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

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

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

For the fiscal year ended December 31, 2010

OR

 

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

For the transition period from                     to                     

Commission File No. 000-49747

 

 

FIRST SECURITY GROUP, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Tennessee   58-2461486
(State of Incorporation)   (I.R.S. Employer Identification No.)
531 Broad Street, Chattanooga, TN   37402
(Address of Principal Executive Offices)   (Zip Code)

(423) 266-2000

(Registrant’s telephone number, including area code)

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

 

Title of Each Class

 

Name of Each Exchange on Which Registered

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

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

None

 

 

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

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

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

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

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

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

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

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

The aggregate market value of the registrant’s outstanding common stock held by nonaffiliates of the registrant as of June 30, 2010, was approximately $29.4 million, based on the registrant’s closing sales price as reported on the NASDAQ Global Select Market. There were 16,418,140 shares of the registrant’s common stock outstanding as of April 15, 2011.

DOCUMENTS INCORPORATED BY REFERENCE

 

Document

 

Parts Into Which Incorporated

None.

 

 

 

 


Table of Contents
Index to Financial Statements

TABLE OF CONTENTS

 

PART I

  

Item 1.

  

Business

     1   

Item 1A.

  

Risk Factors

     23   

Item 1B.

  

Unresolved Staff Comments

     35   

Item 2.

  

Properties

     35   

Item 3.

  

Legal Proceedings

     38   

Item 4.

  

[Removed and Reserved.]

     38   

PART II

     

Item 5.

  

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

     39   

Item 6.

  

Selected Financial Data

     41   

Item 7.

  

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

     47   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     84   

Item 8.

  

Financial Statements and Supplementary Data

     87   

Item 9A.

  

Controls and Procedures

     139   

Item 9B.

  

Other Information

     142   

PART III

     

Item 10.

  

Directors, Executive Officers and Corporate Governance

     143   

Item 11.

  

Executive Compensation

     143   

Item 12.

  

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

     143   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     143   

Item 14.

  

Principal Accountant Fees and Services

     143   

PART IV

     

Item 15.

  

Exhibits and Financial Statement Schedules

     144   

SIGNATURES

     146   

 

i


Table of Contents
Index to Financial Statements

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

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

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

governmental monetary and fiscal policies, as well as legislative and regulatory changes, including, but not limited to, implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

 

   

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

 

   

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

 

   

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

 

ii


Table of Contents
Index to Financial Statements
   

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

 

   

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

 

   

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

 

   

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

 

   

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

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

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

For other factors, risks and uncertainties that could cause our actual results to differ materially from estimates and projections contained in these forward-looking statements, please read the “Risk Factors” section of this Annual Report beginning on page 23.

 

iii


Table of Contents
Index to Financial Statements

PART I

 

Item 1. Business

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

BUSINESS

First Security Group, Inc.

We are a bank holding company headquartered in Chattanooga, Tennessee. We currently operate 37 full-service banking offices through our wholly-owned bank subsidiary, FSGBank. We serve the banking and financial needs of various communities in eastern and middle Tennessee, as well as northern Georgia.

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

First Security Group, Inc. was incorporated in 1999 as a Tennessee corporation to serve as a bank holding company, and is regulated and supervised by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). As of December 31, 2010, we had total assets of approximately $1.2 billion, total deposits of approximately $1.0 billion and stockholders’ equity of approximately $93.4 million.

FSGBank, National Association

FSGBank currently operates 37 full-service banking-offices along the Interstate corridors of eastern and middle Tennessee and northern Georgia, and is primarily regulated by the Office of the Comptroller of the Currency (the “OCC”). In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank, while FSGBank operates under the name of Jackson Bank & Trust along the Interstate 40 corridor. FSGBank also provides trust and investment management, mortgage banking, financial planning and electronic banking services, such as Internet banking (www.FSGBank.com), online bill payment, cash management, ACH originations, and remote deposit capture.

