unrealized losses in other securities are two trust preferred securities. The unrealized losses in the trust preferred securities are primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. Based on results of the Company’s impairment assessment, the unrealized losses at September 30, 2010 are considered temporary.

NOTE 7 – LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES

The following table presents loans by type.

 

    September 30, 2010     December 31, 2009     September 30, 2009  
    (in thousands)  

Loans secured by real estate-

     

Residential 1-4 family

  $ 258,579      $ 281,354      $ 284,811   

Commercial

    236,991        259,819        233,692   

Construction

    101,870        153,144        176,570   

Multi-family and farmland

    37,816        37,960        37,461   
                       
    635,256        732,277        732,534   

Commercial loans

    91,637        146,016        148,473   

Consumer installment loans

    37,884        48,927        51,866   

Leases, net of unearned income

    10,139        19,730        24,679   

Other

    2,502        5,068        6,743   
                       

Total loans

    777,418        952,018        964,295   

Allowance for loan and lease losses

    (25,320     (26,492     (25,686
                       

Net loans

  $ 752,098      $ 925,526      $ 938,609   
                       

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

The following table presents an analysis of the allowance for loan and lease losses. The provision expense for loan and lease losses in the table does not include the Company’s provision accrual for unfunded commitments of $18 thousand and $18 thousand for the nine months ended September 30, 2010 and 2009, respectively. The reserve for unfunded commitments totaled $223 thousand and $199 thousand as of September 30, 2010 and 2009, respectively, and is included in other liabilities in the consolidated balance sheets.

 

    September 30, 2010     September 30, 2009  
    (in thousands)  

Allowance for loan and lease losses-beginning of period

  $ 26,492      $ 17,385   

Provision expense for loan and lease losses

    26,406        20,451   

Loans charged-off

    (28,130     (12,443

Loan loss recoveries

    552        293   
               

Allowance for loan and lease losses-end of period

  $ 25,320      $ 25,686   
               

The Company classifies a loan as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans were $45,395 thousand, $40,118 thousand and $23,608 thousand at September 30, 2010, December 31, 2009 and September 30, 2009, respectively. Nonaccrual loans were $55,083 thousand, $45,454 thousand and $31,463 thousand at September 30, 2010, December 31, 2009 and September 30, 2009, respectively. Loans past due 90 days or more and still accruing interest were $6,025 thousand, $4,524 thousand and $3,377 thousand as of September 30, 2010, December 31, 2009 and September 30, 2009, respectively. The Company had no significant outstanding commitments to lend additional funds to customers whose loans have been placed on nonaccrual status.

Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may change in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

NOTE 8 – GOODWILL

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

 

    September 30, 2010     December 31, 2009     September 30, 2009  
    (in thousands)  

Goodwill – beginning of period

  $ —        $ —        $ 27,156   

Goodwill acquired

    —          —          —     

Goodwill impairment

    —          —          (27,156
                       

Goodwill – end of period

  $ —        $ —        $ —     
                       

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

The Company engaged an independent valuation firm to assist in computing the fair value estimate for the goodwill impairment assessment as of September 30, 2009. The firm utilized two separate valuation methodologies for Step 1 and compared the results of each to determine the fair value of the

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

goodwill associated with the Company’s prior bank acquisitions. The valuation methodologies utilized included a discounted cash flow valuation technique and a comparison of the average price to book value of comparable bank acquisitions. Both methods indicated a valuation below the book value of the Company. The firm conducted Step 2, which assigned fair values to all assets, liabilities and other (non-goodwill) intangibles. The results of Step 2 indicated a full goodwill impairment of $27,156 thousand that was recorded in non-interest expense in the Consolidated Income Statements during the nine months ended September 30, 2009. The impairment was primarily a result of the continuing economic downturn and its implications on bank valuations.

The goodwill was associated with six prior acquisitions. Three acquisitions were taxable asset purchases and three were non-taxable stock purchases. The goodwill impairment that is deductible for tax is $6,953 thousand, which added $2,394 thousand to the tax benefit recognized in the third quarter of 2009. The remaining $20,203 thousand goodwill impairment is not deductible for taxes and thus no tax benefit was recognized in 2009.

NOTE 9 – GUARANTEES

The Company, as part of its ongoing business operations, issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company to guarantee the performance of a customer to a third-party. A financial standby letter of credit is a commitment to guarantee a customer’s repayment of an outstanding loan or debt instrument. In a performance standby letter of credit, the Company guarantees a customer’s performance under a contractual nonfinancial obligation for which it receives a fee. The maximum potential amount of future payments the Company could be required to make under its standby letters of credit at September 30, 2010, December 31, 2009, and September 30, 2009 was $14,625 thousand, $16,077 thousand, and $15,972 thousand, respectively. The Company’s outstanding standby letters of credit generally have a term of one year and some may have renewal options. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

NOTE 10 – STOCKHOLDERS’ EQUITY

Common Stock and ESOP Activity

On January 27, 2010, the Company’s Board of Directors elected to suspend the dividend on the Company’s common stock. The Company may not pay dividends on common stock unless all Preferred Stock dividends have been paid.

On July 22, 2010, the Company filed with the State of Tennessee, Articles of Amendment to the Charter of Incorporation to increase the number of authorizes shares of common stock from 50 million to 150 million, in accordance with shareholder approval obtained on June 30, 2010.

On September 30, 2010, June 30, 2010 and March 31, 2010, the Company released 22,189, 70,701 and 65,655 shares, respectively, from the Employee Stock Ownership Plan (ESOP) for the employer matching contribution. Prior to July 1, 2010, the employer match was 100% of the employee’s contribution up to 6% of the employee’s compensation for the first six months of 2010. Effective July 1, 2010, the 6% employer match was reduced to 1% of the employee’s compensation for the remainder of the Plan year. The number of unallocated, committed to be released, and allocated shares for the ESOP are presented in the following table.

 

     Unallocated Shares     Committed to be
released shares
     Allocated
Shares
     Compensation
Expense

(in thousands)
 

Shares as of December 31, 2009

     768,787        —           431,889      

Shares allocated during 2010

     (158,545     —           158,545       $ 310   
                            

Shares as of September 30, 2010

     610,242        —           590,434      
                            

Preferred Stock

The Company’s Board of Directors elected to defer payment on the February 15, 2010, May 15, 2010 and August 16, 2010 dividends on the Series A Preferred Stock (Preferred Stock). Dividends for the

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

Preferred Stock are cumulative. The Company recognized $413 thousand and $1,238 thousand for the three and nine months ended September 30, 2010. As of September 30, 2010, the unpaid, accrued dividend is $1,444 thousand. For the three and nine months ended September 30, 2010, the Company recognized $95 thousand and $281 thousand, respectively, in Preferred Stock discount accretion.

The Preferred Stock was issued under the Capital Purchase Program (CPP) administered by the U.S. Department of the Treasury (Treasury) under the Troubled Asset Relief Program (TARP). If the Company misses six quarterly Preferred Stock dividend payments, whether or not consecutive, the Treasury will have the right to appoint two directors to the Company’s Board of Directors until all accrued but unpaid dividends have been paid on the Preferred Stock. As of September 30, 2010, the Company has deferred three dividend payments.

On September 7, 2010, the Company entered into a Written Agreement with the Federal Reserve Bank of Atlanta. As part of the Written Agreement, the Company is prohibited from declaring or paying dividends without prior written consent from the Federal Reserve. Note 3 provides additional information on the Written Agreement.

NOTE 11 – TAXES

The Company accounts for income taxes in accordance with ASC 740, which requires an asset and liability approach for the financial accounting and reporting of income taxes. Under this method, deferred income taxes are recognized for the expected future tax consequences of differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. These balances are measured using the enacted tax rates expected to apply in the year(s) in which these temporary differences are expected to reverse. The effect on deferred income taxes of a change in tax rates is recognized in income in the period when the change is enacted.

In accordance with ASC 740, the Company is required to establish a valuation allowance for deferred tax assets when it is “more likely than not” that a portion or all of the deferred tax assets will not be realized. The evaluation requires significant judgment and extensive analysis of all available positive and negative evidence, the forecasts of future income, applicable tax planning strategies and assessments of the current and future economic and business conditions.

As of September 30, 2010, the Company established a $17,432 thousand deferred tax asset valuation allowance after evaluating all available positive and negative evidence. Positive evidence included the existence of taxes paid in available carryback years. Negative evidence included a cumulative loss in recent years and general business and economic trends. As business and economic conditions change, the Company will re-evaluate the valuation allowance.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

For the three and nine months ended September 30, 2010, the Company recognized an income tax provision of $9,384 thousand and $6,461 thousand, respectively. For the three and nine months ended September 30, 2009, the Company recognized income tax benefit of $4,877 thousand and $7,326 thousand, respectively. The following reconciles the income tax provision (benefit) to statutory rates:

 

     Three Months Ended     Nine Months Ended  
     September 30,     September 30,  
     2010     2009     2010     2009  
     (in thousands)  

Federal taxes at statutory tax rate

   $ (6,932   $ (11,222   $ (9,027   $ (12,823

Tax exempt loss on non-deductible goodwill impairment

     —          6,869        —          6,869   

Tax exempt earnings on loans and securities

     (115     (137     (366     (414

Tax exempt earnings on bank owned life insurance

     (84     (85     (256     (256

Low-income housing tax credits

     (103     —          (310     —     

Other, net

     20        (93     123        (174

State tax provision, net of federal effect

     (834     (209     (1,135     (528

Changes in the deferred tax asset valuation allowance

     17,432        —          17,432        —     
                                

Income tax provision (benefit)

   $ 9,384      $ (4,877   $ 6,461      $ (7,326
                                

The deferred tax asset valuation allowance of $17,432 thousand fully offset the income tax benefits recognized for the three and nine months ended September 30, 2010. The benefit recognized before the valuation allowance primarily related to increases in deferred tax assets, including the allowance for loan and lease losses and the year-to-date operating loss. The benefit recognized during the three and nine months ended September 30, 2009, primarily relates to increases in deferred tax assets including the increase associated with the temporary difference of the allowance for loan and lease losses, the tax-deductible portion of the goodwill impairment and the year-to-date net operating loss.

The Company recognized a goodwill impairment of $27,156 thousand in the third quarter of 2009. Approximately $6,953 thousand of the impairment was deductible for taxes, which represents $2,394 thousand of the total 2009 income tax benefit. The remaining $20,203 thousand of the impairment was not deductible for taxes. As shown above, this non-deductible portion significantly impacts the effective tax rate for 2009.

The Company evaluated its material tax positions as of September 30, 2010. Under the “more-likely-than-not” threshold guidelines, the Company believes it has identified all significant uncertain tax benefits. The Company evaluates, 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 the Company’s consolidated financial statements. The roll-forward of unrecognized tax benefits is as follows:

 

     Amount  
     (in thousands)  

Balance at January 1, 2010

   $ 1,146   

Increases related to prior year tax positions

     —     

Increases related to current year tax positions

     148   

Lapse of statute

     —     
        

Balance at September 30, 2010

   $ 1,294   
        

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

NOTE 12 – FAIR VALUE MEASUREMENTS

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

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2010, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the hierarchy. In such cases, the fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2010.

 

    Balance as of
September 30, 2010
    Quoted Prices in
Active Markets for
Identical Assets

(Level 1)
    Significant Other
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
 
    (in thousands)  

Financial assets

       

Securities available-for-sale

  $ 155,108      $ —        $ 154,858      $ 250   

Loans held for sale

    3,386        —          3,386        —     

Forward loan sales contracts

    35        —          35        —     

Financial liabilities

       

None

    —          —          —          —     

The following table presents additional information about changes in assets and liabilities measured at fair value on a recurring basis and for which the Company utilized Level 3 inputs to determine fair value as of September 30, 2010.

 

     Beginning
Balance
     Total
Realized
and
Unrealized
Gains or
Losses
     Purchases,
Sales, Other
Settlements
and
Issuances,
net
     Net
Transfers In
and/or Out
of Level 3
     Ending
Balance
 
     (in thousands)  

Financial assets

              

Securities available-for-sale

   $ 250       $ —         $ —         $ —         $ 250   

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

At September 30, 2010, the Company also had assets and liabilities measured at fair value on a non-recurring basis. Items measured at fair value on a non-recurring basis include other real estate owned (OREO), repossessions and collateral-dependent impaired loans. Such measurements were determined utilizing Level 2 and Level 3 inputs.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

Upon recognition, OREO and repossessions are measured at fair value, which becomes the cost basis. The cost basis is subsequently re-measured at fair value when events or circumstances occur that indicate the initial fair value has declined. Collateral-dependent impaired loans are measured at fair value based on the appraised value of the collateral. A loan is collateral-dependent when repayment of the loan is expected solely by the underlying collateral and there are no other available and reliable sources of repayment. If the recorded investment in the impaired loan exceeds the measure of fair value, the shortfall is recognized as a charge-off. The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis, for which impairment was recognized during the nine months ended September 30, 2010.

 

    Carrying
Value as of
September 30, 2010
    Level 1
Fair Value
Measurement
    Level 2
Fair Value
Measurement
    Level 3
Fair Value
Measurement
    Valuation
Allowance as of
September 30, 2010
 
    (in thousands)  

Other real estate owned

  $ 14,425      $ —        $ 14,425      $ —        $ 5,387   

Repossessions

    491        —          491        —          230   

Collateral-dependent loans

    28,084        —          28,084        —          14,867   

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

 

    September 30, 2010     December 31, 2009     September 30, 2009  
    Carrying
Amount
    Fair Value     Carrying
Amount
    Fair Value     Carrying
Amount
    Fair Value  
    (in thousands)  

Financial assets

           

Cash and cash equivalents

  $ 8,545      $ 8,545      $ 23,220      $ 23,220      $ 14,711      $ 14,711   

Interest bearing deposits in banks

  $ 224,111      $ 224,111      $ 152,616      $ 152,616      $ 5,394      $ 5,394   

Securities available-for-sale

  $ 155,108      $ 155,108      $ 143,045      $ 143,045      $ 147,175      $ 147,175   

Loans held for sale

  $ 3,386      $ 3,386      $ 1,225      $ 1,225      $ 1,001      $ 1,001   

Loans

  $ 774,032      $ 793,061      $ 950,793      $ 959,689      $ 963,294      $ 983,185   

Allowance for loan and lease losses

  $ (25,320   $ (25,320   $ (26,492   $ (26,492   $ (25,686   $ (25,686

Financial liabilities

           

Deposits

  $ 1,112,204      $ 1,118,438      $ 1,182,673      $ 1,187,263      $ 1,019,287      $ 1,025,567   

Federal funds purchased and securities sold under agreements to repurchase

  $ 17,676      $ 17,676      $ 17,911      $ 17,911      $ 20,463      $ 20,463   

Other borrowings

  $ 81      $ 81      $ 94      $ 94      $ 7,724      $ 7,724   

The following methods and assumptions were used by the Company in estimating fair value of each class of financial instruments for which it is practicable to estimate that value:

 

   

Cash and cash equivalents – The carrying value of cash and cash equivalents approximates fair value.

 

   

Interest bearing deposits in banks – The carrying amounts of interest bearing deposits in banks approximate fair value.

 

   

Securities – The Company’s securities are valued utilizing Level 2 inputs with the exception of one $250 thousand bond. Level 2 inputs are based on quoted prices for similar assets in active markets.

 

   

Loans held for sale – Fair value for loans held for sale are based on quoted prices for similar assets in active markets.

 

   

Loans – For variable-rate loans that reprice frequently and have no significant changes in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans and other consumer loans are estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans and

 

20


Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

leases is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers of similar credit ratings quality. Fair value for impaired loans and leases are estimated using discounted cash flow analysis or underlying collateral values, where applicable.