FSGBank is the successor to our three previous banks: Dalton Whitfield Bank (organized in 1999), Frontier Bank (acquired in 2000) and First State Bank (acquired in 2002). Dalton Whitfield Bank was a state bank organized under the laws of Georgia engaged in a general commercial banking business. Dalton Whitfield Bank opened for business in September 1999, and simultaneously acquired selected assets and substantially all of the deposits of Colonial Bank’s three branches located in Dalton, Georgia. In 2003, Premier National Bank of Dalton merged with and into Dalton Whitfield Bank for an aggregate purchase price of $11.7 million in cash and stock.

Frontier Bank was a state savings bank organized under the laws of Tennessee in 2000 as First Central Bank of Monroe County. We acquired First Central Bank of Monroe County in 2000 for an aggregate purchase price of

 

1


Table of Contents
Index to Financial Statements

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

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

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

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

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

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

FSGBank is a member of the Federal Reserve Bank of Atlanta and a member of the Federal Home Loan Bank of Cincinnati (the “FHLB”). FSGBank’s deposits are insured by the FDIC. FSGBank operates 31 full-service banking offices in eastern and middle Tennessee and six offices in northern Georgia.

Market Area and Competition

We currently conduct business principally through 37 branches in our market areas of Bradley, Hamilton, Jackson, Jefferson, Knox, Loudon, McMinn, Monroe, Putnam and Union Counties, Tennessee and Catoosa and Whitfield Counties, Georgia. Our markets follow the Interstate 75 corridor between Dalton, Georgia (approximately one hour north of Atlanta, Georgia) and Jefferson City, Tennessee (approximately 30 minutes north of Knoxville, Tennessee) and the Interstate 40 corridor between Nashville, Tennessee and Knoxville, Tennessee. Based upon data available from the FDIC as of June 30, 2010, FSGBank’s total deposits ranked 6th among financial institutions in our market area, representing approximately 4.9% of the total deposits in our market area.

 

2


Table of Contents
Index to Financial Statements

The table below shows our deposit market share in the counties we serve according to data from the FDIC website as of June 30, 2010.

 

Market

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

Tennessee

              

Bradley County

     2       $ 18       $ 1,467         10         1.3

Hamilton County1, 2

     9         507         6,467         4         7.8

Jackson County

     3         64         118         1         55.0

Jefferson County

     2         110         525         1         20.9

Knox County

     3         65         9,033         12         0.7

Loudon County

     2         31         726         7         4.3

McMinn County

     1         35         881         6         3.9

Monroe County

     5         67         602         5         11.1

Putnam County

     3         79         1,475         6         5.4

Union County

     2         45         122         2         36.9

Georgia

              

Catoosa County

     1         6         862         9         0.7

Whitfield County2

     6         143         1,764         4         8.1
                                

FSGBank

     39       $ 1,169       $ 24,043         6         4.9
                                

 

1

Our brokered deposits, totaling $352.5 million at June 30, 2010, are included in the totals for Hamilton County.

2

Subsequent to June 30, 2010, we closed a branch in Whitfield County and a branch in Hamilton County.

Our retail, commercial and mortgage divisions operate in highly competitive markets. We compete directly in retail and commercial banking markets with other commercial banks, savings and loan associations, credit unions, mortgage brokers and mortgage companies, mutual funds, securities brokers, consumer finance companies, other lenders and insurance companies, locally, regionally and nationally. Many of our competitors compete with offerings by mail, telephone, computer and/or the Internet. Interest rates, both on loans and deposits, and prices of services are significant competitive factors among financial institutions generally. Office locations, types and quality of services and products, office hours, customer service, a local presence, community reputation and continuity of personnel are also important competitive factors that we emphasize.

Many other commercial or savings institutions currently have offices in our primary market areas. These institutions include many of the largest banks operating in Tennessee and Georgia, including some of the largest banks in the country. Many of our competitors serve the same counties we do. Within our market area, there are 69 different commercial or savings institutions.