 

   

Deposit liabilities – The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value for fixed-rate certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregate expected maturities on time deposits.

 

   

Federal funds purchased and securities sold under agreements to repurchase – These borrowings generally mature in 90 days or less and, accordingly, the carrying amount reported in the balance sheet approximates fair value.

 

   

Other borrowings – Other borrowings carrying amount reported in the consolidated balance sheets approximates fair value.

NOTE 13 – FAIR VALUE OPTION

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

The Company records all newly-originated loans held for sale under the fair value option. Origination fees and costs are recognized in earnings at the time of origination. The servicing value is included in the fair value of the loan and recognized at origination of the loan. The Company uses derivatives to hedge changes in servicing value as a result of including the servicing value in the fair value of the loan. The estimated impact from recognizing servicing value, net of related hedging costs, as part of the fair value of the loan is captured in the mortgage loan and related fees component of noninterest income.

As of September 30, 2010, December 31, 2009 and September 30, 2009, there was $3,386 thousand, $1,225 thousand and $1,001 thousand in loans held for sale recorded at fair value, respectively. For the three and nine months ended September 30, 2010, approximately $319 thousand and $704 thousand in loan origination and related fee income was recognized in noninterest income, respectively, and an insignificant amount of origination and related fee expense, respectively, was recognized in noninterest expense utilizing the fair value option.

For the nine months ended September 30, 2010, the Company recognized a gain of $45 thousand due to changes in fair value for loans held for sale in which the fair value option was elected. This amount does not reflect the change in fair value attributable to the related hedges the Company used to mitigate the interest rate risk associated with loans held for sale. The changes in the fair value of the hedges were also recorded in the mortgage loan and related fee component of noninterest income, and reduced income by $39 thousand.

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

 

     Aggregate fair
value
     Aggregate unpaid
principal balance
under FVO
     Fair value carrying
amount over (under)
unpaid principal
 
     (in thousands)  

Loans held for sale

   $ 3,386       $ 3,421       $ (35

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

NOTE 14 – DERIVATIVE FINANCIAL INSTRUMENTS

The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity, as necessary, to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of September 30, 2010, the Company has not entered into a transaction in a dealer capacity.

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

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

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

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

On August 28, 2007 and March 26, 2009, the Company elected to terminate a series of interest rate swaps with a total notional value of $150 million and $50 million, respectively. At termination, the swaps had a market value of $2,010 thousand and $5,778 thousand, respectively. These gains are being accreted into interest income over the remaining life of the originally hedged items. The Company recognized a total of $1,532 thousand for the nine months ended September 30, 2010.

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

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

 

     20101      2011      2012      Total  
     (in thousands)  

Accretion of gain from 2007 terminated swaps

   $ 80       $ 219       $ 62       $ 361   

Accretion of gain from 2009 terminated swaps

   $ 410       $ 1,628       $ 1,272       $ 3,310   

 

1

Represents the gain accretion for October 1, 2010 to December 31, 2010. Excludes the amounts recognized in the first nine months of 2010.

The following table presents the cash flow hedges as of September 30, 2010.

 

    Notional
Amount
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Accumulated
Other
Comprehensive
Income
    Maturity
Date
 
    (in thousands)  

Asset hedges

         

Cash flow hedges:

         

Forward contracts

  $ 3,386      $ 38      $ 3      $ 23        Various   
                                 
  $ 3,386      $ 38      $ 3      $ 23     
                                 

Terminated asset hedges

         

Cash flow hedges: 1

         

Interest rate swap

  $ 25,000      $ —        $ —        $ 53        June 28, 2011   

Interest rate swap

    20,000        —          —          40        June 28, 2011   

Interest rate swap

    35,000        —          —          145        June 28, 2012   

Interest rate swap

    25,000        —          —          1,092        October 15, 2012   

Interest rate swap

    25,000        —          —          1,092        October 15, 2012   
                                 
  $ 130,000      $ —        $ —        $ 2,422     
                                 

 

1

The $2.4 million of gains, net of taxes, recorded in accumulated other comprehensive income as of September 30, 2010, will be reclassified into earnings as interest income over the remaining life of the respective hedged items.

The following table presents additional information on the active derivative positions as of September 30, 2010.

 

          Consolidated Balance
Sheet Presentation
    Consolidated Income
Statement Presentation
 
          Assets     Liabilities     Gains  
    Notional     Classification     Amount     Classification     Amount     Classification     Amount
Recognized
 
    (in thousands)  

Hedging Instrument:

             

Forward contracts

  $ 3,386        Other assets      $ 35        Other liabilities        N/A       
 
Noninterest
income – other
  
  
  $ (35

Hedged Items:

             

Loans held for sale

    N/A       
 
Loans held for
sale
  
  
  $ 3,386        N/A        N/A       
 
Noninterest
income – other
  
  
    N/A   

For the three and nine months ended September 30, 2010, no significant amounts were recognized for hedge ineffectiveness.

NOTE 15 – ACCOUNTING POLICIES RECENTLY ADOPTED AND PENDING ACCOUNTING PRONOUNCEMENTS

Effective January 1, 2010, the Company adopted the provisions of the FASB Accounting Standards Update 2010-06, “Improving Disclosures about Fair Value Measurements” (ASU 2010-06), which updates ASC 820 to require disclosure of significant transfers into and out of Level 1 and Level 2 of the fair value hierarchy, as well as disclosure of an entity’s policy for determining when transfers between all levels of the hierarchy are recognized. ASC 820, as amended, also provides enhanced disclosure requirements regarding purchases, sales, issuances, and settlements related to recurring Level 3 measurements, and requires separate disclosure in the Level 3 reconciliation of total gains and losses

 

23


Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

recognized in other comprehensive income. The updated provisions of ASC 820 require that fair value measurement disclosures be provided by each “class” of assets and liabilities, and that disclosures providing a description of the valuation techniques and inputs used to measure fair value be included for both recurring and nonrecurring fair value measurements classified as either Level 2 or Level 3. The provisions of ASU 2010-06 are effective for periods beginning after December 15, 2009, except for the requirement to provide the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis which will be effective for periods beginning after December 15, 2010. Comparative disclosures are required only for periods ending subsequent to initial adoption. The Company revised its disclosures accordingly.

Effective January 1, 2010, the Company adopted the provisions of the FASB Accounting Standards Update 2009-16, “Accounting for Transfers of Financial Assets” (ASU 2009-16). ASU 2009-16 updates ASC 860 to provide for the removal of the qualifying special purpose entity (“QSPE”) concept from GAAP, resulting in the evaluation of all former QSPEs for consolidation on and after January 1, 2010 in accordance with ASC 810. The amendments to ASC 860 modify the criteria for achieving sale accounting for transfers of financial assets and define the term participating interest to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale. The updated provisions of ASC 860 also provide that a transferor should recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. ASC 860, as amended, requires enhanced disclosures which are generally consistent with, and supersede, the disclosures previously required by the Codification update to ASC 810 and ASC 860 which was effective for periods ending after December 15, 2008. The provisions of ASU 2009-16 are effective prospectively for new transfers of financial assets occurring in fiscal years beginning after November 15, 2009, and in interim periods within those fiscal years. ASC 860’s amended disclosure requirements should be applied to transfers that occurred both before and after the effective date of the Codification update, with comparative disclosures required only for periods subsequent to initial adoption for those disclosures not previously required under the Codification update to ASC 810 and ASC 860 which was effective for periods ending after December 15, 2008. The adoptions did not impact the Company’s consolidated financial statements.

Effective December 31, 2009, the Company adopted the provisions of FASB Accounting Standards Update (ASU) 2009-05, “Measuring Liabilities at Fair Value” (ASU 2009-05) to the FASB Accounting Standards Codification (ASC or Codification). ASU 2009-05 updates ASC 820 to clarify that a quoted price for the identical liability, when traded as an asset in an active market, is a Level 1 measurement for that liability when no adjustment to the quoted price is required. ASU 2009-05 further amends ASC 820 to provide that if a quoted price for an identical liability does not exist in an active market, the fair value of the liability should be measured using an approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. Under the updated provisions of ASC 820, for such liabilities fair value will be measured using either a valuation technique that uses the quoted price of the identical liability when traded as an asset, a valuation technique that uses the quoted price for similar liabilities or similar liabilities when traded as an asset, or another valuation technique that is consistent with the principles of ASC 820. The adoption had no significant impact on the Company’s consolidated financial statements.

Effective September 30, 2009, the Company adopted the provisions of the FASB Accounting Standard Codification 105-10, “Generally Accepted Accounting Principles.” This standard establishes the FASB Accounting Standards Codification as the single source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP, other than guidance issued by the SEC. Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority, with this Statement superseding all then-existing non-SEC accounting and reporting standards as of its effective date. Following this Statement, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standard Updates that will serve only to update the Codification. In conjunction with the adoption of this Statement, all references to pre-Codification Statements have either been removed or updated to reflect the new Codification reference. The adoption of this Statement did not have a significant impact on the Company’s consolidated financial statements.

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

 

Effective June 30, 2009, the Company adopted the FASB ASC 855, “Subsequent Events.” ASC 855 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.

Effective June 30, 2009, the Company adopted ASC 825-10, “Financial Instruments.” This update requires disclosures about the fair value of financial instruments in interim financial statements. The guidance requires that disclosures be included in both interim and annual financial statements of the methods and significant assumptions used to estimate the fair value of financial instruments. Comparative disclosures are required only for periods ending subsequent to initial adoption. The additional required disclosures are presented in Note 12 of the Company’s consolidated financial statements.

Effective March 31, 2009, the Company adopted the FASB Codification update ASC 320-10-35 which replaces the “intent and ability to hold to recovery” indicator of other-than-temporary impairment in ASC 320-10-35 for debt securities. The guidance, issued in April 2009, establishes a new method of recognizing and reporting other-than-temporary impairments of debt securities as well as requiring additional disclosures related to debt and equity securities. Under the new guidance, an impairment is other-than-temporary if any of the following conditions exist: (1) the entity intends to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis or (3) the entity does not expect to recover the security’s entire amortized cost basis, even if the entity does not intend to sell. Additionally, the guidance requires that for impaired securities that an entity does not intend to sell that it is not more-likely-than-not that it will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. The guidance discusses the proper interaction with other authoritative guidance, including the additional factors that must be considered in an other-than-temporary impairment analysis. The additional disclosure requirements include a roll-forward of amounts recognized in earnings for debt securities for which an other-than-temporary impairment has been recognized and the noncredit portion of the other-than-temporary impairment that has been recognized in other comprehensive income. The adoption did not impact the Company’s consolidated financial statements.

Effective March 31, 2009, the Company first applied the provisions of the FASB ASC 820-10, “Fair Value Measurements and Disclosures,” that was issued in April 2009. The update provides factors that an entity should consider when determining whether a market for an asset is not active. If, after evaluating the relevant factors, the evidence indicates that a market is not active, the guidance provides an additional list of factors that an entity must consider when determining whether events and circumstances indicate that a transaction which occurred in an inactive market is orderly. The guidance requires that entities place more weight on observable transactions determined to be orderly and less weight on transactions for which there is insufficient information to determine whether the transaction is orderly when determining the fair value of an asset or liability under applicable authoritative guidance. The guidance also requires enhanced disclosures, including disclosure of a change in valuation technique that results from its application and disclosure of fair value measurements for debt and equity securities by major security types. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of the Codification update to ASC 815-10-50 which requires expanded disclosures about an entity’s derivative instruments and hedging activities, but does not change previous authoritative guidance on scope or accounting. This updated guidance requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under GAAP and its related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. To meet those objectives, this guidance requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures in a tabular format about fair value amounts and gains and losses on derivative instruments including specific disclosures

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

regarding the location and amounts of derivative instruments in the financial statements, and disclosures about credit-risk-related contingent features in derivative agreements. The guidance also clarifies derivative instruments that are subject to the concentration of credit-risk disclosures. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 805. This update establishes principles and requirements for how an acquirer in a business combination: recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and discloses information to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 805, which requires that an acquirer recognize at fair value as of the acquisition date an asset acquired or liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of the asset or liability can be determined during the measurement period. The guidance provides that if the acquisition-date fair value of an asset acquired or liability assumed in a business combination that arises from a contingency cannot be determined during the measurement period, the asset or liability should be recognized at the acquisition date if information available before the end of the measurement period indicates that it is probable that an asset existed or a liability had been incurred at the acquisition date and the amount of the asset or liability can be reasonably estimated. Additionally, the guidance requires enhanced disclosures regarding assets and liabilities arising from contingencies which are recognized at the acquisition date of a business combination, including the nature of the contingencies, the amounts recognized at the acquisition date and the measurement basis applied. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 810, as amended. The update establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This guidance clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be clearly reported as equity in the consolidated financial statements. Additionally, the guidance requires that the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated income statement. The adoptions did not impact the Company’s consolidated financial statements.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In this Form 10-Q, “First Security,” “we,” “us,” “the Company” and “our” refer to First Security Group, Inc.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of our statements contained in this Form 10-Q 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; changes in loan underwriting, credit review or loss reserve policies; the failure of assumptions underlying the establishment of reserves for possible loan losses; changes in political and economic conditions; changes in financial market conditions; 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; First Security’s lack of participation in a “stress test” under the Federal Reserve’s Supervisory Capital Assessment Program; the effects of competition from other commercial banks, thrifts, and other financial institutions; and the effect of any mergers, acquisitions or other transactions, to which we or our subsidiary may from time to time be a party.

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 Form 10-Q 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.

THIRD QUARTER 2010 AND RECENT EVENTS

The following discussion and analysis sets forth the major factors that affected results of operations and financial condition reflected in the unaudited consolidated financial statements for the three and nine month periods ended September 30, 2010 and 2009. Such discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and the notes attached thereto.

Company Overview

First Security Group, Inc. is a bank holding company headquartered in Chattanooga, Tennessee, with $1.2 billion in assets as of September 30, 2010. Founded in 1999, First Security’s community bank subsidiary, FSGBank, N.A. has 37 full-service banking offices, including the headquarters, along the interstate corridors of eastern and middle Tennessee and northern Georgia and 325 full-time equivalent employees. In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank; along the Interstate 40 corridor in Tennessee, FSGBank operates under the name of Jackson Bank & Trust. FSGBank provides retail and commercial banking services, trust and investment management, mortgage banking, financial planning and internet banking (www.FSGBank.com) services.

 

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Recent Regulatory Events

Effective September 7, 2010, First Security entered into a Written Agreement (Agreement) with the Federal Reserve Bank of Atlanta (Federal Reserve). The Agreement is designed to ensure First Security is a source of strength to FSGBank. Substantially all of the requirements of the Agreement are similar to those already in effect for FSGBank pursuant to the Consent Order that is described below. On September 14, 2010, we filed a current report on Form 8-K describing the Agreement. The Form 8-K also provides a copy of the fully executed Agreement.

Effective April 28, 2010, FSGBank reached an agreement with its primary regulator, the Office of the Controller of the Currency (OCC), regarding the issuance of a Consent Order (Order). The Order is a result of the OCC’s regular examination of the FSGBank in the fall of 2009 and directs FSGBank to take actions intended to strengthen its overall condition. All customer deposits remain fully insured by the FDIC to the maximum extent allowed by law; the Order does not impact this coverage in any manner. On April 29, 2010, First Security filed a current report on Form 8-K describing the Order and the related actions taken by the Bank to date. The Form 8-K also provides a copy of the fully executed Order.

Prior to and following the OCC’s regularly scheduled exam in the fall of 2009, we developed and began implementing a number of strategic initiatives designed to improve both the operations and the financial performance of First Security. The Order establishes a framework and timeline for fully implementing certain of our strategic initiatives. We believe the successful execution of our initiatives will result in full compliance with the Order and position us for long-term growth and a return to profitability.