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

 

3


Table of Contents
Index to Financial Statements

Lending Activities

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

Our loan portfolio at December 31, 2010 was comprised as follows:

 

         Amount              Percentage of    
Portfolio
 
     (in thousands, except percentages)  

Loans secured by real estate—

     

Residential 1-4 family

   $ 252,026         34.7

Commercial

     226,357         31.1

Construction

     84,232         11.6

Multi-family and farmland

     36,393         5.0
                 
     599,008         82.4

Commercial loans

     82,807         11.4

Consumer installment loans

     33,860         4.7

Leases, net of unearned income

     7,916         1.1

Other

     3,500         0.4
                 

Total loans

   $ 727,091         100.0
                 

In addition, we have entered into contractual obligations, via lines of credit and standby letters of credit, to extend approximately $127.4 million and $14.1 million, respectively, in credit as of December 31, 2010. We use the same credit policies in making these commitments as we do for our other loans. At December 31, 2010, our contractual obligations to extend credit were comprised as follow:

 

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

Contractual obligations secured by real estate—

     

Residential 1-4 family

   $ 71,117         50.2

Commercial

     11,057         7.8

Construction

     5,787         4.1

Multi-family and farmland

     1,857         1.3
                 
     89,818         63.4

Commercial loans

     43,949         31.1

Consumer installment loans

     5,027         3.6

Leases, net of unearned income

     —           —  

Other

     2,673         1.9
                 

Total contractual obligations

   $ 141,467         100.0
                 

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

 

4


Table of Contents
Index to Financial Statements

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

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

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

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

Consumer. We make a variety of loans to individuals for personal, family and household purposes, including secured and unsecured installment and term loans. Consumer loans entail greater risk than other loans, particularly in the case of consumer loans that are unsecured or secured by depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an

 

5


Table of Contents
Index to Financial Statements

adequate source of repayment for the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by job loss, divorce, illness or personal hardships.

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

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

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

Lending Policies. Our Board of Directors has established and periodically reviews our bank’s lending policies and procedures. We have established common documentation and standards based on the type of loans among our regions. There are regulatory restrictions on the dollar amount of loans available for each lending relationship. National banking regulations provide that no loan relationship may exceed 15% of a bank’s Tier 1 capital. At December 31, 2010, our legal lending limit was approximately $12.8 million. In addition, we have established a “house” limit of $10 million for each lending relationship. Any loan request exceeding the house limit must be approved by a committee of our Board of Directors. We occasionally sell participation interests in loans to other lenders, primarily when a loan exceeds our house lending limits.

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

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

The federal banking regulators have issued guidance regarding the risks posed by commercial real estate (“CRE”) lending concentrations. CRE loans generally include land development, construction loans and loans

 

6


Table of Contents
Index to Financial Statements

secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines to help identify institutions that are potentially exposed to significant CRE risk:

 

   

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

 

   

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

As of December 31, 2010, our concentrations were within the thresholds of the CRE guidance.

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2010, approximately 82.4% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized.

We offer a variety of loan products with payment terms and rate structures that have been designed to meet the needs of our customers within an established framework of acceptable credit risk. Payment terms range from fully amortizing loans that require periodic principal and interest payments to terms that require periodic payments of interest-only with principal due at maturity. Interest-only loans are a typical characteristic in commercial and home equity lines-of-credit and construction loans (residential and commercial). As of December 31, 2010, we had approximately $279.5 million of interest-only loans, which primarily consist of home equity loans 28.5% construction and land development loans (22.9%), commercial and industrial loans (18.2%) and commercial real estate loans (14.8%). The loans have an average maturity of approximately 18 months or less, with the exception of home equity lines-of-credit which have an average maturity of approximately six and a half years. The interest-only loans are fully underwritten and within our lending policies.

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

Deposits

Our principal source of funds for loans and investing in securities is core deposits. We offer a wide range of deposit services, including checking, savings, money market accounts and certificates of deposit. We obtain most of our deposits from individuals and businesses in our market areas. We believe that the rates we offer for core deposits are competitive with those offered by other financial institutions in our market areas. We have also chosen to obtain a portion of our deposits from outside our market through brokered deposits. Our brokered deposits represented 30.0% of total deposits as of December 31, 2010. Other sources of funding include advances from the FHLB, subordinated debt and other borrowings. These other sources enable us to borrow funds at rates and terms, which at times, are more beneficial to us. During the fourth quarter of 2009 and first quarter of 2010, we enhanced our liquidity by issuing over $255 million in brokered certificates of deposits and placing the excess funds in our interest bearing deposit account at the Federal Reserve Bank of Atlanta. At December 31, 2010, our balance at the Federal Reserve Bank of Atlanta was approximately $199 million. This excess cash is available to fund our contractual obligations and prudent investment opportunities.

Other Banking Services

Given client demand for increased convenience and account access, we offer a range of products and services, including 24-hour internet banking, ACH transactions, remote deposit capture, wire transfers, direct deposit, traveler’s checks, safe deposit boxes, and United States savings bonds. We earn fees for most of these

 

7


Table of Contents
Index to Financial Statements

services. We also receive ATM transaction fees from transactions performed by our customers participating in a shared network of ATMs and a debit card system that our customers can use throughout Tennessee and Georgia, as well as in other states. Additionally, we offer wealth management services including private client services, financial planning, trust administration, investment management and estate planning services.

Securities

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

Seasonality and Cycles

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

Employees

On December 31, 2010, we had 302 full-time employees and 14 part-time employees. We consider our employee relations to be good, and we have no collective bargaining agreements with any employees.

Website Address

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

 

8


Table of Contents
Index to Financial Statements

SUPERVISION AND REGULATION

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

 

   

how, when and where we may expand geographically;

 

   

into what product or service market we may enter;

 

   

how we must manage our assets or liabilities; and

 

   

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

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

First Security

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

Written Agreement. Effective September 7, 2010, First Security entered into a Written Agreement (the “Agreement”) with the Federal Reserve Bank of Atlanta (the “Federal Reserve Bank”). The Agreement is designed to enhance our ability to act as 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 entered into with the Office of the Comptroller of the Currency on April 28, 2010, and discussed below.

Pursuant to the Agreement, First Security is prohibited from declaring or paying dividends without prior written consent from the Federal Reserve Bank. In addition, pursuant to the Agreement, without the prior written consent of regulators, First Security is prohibited from taking dividends, or any other form of payment representing a reduction of capital, from FSGBank; incurring, increasing or guaranteeing any debt; or redeeming any shares of First Security’s common stock. First Security is also obligated to provide quarterly written progress reports to the Federal Reserve Bank.

In accordance with the Agreement, First Security submitted to the Federal Reserve Bank a copy of FSGBank’s capital plan that had previously been submitted to the OCC. The Agreement does not contain specific target capital ratios or specific timelines, but requires that the plan address First Security’s current and future capital requirements, FSGBank’s current and future capital requirements, the adequacy of FSGBank’s capital taking into account its risk profile, and the source and timing of additional funds necessary to fulfill First Security’s and FSGBank’s future capital requirements. Neither the OCC nor the Federal Reserve Bank have approved FSGBank’s capital plan and FSGBank is not in compliance with the capital requirements contained in the Consent Order.

The provisions of the Agreement remain in effect and enforceable until stayed, modified, terminated or suspended by the Federal Reserve Bank. We are currently deemed not in compliance with several provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve Bank. We can provide no assurances that we will be able to comply fully with the Agreement, that

 

9


Table of Contents
Index to Financial Statements

efforts to comply with the Agreement will not have a material adverse effect on the operations and financial condition of First Security, or that further enforcement actions won’t be imposed on First Security.

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

 

   

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

 

   

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

 

   

merging or consolidating with any other bank holding company.

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

Under the Bank Holding Company Act, if we are adequately capitalized and adequately managed, we or any other bank holding company located within Tennessee or Georgia, may purchase a bank located outside of Tennessee or Georgia. Conversely, an adequately capitalized and adequately managed bank holding company located outside of Tennessee or Georgia may purchase a bank located inside Tennessee or Georgia. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in specified concentrations of deposits. Currently, Georgia law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been incorporated for three years, and Tennessee law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been incorporated for five years. Because FSGBank has been chartered for more than five years, this restriction would not limit our ability to sell.

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

 

   

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

 

   

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

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

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

 

10


Table of Contents
Index to Financial Statements

regulations implementing the Gramm-Leach-Bliley Act, a financial holding company may engage in additional activities that are financial in nature or incidental or complementary to financial activity. Those activities include, among other activities, certain insurance and securities activities.