The OCC is currently conducting its regularly scheduled safety and soundness examination and is working with the Board and management to address certain items within the previously submitted strategic and capital plans. The Order required FSGBank to maintain certain capital ratios within 120 days of it execution. The September 30, 2010 Call Report was the first public financial statement related to a period subsequent to the 120 day requirement. As of September 30, 2010, the Bank’s total capital to risk-weighted assets was 12.93 percent and the Tier 1 capital to adjusted total assets was 7.43 percent. The Bank has notified the OCC of the non-compliance. The Bank anticipates submitting revised earnings and capital plans to the OCC during the fourth quarter of 2010.

 

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Strategic Initiatives

During 2009 and 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

     

•     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

•     OREO management

  

Transferred OREO management to the special assets department

   3rd quarter 2010

•     OREO sales

  

Outsourced the marketing and sales function for most foreclosed residential properties to market leading real estate firms

   4th quarter 2010

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

•     Loan policy

  

Amended existing loan policy to provide the framework and guidelines for current and future loans

   2nd quarter 2010

Management

     

•     Chief risk officer

  

Elevated risk manager to executive level with expanded responsibilities

   1st quarter 2010

•     Chief credit officer

  

Hired experienced executive credit officer to oversee credit administration

   2nd quarter 2010

•     Retail banking president

  

Created new executive level position responsible for consumer and small-business loan and deposit relationships and associated retail lenders

   3rd quarter 2010

•     Commercial banking president

  

Created new executive level position responsible for commercial loan and deposit relationships and associated commercial lenders

   3rd quarter 2010

•     Chief operating officer and president

  

Hired experienced bank executive to manage and oversee banking operations, including the credit, financial, retail banking and commercial banking functions

   3rd quarter 2010

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

Overview

Market Conditions

Most indicators point toward the overall U.S. economy transitioning to a gradual recovery period over the balance of 2010 and 2011. Some economists have indicated that the future recovery may bring with it few new jobs. As our financial results can be a reflection of our regional economy, we closely monitor and evaluate local and regional economic trends.

Announced in 2008, the $1 billion Volkswagen automotive production facility is preparing for the launch of vehicle production in 2011. The Volkswagen plant will bring about 2,000 direct jobs, including

 

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approximately 400 white-collar jobs, and up to 9,500 supplier-related jobs to the region. We believe the positive economic impact on Chattanooga and the surrounding region from Volkswagen and other recently announced large economic investments 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 larger market areas benefit from more stable rates of employment. Our major market areas of Chattanooga and Knoxville have a lower unemployment rate of 8.3% and 7.3%, respectively (as of September 2010, the most recent available data), than the Tennessee rate of 9.4%. The economy of the Dalton, Georgia MSA is primarily centered on the carpet and floor-covering industries. With the decline in housing starts and the overall economy, Dalton has been the most negatively impacted region in our footprint. The unemployment rate in the Dalton MSA is 11.8% (as of September 2010) compared to the Georgia rate of 10.0%. For the Chattanooga and Knoxville MSAs, the number of unemployed workers is decreasing and, as of September 2010, has declined by 17.6% in Chattanooga and 21.9% in Knoxville since the peak in June 2009. We believe these positive employment trends will continue throughout 2010 and into 2011.

Our market area has also benefited from a relatively stable housing environment. According to the National Association of REALTORS, the year-over-year median sales prices of existing single-family homes was unchanged for the Chattanooga MSA and declined by 0.8% for the Knoxville MSA compared to 1.6% increase for the nation and a 2.0% decline for the census region identified as the South as of June 30, 2010 (the most recent available data). While residential real estate values may continue to decline, we are hopeful that the stabilization in housing prices will continue.

Financial Results

As of September 30, 2010, we had total consolidated assets of $1.2 billion, total loans of $777.4 million, total deposits of $1.1 billion and stockholders’ equity of $106.8 million. For the three and nine months ended September 30, 2010, our net loss available to common stockholders was $30.2 million and $34.5 million, respectively, resulting in basic and diluted net loss of $1.92 per share for the quarter and $2.20 per share for the year-to-date period. During the third quarter of 2010, we recorded a $17.4 million valuation allowance on our deferred taxes.

As of September 30, 2009, we had total consolidated assets of $1.2 billion, total loans of $964.3 million, total deposits of $1.0 billion and stockholders’ equity of $145.2 million. For the three and nine months ended September 30, 2009, our net loss available to common stockholders was $28.6 million and $31.8 million, respectively, resulting in basic and diluted net loss of $1.84 per share for the quarter and $2.05 per share for the year-to-date period. During the third quarter of 2009, we recorded a $27.2 million goodwill impairment.

For the three and nine month periods ended September 30, 2010, net interest income decreased by $2.8 million and $4.9 million, respectively, and noninterest income decreased by $333 thousand and $566 thousand, respectively, compared to the same periods in 2009. For the three and nine months ended September 30, 2010, noninterest expense increased by $2.3 million and $4.6 million, respectively, compared to the same periods in 2009 excluding the $27.2 million goodwill impairment in 2009. The decline in interest income is primarily attributable to the shift in earning assets from loans to interest bearing cash partially offset by reductions in rates on interest bearing liabilities. Noninterest income decreased primarily due to lower deposit fees while noninterest expense, excluding the goodwill impairment, increased primarily due to higher expenses associated with nonperforming assets, including write-downs, losses and holding costs. These increases were partially offset by reductions in salary and benefit expense. Full-time equivalent employees were 325 at September 30, 2010, compared to 348 at September 30, 2009.

The provision for loan and lease losses increased $9.1 million and $6.0 million for the three and nine month periods ended September 30, 2010, respectively, compared to the same periods in 2009.

 

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Our efficiency ratio increased in the third quarter of 2010 to 118.7% compared to 74.9% in the same period of 2009 primarily due to reductions in net interest income and noninterest income and increases to noninterest expense. We anticipate our efficiency ratio to begin to improve during 2011 as we focus on enhancing revenue while reducing certain overhead expenses. The stabilization and possible improvement of our efficiency ratio in the fourth quarter of 2010 and into 2011 is contingent on both macro-economic factors, such as potential changes to the federal funds target rate and micro-economic factors, such as local unemployment and real estate values.

Net interest margin in the third quarter of 2010 was 2.72%, or 124 basis points lower than the prior year period of 3.96%. We believe that our net interest margin will continue to be under pressure until loan balances stabilize. The projected stabilization of our net interest margin is dependent on multiple factors including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, maturities of brokered deposits, and any possible further action by the Federal Reserve Board.

For the third quarter of 2010, our Board of Directors elected to defer payment on the Series A Preferred Stock (Preferred Stock). To date, the Company has deferred three consecutive Preferred Stock dividend payments. If we miss six quarterly Preferred Stock dividend payments, whether or not consecutive, the U.S. Treasury (Treasury) will have the right to appoint two directors to our Board of Directors until all accrued but unpaid dividends have been paid on the Preferred Stock. Pursuant to the Written Agreement between First Security and the Federal Reserve, we may not declare or pay dividends without prior written consent from the Federal Reserve.

RESULTS OF OPERATIONS

We reported a net loss to common stockholders for the three and nine month periods ended September 30, 2010 of $30.3 million and $34.5 million, respectively. During the third quarter of 2010, we established a deferred tax asset valuation allowance of $17.4 million. For the three and nine months ended September 30, 2009, we reported a net loss to common stockholders of $28.6 million and $31.8 million, respectively. During the third quarter of 2009, we recorded a one-time, non-cash goodwill impairment of $27.2 million. In the third quarter of 2010, the basic and diluted net loss per share was $1.92 compared to $1.84 for the same period in 2009. On a year-to-date period, the basic and diluted net loss per share was $2.20 for 2010 compared to $2.05 for 2009.

Excluding the 2009 goodwill impairment, the net loss on a quarterly and year-to-date basis in 2010 was above the comparable amounts in 2009 primarily as a result of the deferred tax valuation allowance as well as higher provision for loan and lease loss expense and the contraction in the net interest margin.

 

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The following table summarizes the components of income and expense and the changes in those components for the three and nine month periods ended September 30, 2010 compared to the same periods in 2009.

CONDENSED CONSOLIDATED INCOME STATEMENT

 

     For the Three
Months Ended
September 30,

2010
   

 

Change from Prior Year

    For the Nine
Months Ended
September 30,

2010
   

 

Change from Prior Year

 
       Amount     Percentage       Amount     Percentage  
     (in thousands, except percentages)  

Interest income

   $ 13,202      $ (2,756     -17.3   $ 42,533      $ (5,999     -12.4

Interest expense

     5,067        9        0.2     15,762        (1,133     -6.7
                                                

Net interest income

     8,135        (2,765     -25.4     26,771        (4,866     -15.4

Provision for loan and lease losses

     18,415        9,135        98.4     26,424        5,955        29.1
                                                

Net interest income after provision for loan and lease losses

     (10,280     (11,900     -734.6     347        (10,821     -96.9

Noninterest income

     2,404        (333     -12.2     7,266        (566     -7.2

Noninterest expense

     12,512        (24,851     -66.5     34,164        (22,551     -39.8
                                                

Net loss before income taxes

     (20,388     12,618        38.2     (26,551     11,164        29.6

Income tax provision

     9,384        14,261        292.4     6,461        13,787        188.2
                                                

Net loss

     (29,772     (1,643     -5.8     (33,012     (2,623     -8.6

Preferred stock dividends and discount accretion

     508        6        1.2     1,519        69        4.8
                                                

Net loss available to common stockholders

   $ (30,280   $ (1,649     -5.8   $ (34,531   $ (2,692     -8.5
                                                

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. For the three months ended September 30, 2010, net interest income decreased by $2.8 million, or 25.4%, to $8.1 million compared to $10.9 million for the same period in 2009. For the nine months ended September 30, 2010, net interest income decreased by $4.9 million, or 15.4%, to $26.8 million for the period ended September 30, 2010 compared to $31.6 million for the same period in 2009.

We monitor and evaluate the effects of certain risks on our earnings and seek balance between the risks assumed and returns sought. Some of these risks include interest rate risk, credit risk and liquidity risk.

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, our ability to manage the interest earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits.

 

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The following tables summarize net interest income and average yields and rates paid for the quarters ended September 30, 2010 and 2009.

AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS

FULLY TAX EQUIVALENT BASIS

 

     For the Three Months Ended September 30,  
     2010     2009  
     Average
Balance
    Income/
Expense
     Yield/
Rate
    Average
Balance
    Income/
Expense
     Yield/
Rate
 
     (in thousands, except percentages)  

ASSETS

              

Earning Assets:

              

Loans, net of unearned income (1) (2)

   $ 823,753      $ 11,911         5.74   $ 966,677      $ 14,465         5.94

Debt securities – taxable

     115,557        938         3.22     98,500        1,111         4.47

Debt securities – non-taxable (2)

     37,033        512         5.49     42,702        605         5.62

Other earning assets

     236,651        32         0.05     7,663        3         0.16
                                                  

Total earning assets

     1,212,994        13,393         4.38     1,115,542        16,184         5.76
                                      

Allowance for loan and lease losses

     (27,626          (19,201     

Intangible assets

     1,634             28,941        

Cash & due from banks

     7,836             16,379        

Premises & equipment

     32,125             33,842        

Other assets

     81,653             56,423        
                          

TOTAL ASSETS

   $ 1,308,616           $ 1,231,926        
                          

LIABILITIES AND STOCKHOLDERS’ EQUITY

              

Interest bearing liabilities:

              

Interest bearing demand deposits

   $ 65,547        47         0.28   $ 60,756        45         0.29

Money market accounts

     132,945        314         0.94     123,839        357         1.14

Savings deposits

     39,211        27         0.27     36,770        27         0.29

Time deposits of less than $100 thousand

     226,002        1,131         1.99     245,611        1,738         2.81

Time deposits of $100 thousand or more

     178,410        970         2.16     204,664        1,530         2.97

Brokered CDs and CDARS®

     346,197        2,459         2.82     124,644        1,062         3.38

Brokered money markets and NOWs

     —          —           —       77,250        163         0.84

Federal funds purchased

     —          —           —       92        —           0.54

Repurchase agreements

     17,523        117         2.65     18,347        130         2.81

Other borrowings

     83        2         9.56     4,747        6         0.50
                                                  

Total interest bearing liabilities

     1,005,918        5,067         2.00     896,720        5,058         2.24
                                      

Net interest spread

     $ 8,326         2.38     $ 11,126         3.52
                          

Noninterest bearing demand deposits

     155,889             150,571        

Accrued expenses and other liabilities

     10,521             11,856        

Stockholders’ equity

     130,502             166,775        

Accumulated other comprehensive income

     5,786             6,004        
                          

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,308,616           $ 1,231,926        
                          

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

          0.34          0.44
                          

Net interest margin

          2.72          3.96
                          

 

(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 both 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 $191 thousand and $226 thousand for the three months ended September 30, 2010 and 2009, respectively.

 

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The following table presents 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 amount of the change in each category.

CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2010 COMPARED TO 2009

 

     Increase (Decrease) in Interest Income and
Expense Due to Changes in:
 
     Volume     Rate     Total  
     (in thousands)  

Interest earning assets:

      

Loans, net of unearned income

   $ (2,139   $ (415   $ (2,554

Debt securities – taxable

     192        (365     (173

Debt securities – non-taxable

     (80     (13     (93

Other earning assets

     90        (61     29   
                        

Total earning assets

     (1,937     (854     (2,791
                        

Interest bearing liabilities:

      

Interest bearing demand deposits

     4        (2     2   

Money market accounts

     26        (69     (43

Savings deposits

     2        (2     —     

Time deposits of less than $100 thousand

     (139     (468     (607

Time deposits of $100 thousand or more

     (196     (364     (560

Brokered CDs and CDARS®

     1,888        (491     1,397   

Brokered money markets and NOWs

     (163     —          (163

Federal funds purchased

     —          —          —     

Repurchase agreements

     (6     (7     (13

Other borrowings

     (6     2        (4
                        

Total interest bearing liabilities

     1,410        (1,401     9   
                        

Increase (decrease) in net interest income

   $ (3,347   $ 547      $ (2,800
                        

 

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The following tables summarize net interest income and average yields and rates paid for the year-to-date periods ended September 30, 2010 and 2009.

AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS

FULLY TAX EQUIVALENT BASIS

 

     For the Nine Months Ended September 30,  
     2010     2009  
     Average
Balance
    Income/
Expense
     Yield/
Rate
    Average
Balance
    Income/
Expense
     Yield/
Rate
 
     (in thousands, except percentages)  

ASSETS

              

Earning Assets:

              

Loans, net of unearned income (1) (2)

   $ 875,851      $ 38,097         5.82   $ 983,492      $ 43,869         5.96

Debt securities – taxable

     110,036        3,048         3.70     96,827        3,479         4.80

Debt securities – non-taxable (2)

     38,823        1,623         5.59     43,282        1,834         5.67

Other earning assets

     219,126        371         0.23     20,653        38         0.25
                                                  

Total earning assets

     1,243,836        43,139         4.64     1,144,254        49,220         5.75
                                      

Allowance for loan and lease losses

     (26,917          (18,930     

Intangible assets

     1,748             29,266        

Cash & due from banks

     8,157             14,760        

Premises & equipment

     32,553             33,864        

Other assets

     79,963             55,473        
                          

TOTAL ASSETS

   $ 1,339,340           $ 1,258,687        
                          

LIABILITIES AND STOCKHOLDERS’ EQUITY

              

Interest bearing liabilities:

              