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

Support of FSGBank. Under Federal Reserve Board policy, we are expected to act as a source of financial strength for FSGBank and to commit resources to support FSGBank. In addition, pursuant to the Dodd-Frank Wall Street and Consumer Protection Act (the “Dodd-Frank Act”), the federal banking regulators are required to issue, within two years of enactment, rules that require a bank holding company to serve as a source of financial strength for any depository institution subsidiary. This support may be required at times when, without this Federal Reserve Board policy or the impending rules, we might not be inclined to provide it. In addition, any capital loans made by us to FSGBank will be repaid only after FSGBank’s deposits and various other obligations are repaid in full. In the unlikely event of our bankruptcy, any commitment that we give to a bank regulatory agency to maintain the capital of FSGBank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

Non-Bank Subsidiary Examination and Enforcement. As a result of the Dodd-Frank Act, all non-bank subsidiaries not currently regulated by a state or federal agency will now be subject to examination by the Federal Reserve Board in the same manner and with the same frequency as if its activities were conducted by the lead bank subsidiary. These examinations will consider whether the activities engaged in by the non-bank subsidiary pose a material threat to the safety and soundness of its insured depository institution affiliates, are subject to appropriate monitoring and control, and comply with applicable laws. Pursuant to this authority, the Federal Reserve Board may also take enforcement action against non-bank subsidiaries.

TARP Participation. On October 14, 2008, the U.S. Treasury announced the capital purchase component of TARP. This program was instituted by the U.S. Treasury pursuant to the Emergency Economic Stabilization Act of 2008, which provides up to $700 billion to the U.S. Treasury to, among other things, take equity ownership positions in financial institutions. The TARP capital purchase program is intended to encourage financial institutions to build capital and thereby increase the flow of financing to businesses and consumers. We participated in the capital purchase component of TARP.

FSGBank

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

Consent Order. On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order, FSGBank consented and agreed to the issuance of a Consent Order (the “Order”) by the OCC. In the negotiated Order, FSGBank and the OCC agreed as to areas of FSGBank’s operations that warrant improvement and a plan for making those improvements. The Order imposes no fines or penalties on FSGBank. FSGBank’s 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.

 

11


Table of Contents
Index to Financial Statements

We are currently deemed not in compliance with the provisions of the Order, including the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. We can provide no assurances that we will be able to comply fully with the Order, that efforts to comply with the Order will not have a material adverse effect on the operations and financial condition of FSGBank, or that further enforcement actions won’t be imposed on FSGBank.

Pursuant to the Order, FSGBank was required to appoint a compliance committee to oversee FSGBank’s compliance with the Order. FSGBank’s compliance committee currently consists of the Bank’s independent directors: William C. Hall, Carol H. Jackson, Ralph L. Kendall, D. Ray Marler, and Ralph E. Mathews, Jr.

Under the Order, FSGBank is required to develop and submit to the OCC for review a written strategic plan covering at least a three-year period. The strategic plan is required to, among other things, include objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, and reduction in the volume of nonperforming assets, together with strategies to achieve these objectives. The OCC has not accepted our written strategic plan.

Within 120 days from the effective date of the Order, the Bank was required to achieve and thereafter maintain total capital at least equal to 13% of risk-weighted assets and Tier 1 capital at least equal to 9% of adjusted total assets. Within 90 days from the effective date of the Order, the Bank was required to develop and submit to the OCC for review a written capital plan covering at least a three-year period. The capital plan shall, among other things, included specific plans for maintaining adequate capital and a discussion of the sources and timing of additional capital and contingency plans for alternative sources of capital. The OCC has not accepted our capital plan. As of December 31, 2010, FSGBank’s total risk-based capital ratio was 12.2% and its leverage ratio was 7.1%. We are considering a variety of strategic alternatives intended to achieve and maintain the prescribed capital ratios.

Under the Order, FSGBank’s Board of Directors prepared a written assessment of the capabilities of the Bank’s executive officers to perform present and anticipated duties, including the execution of the strategic plan. If any changes are deemed necessary by the Board, the OCC shall have the power to disapprove the appointment of a new proposed executive officer. The Order also requires annual written performance appraisals for each executive officer.