Interest bearing demand deposits

   $ 65,751        142         0.29   $ 61,834        146         0.32

Money market accounts

     134,892        1,028         1.02     124,625        1,178         1.26

Savings deposits

     38,536        77         0.27     35,757        77         0.29

Time deposits of less than $100 thousand

     235,175        3,722         2.12     245,154        5,687         3.10

Time deposits of $100 thousand or more

     192,980        3,261         2.26     202,518        4,934         3.26

Brokered CDs and CDARS®

     341,003        7,112         2.79     151,892        3,988         3.51

Brokered money markets and NOWs

     8,772        57         0.87     77,828        490         0.84

Federal funds purchased

     —          —           —       448        4         1.19

Repurchase agreements

     18,790        358         2.55     20,884        373         2.39

Other borrowings

     87        5         7.68     2,192        18         1.10
                                                  

Total interest bearing liabilities

     1,035,986        15,762         2.03     923,132        16,895         2.45
                                      

Net interest spread

     $ 27,377         2.61     $ 32,325         3.30
                          

Noninterest bearing demand deposits

     154,312             149,300        

Accrued expenses and other liabilities

     10,090             12,535        

Stockholders’ equity

     133,093             167,325        

Accumulated other comprehensive income

     5,859             6,395        
                          

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,339,340           $ 1,258,687        
                          

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

          0.33          0.48
                          

Net interest margin

          2.94          3.78
                          

 

(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 both 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 $606 thousand and $688 thousand for the nine months ended September 30, 2010 and 2009, respectively.

 

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The following table presents 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 amount of the change in each category.

CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2010 COMPARED TO 2009

 

     Increase (Decrease) in Interest Income and
Expense Due to Changes in:
 
     Volume     Rate     Total  
     (in thousands)  

Interest earning assets:

      

Loans, net of unearned income

   $ (4,908   $ (864   $ (5,772

Debt securities – taxable

     464        (895     (431

Debt securities – non-taxable

     (193     (18     (211

Other earning assets

     364        (31     333   
                        

Total earning assets

     (4,273     (1,808     (6,081
                        

Interest bearing liabilities:

      

Interest bearing demand deposits

     9        (13     (4

Money market accounts

     94        (244     (150

Savings deposits

     6        (6     —     

Time deposits of less than $100 thousand

     (246     (1,719     (1,965

Time deposits of $100 thousand or more

     (245     (1,428     (1,673

Brokered CDs and CDARS®

     4,941        (1,817     3,124   

Brokered money markets and NOWs

     (435     2        (433

Federal funds purchased

     (4     —          (4

Repurchase agreements

     (38     23        (15

Other borrowings

     (17     4        (13
                        

Total interest bearing liabilities

     4,065        (5,198     (1,133
                        

Increase (decrease) in net interest income

   $ (8,338   $ 3,390      $ (4,948
                        

Net Interest Income – Volume and Rate Changes

Interest income for the third quarter of 2010 was $13.2 million, a 17.3% decrease compared to the same period in 2009. Average earning assets increased $97.5 million, or 8.7%, in the third quarter of 2010 compared to the same period in 2009. The increase in average earning assets was led by average other earning assets, which increased $229.0 million, and investment securities, which increased $11.4 million. These increases were offset by declines in the loan portfolio, which decreased $142.9 million. Average loans declined primarily due to current economic conditions while other earning assets increased as we maintained over $234 million in an interest bearing account at the Federal Reserve Bank of Atlanta. The yield on this account is approximately 25 basis points. The increase in this account was primarily funded by an increase in brokered deposits, as well as reductions in our loan portfolio. The purpose of the increase in liquid assets was to reduce liquidity risk, which we describe more fully below in the Liquidity section, resulting from deteriorating asset quality and the Consent Order. Investment securities increased as we reinvested the cash flow from the investment securities portfolio into new securities. The change in mix of earning assets reduced interest income by $1.9 million (on a tax equivalent basis) for the third quarter of 2010 compared to 2009, while the decline in yields on earning assets, as discussed further below, reduced interest income by an additional $854 thousand.

Interest income for the nine months ended September 30, 2010 was $42.5 million, a 12.4% decrease compared to the same period in 2009. Average earning assets increased $99.6 million, or 8.7%, in 2010 compared to 2009. On a year-to-date basis, average other earning assets increased $198.5 million, average loans decreased $107.6 million and investment securities increased $8.8 million. The change in mix of earning assets reduced interest income by $4.3 million (on a tax equivalent basis) for 2010 compared to 2009. The reduction in rates earned resulted in a $1.8 million (on a tax equivalent basis) decline in interest income, as discussed below.

The reductions in interest income due to changes in volume for both the three and nine months ended September 30, 2010 were further impacted by the decline in the yield on earning assets. The tax

 

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equivalent yield on earning assets decreased by 138 basis points and 111 basis points for the three and nine month periods ended September 30, 2010, respectively, compared to the same periods in 2009. Comparing the third quarter of 2010 to 2009, the yield on loans declined 20 basis points from 5.94% to 5.74%. We anticipate the yield on loans to stabilize or improve over time as we have instituted higher loan pricing floors on new and renewing loans; however, reversed interest caused by loans downgraded to nonaccrual may continue to put additional pressure on the loan yield. Our loan portfolio is approximately 59% fixed rate, 36% variable rate and 5% adjustable rate. The variable rate loans reprice simultaneously with changes in the associated index, such as Prime, LIBOR or Treasury bond rates, while the repricing of adjustable rate loans is based on a time component in addition to changes in the associated index. Accordingly, changes in the target federal funds rate (and the implied correlation to the Prime lending rate) have an immediate impact on the yield of our earning assets.

Total interest expense was $5.1 million in the third quarter of 2010, or $9 thousand higher than the same period in 2009. On a year-to-date basis, total interest expense was $15.8 million, or 6.7% lower than the same period in 2009. Average interest bearing liabilities increased for the three and nine month periods ending September 30, 2010 by $109.2 million, or 12.2%, and $112.9 million, or 12.2%, compared to the same periods in 2009. Average brokered deposits increased $144.3 million and $120.1 million for the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009. The increases in brokered deposits were partially offset by reductions in retail and jumbo CDs. The $1.4 million increase in interest expense due to increases in volume was nearly fully offset by reductions in rates. On a year-to-date basis, increases in volume added $4.1 million, fully offset by a reduction in interest expense of $5.2 million due to reductions in deposit rates. The decrease in rates is due primarily to term deposits maturing and repricing at lower current market rates.

We expect average loans to continue to decline before beginning to stabilize in the next six months as the regional economy begins to enter into some measure of recovery. Investment securities will continue to grow as earnings are reinvested into new securities. We expect other earning assets to begin to decline during the fourth quarter of 2010 and into 2011 as brokered deposits mature without being replaced. Rates paid on deposits for the fourth quarter are expected to be consistent with third quarter results.

Net Interest Income – Net Interest Spread and Net Interest Margin

The banking industry uses two key ratios to measure 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 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.

Our net interest rate spread (on a tax equivalent basis) was 2.38% and 2.61% for the three and nine months ended September 30, 2010, respectively, compared to 3.52% and 3.30% for the same periods in 2009, respectively. Our net interest margin (on a tax equivalent basis) was 2.72% and 2.94% for the three and nine months ended September 30, 2010, respectively, compared to 3.96% and 3.78% for the same periods in 2009, respectively. The decreased net interest spread and margin are the result of the combination of lower loan volumes and higher brokered deposit volumes partially offset by deposits rates reducing faster than asset yields. During December of 2009 and first quarter of 2010, we issued over $180.0 million in brokered deposits to improve our contingent funding capacity. A portion of these funds were utilized to payoff our variable-rate brokered money market account during the first quarter of 2010. The remaining funds were placed in our interest bearing account at the Federal Reserve. As of September 30, 2010, our balance at the Federal Reserve was approximately $223 million. The negative spread associated between the interest bearing cash and the brokered deposits will continue to negatively impact our net interest spread and margin. Average interest bearing liabilities as a percentage of average earning assets was 82.9% for the three-month period ended September 30, 2010 compared to 80.4% for the same period in 2009. Noninterest bearing funding sources contributed 34 basis points to the net interest margin during the third quarter of 2010 compared to 44 basis points in the same period in 2009.

 

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In prior years, we terminated two sets of interest rate swaps. The combined gains at termination were $7.8 million, which are being accreted into interest income over the remaining life of the originally hedged items. For the three and nine months ended September 30, 2010, the accretion of the swaps added approximately $490 thousand and $1.5 million, respectively, to interest income compared to $530 thousand and $1.8 million for the same periods in 2009.

We anticipate our net interest margin will stabilize and improve over the next six months. However, improvement is dependent on multiple factors including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, maturities of brokered deposits, and any possible further action by the Federal Reserve Board.

Provision for Loan and Lease Losses

The provision for loan and lease losses charged to operations during the three months ended September 30, 2010 was $18.4 million compared to $9.3 million in the same period of 2009. Net charge-offs for the third quarter of 2010 were $19.9 million compared to net charge-offs of $2.9 million for the same period in 2009. The provision for the nine months ended September 30, 2010 and 2009 was $26.4 million and $20.5 million, respectively. Annualized net charge-offs as a percentage of average loans were 9.67% for the three months ended September 30, 2010 compared to 1.18% for the same period in 2009. Our peer group’s average (as reported in the June 30, 2010 Uniform Bank Performance Report) was 1.23%.

The increase in our provision for loan and lease losses on a quarterly and year-to-date basis in 2010 compared to the same periods in 2009 resulted from 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. As of September 30, 2010, we determined our allowance of $25.3 million was adequate to provide for credit losses, which we describe more fully below in the Allowance for Loan and Lease Losses section. We will reanalyze the allowance for loan and lease losses on at least a quarterly basis, and the next review will be at December 31, 2010, or sooner if needed, and the provision expense will be adjusted accordingly, if necessary.

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 calculations made to determine our allowance for loan and lease losses, these quarterly credit quality assessments will also determine our provision expense. As these credit quality assessments are currently in process for the fourth quarter of 2010, we cannot accurately estimate our provision expense for the quarter-ended December 31, 2010.

Noninterest Income

Noninterest income totaled $2.4 million for the third quarter of 2010, a decrease of $333 thousand, or 12.2%, from the same period in 2009. On a year-to-date basis, noninterest income totaled $7.3 million, a decrease of $566 thousand, or 7.2%, from the 2009 level. The quarterly and year-to-date declines are primarily a result of lower deposit fees.

 

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The following table presents the components of noninterest income for the periods ended September 30, 2010 and 2009.

NONINTEREST INCOME

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
     2010      Percent
Change
    2009      2010      Percent
Change
    2009  
     (in thousands, except percentages)  

Non-sufficient funds (NSF) fees

   $ 719         -21.2   $ 913       $ 2,277         -14.6   $ 2,666   

Service charges on deposit accounts

     232         -14.4     271         722         -13.5     835   

Point-of-sale (POS) fees

     322         10.7     291         948         14.8     825   

Bank-owned life insurance income

     251         —       251         754         —       754   

Mortgage loan and related fees

     319         -17.1     385         704         -14.7     826   

Trust fees

     190         -0.5     191         567         5.6     537   

Gain on sale of available for sale securities

     —           —       —           57         100.0     —     

Other income

     371         -14.7     435         1,237         -10.9     1,389   
                                                   

Total noninterest income

   $ 2,404         -12.2   $ 2,737       $ 7,266         -7.2   $ 7,832   
                                                   

Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including non-sufficient funds fees, were $951 thousand for the third quarter of 2010, a decrease of $233 thousand, or 19.7%, from the same period in 2009. While service charges and fees on deposit accounts typically correspond to the level and mix of our customer deposits, the implementation of the Dodd-Frank financial reform legislation may directly or indirectly impact the fee structure of our deposit products; therefore, we cannot reasonably estimate deposit fees for future periods.

Point-of-sale fees increased 10.7% and 14.8% to $322 thousand and $948 thousand for the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009. 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, although it is unclear if certain provisions affecting interchange fees for card issuers included in the Dodd-Frank financial reform legislation will have a future material impact on this product and its revenue.

Bank-owned life insurance income was $251 thousand and $754 thousand for the three and nine months ended September 30, 2010, respectively. 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. In addition, 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 5.88% through September 30, 2010.

Mortgage loan and related fees for the third quarter of 2010 decreased $66 thousand, or 17.1%, to $319 thousand compared to $385 thousand in the third quarter of 2009. For the nine months ended September 30, 2010, mortgage income decreased $122 thousand, or 14.7%, compared to the same period in 2009. As discussed in Note 13 to our consolidated financial statements, we elect the fair value option for all held for sale loan originations. This election impacts the timing and recognition of origination fees and costs, as well as the value of servicing rights. The recognition of the income and fees is concurrent with the origination of the loan.

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. Mortgages originated in the secondary market totaled $15.6 million and $33.4 million for the

 

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three and nine months ended September 30, 2010, respectively. Mortgages sold in the secondary market for the three and nine months ended September 30, 2010 totaled $14.9 million and $31.2 million, respectively. Mortgages originated in the secondary market totaled $15.0 million and $51.0 million for the three and nine months ended September 30, 2009, respectively. Mortgages sold in the secondary market for the three and nine months ended September 30, 2009 totaled $17.9 million and $51.6 million, respectively. We sold these loans with the right to service the loan being released to the purchaser for a fee. Mortgage income for the remainder of the year is dependent on mortgage rates as well as our ability to generate higher levels of held for sale loans.

Trust fees were consistent for the three months ended September 30, 2010 compared to the same period in 2009 and increased $30 thousand for the nine months ended September 30, 2010 compared to the same period in 2009. As of September 30, 2010, our trust and wealth management department had 471 accounts with assets held under management of $204.9 million compared to 427 accounts with assets held under management of $182.8 million as of September 30, 2009. For the fourth quarter of 2010 and into 2011, we anticipate higher trust fees as marketing campaigns are underway to increase the number of trust accounts.

Other income for the third quarter of 2010 was $371 thousand compared to $435 thousand for the same period in 2009. For the nine months ended September 30, 2010, other income decreased $152 thousand to $1.2 million compared to the same period in 2009. The components of other income primarily consist of ATM fee income, gains on sales of other real estate owned (OREO) and repossessions, underwriting revenue, and safe deposit box fee income.

Noninterest Expense

Noninterest expense for the three and nine months ended September 30, 2010 totaled $12.5 million and $34.2 million, respectively, compared to $37.4 million and $56.7 million for the respective periods in 2009. Both periods in 2009 included a goodwill impairment of $27.2 million. Excluding the 2009 goodwill impairment, noninterest expense increased $2.3 million, or 22.6%, for the three months ended September 30, 2010. On a year-to-date basis, noninterest expense, excluding the 2009 goodwill impairment, increased $4.6 million in 2010 compared to 2009. The quarterly and year-to-date increases are primarily due to higher levels of write-downs on OREO properties and repossessions as well as higher FDIC insurance assessments and professional fees.

 

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The following table represents the components of noninterest expense for the three and nine month periods ended September 30, 2010 and 2009.

NONINTEREST EXPENSE

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
     2010      Percent
Change
    2009      2010      Percent
Change
    2009  
     (in thousands, except percentages)  

Salaries & benefits

   $ 4,787         -2.4   $ 4,903       $ 14,438         -5.7   $ 15,303   

Occupancy

     908         6.0     857         2,633         1.0     2,606   

Furniture and equipment

     522         -17.9     636         1,554         -19.0     1,919   

FDIC insurance

     1,044         137.8     439         2,581         86.1     1,387   

Professional fees

     936         66.5     562         2,344         79.3     1,307   

Write-downs on other real estate owned and repossessions

     1,575         1,212.5     120         2,715         435.5     507   

Losses on other real estate owned and repossessions

     88         -40.9     149         763         163.1     290   

OREO and repossession holding costs

     356         7.6     331         1,269         97.0     644   

Data processing

     354         -8.5     387         1,089