Within 60 days from the effective date of the Order, FSGBank was required to review and revise its existing credit policy to improve the Bank’s loan portfolio management, as well as FSGBank’s policies related to leasing, retail credit, and collateral exceptions. Within 90 days of the effective date of the Order, FSGBank was required to review and revise its independent and on-going loan review program. Ongoing reviews may, however, continue to result in positive or negative changes to certain loan classifications.

FSGBank was also required to review and revise its program for the Allowance for Loan and Lease Losses (“ALLL”). The Board of Directors is required to review the adequacy of the ALLL quarterly, and any deficiency shall be remedied in the calendar quarter it is discovered. Within 90 days of the effective date of the Order, FSGBank was required to review and revise its existing program to protect the Bank’s interest in criticized assets. Beginning with the effective date of the Order, FSGBank may not extend any credit to, or for the benefit of, any borrower who has a loan that is criticized as “doubtful,” “substandard” or “special mention,” unless FSGBank documents that such extension of credit is in FSGBank’s best interest. We continue to work with the OCC to address these policies.

Within 90 days of the effective date of the Order, FSGBank was required to review and revise the Bank’s existing written concentration management program, and adopt plans to reduce the risk of exposure to any concentration deemed imprudent. Within 60 days of the effective date of the Order, FSGBank was required to review and revise its comprehensive liquidity risk management program, including the preparation of periodic liquidity reports and a contingency funding plan. We continue to work with the OCC to address these policies.

 

12


Table of Contents
Index to Financial Statements

The Order will remain in effect and enforceable until it is modified, terminated, suspended or set aside by the OCC.

Because the Order establishes specific capital amounts to be maintained by FSGBank, FSGBank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if FSGBank exceeds the levels of capital set forth in the Order. As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.

FSGBank is committed to complying with the terms of the Order. FSGBank reports to the OCC monthly regarding its progress in complying with the provisions included in the Order. Compliance with the terms of the Order is an ongoing priority for the Board of Directors and management of FSGBank.

Branching. National banks are required by the National Bank Act to adhere to branching laws applicable to state banks in the states in which they are located. Under both Tennessee and Georgia law, FSGBank may open branch offices throughout Tennessee or Georgia with the prior approval of the OCC. Prior to the enactment of the Dodd-Frank Act, FSGBank and any other national- or state-chartered bank were generally permitted to branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. However, interstate branching is now permitted for all national- and state-chartered banks as a result of the Dodd-Frank Act, provided that a state bank chartered by the state in which the branch is to be located would also be permitted to establish a branch.

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

As a bank’s capital position deteriorates, federal banking regulators are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. As of December 31, 2010, the Bank was considered “adequately capitalized” for regulatory purposes.

A “well capitalized” bank is one that is not required to meet and maintain a specific capital level for any capital measure, pursuant to any written agreement, order, capital directive, or other remediation, and significantly exceeds all of its capital requirements, which include maintaining a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, and a Tier 1 leverage ratio of at least 5%. Generally, a classification as well capitalized will place a bank outside of the regulatory zone for purposes of prompt corrective action. However, a well capitalized bank may be reclassified as “adequately capitalized” based on criteria other than capital, if the federal regulator determines that a bank is in an unsafe or unsound condition, or is engaged in unsafe or unsound practices, which requires certain remedial action.

An “adequately capitalized” bank meets the required minimum level for each relevant capital measure, including a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a Tier 1 leverage ratio of at least 4%. A bank that is adequately capitalized is prohibited from directly or indirectly accepting, renewing or rolling over any brokered deposits, absent applying for and receiving a waiver from the applicable regulatory authorities. Institutions that are not well capitalized are also prohibited, except in very limited circumstances where the FDIC permits use of a higher local market rate, from paying yields for deposits in excess of 75 basis points above a national average rate for deposits of comparable maturity, as calculated by the FDIC. In addition, all institutions are generally prohibited from making capital distributions and paying

 

13


Table of Contents
Index to Financial Statements

management fees to controlling persons if, subsequent to such distribution or payment, the institution would be undercapitalized. Finally, an adequately capitalized bank may be forced to comply with operating restrictions similar to those placed on undercapitalized banks.

An “undercapitalized” bank fails to meet the required minimum level for any relevant capital measure. A bank that reaches the undercapitalized level is likely subject to a formal agreement or another formal supervisory sanction. An undercapitalized bank is not only subject to the requirements placed on adequately capitalized banks, but also becomes subject to the following operating and managerial restrictions, which:

 

   

prohibit capital distributions;

 

   

prohibit payment of management fees to a controlling person;

 

   

require the bank to submit a capital restoration plan within 45 days of becoming undercapitalized;

 

   

require close monitoring of compliance with capital restoration plans, requirements and restrictions by the primary federal regulator;

 

   

restrict asset growth by requiring the bank to restrict its average total assets to the amount attained in the preceding calendar quarter;

 

   

require prior approval by the primary federal regulator for acquisitions, branching and new lines of business; and

 

   

prohibit any material changes in accounting methods.

Finally, an undercapitalized institution may be required to comply with operating restrictions similar to those placed on significantly undercapitalized institutions.

A “significantly undercapitalized” bank has a total risk-based capital ratio less than 6%, a Tier 1 risk-based capital less than 3%, and a Tier 1 leverage ratio less than 3%. In addition to being subject to the restrictions applicable to undercapitalized institutions, significantly undercapitalized banks become subject to the following additional restrictions, which:

 

   

require the sale of enough securities so that the bank is adequately capitalized or, if grounds for conservatorship or receivership exist, the merger or acquisition of the bank;

 

   

restrict affiliate transactions;

 

   

further restrict growth, including a requirement that the bank reduce its total assets;

 

   

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

 

   

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

 

   

prohibit the acceptance of deposits from correspondent banks, including renewals and rollovers of prior deposits;

 

   

require prior approval of capital distributions by holding companies;

 

   

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

 

   

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

Finally, without prior regulatory approval, a significantly undercapitalized institution must restrict the compensation paid to its senior executive officers, including the payment of bonuses and compensation that exceeds the officer’s average rate of compensation during the 12 calendar months preceding the calendar month in which the bank became undercapitalized.

 

14


Table of Contents
Index to Financial Statements

A “critically undercapitalized” bank has a Tier 1 leverage ratio that is equal to or less than 2%. In addition to the appointment of a receiver in not more than 90 days, or such other action as determined by an institution’s primary federal regulator, an institution classified as critically undercapitalized is subject to the restrictions applicable to undercapitalized and significantly undercapitalized institutions, and is further prohibited from doing the following without the prior written regulatory approval:

 

   

entering into material transactions other than in the ordinary course of business;

 

   

extending credit for any highly leveraged transaction;

 

   

amending the institution’s charter or bylaws, except to the extent necessary to carry out any other requirements of law, regulation or order;

 

   

making any material change in accounting methods;

 

   

engaging in certain types of transactions with affiliates;

 

   

paying excessive compensation or bonuses, including golden parachutes;

 

   

paying interest on new or renewed liabilities at a rate that would increase the institution’s weighted average cost of funds to a level significantly exceeding the prevailing rates of its competitors; and

 

   

making principal or interest payment on subordinated debt 60 days or more after becoming critically undercapitalized.

In addition, a bank’s primary federal regulator may impose additional restrictions on critically undercapitalized institutions consistent with the intent of the prompt corrective action regulations. Once an institution has become critically undercapitalized, subject to certain narrow exceptions such as a material capital remediation, federal banking regulators will initiate the resolution of the institution.

FDIC Insurance Assessments. FSGBank’s deposits are insured by the Deposit Insurance Fund (the “DIF”) of the FDIC up to the maximum amount permitted by law, which was permanently increased to $250,000 by the Dodd-Frank Act. The FDIC uses the DIF to protect against the loss of insured deposits if an FDIC-insured bank or savings association fails. Pursuant to the Dodd-Frank Act, the FDIC must take steps, as necessary, for the DIF reserve ratio to reach 1.35% of estimated insured deposits by September 30, 2020. The Bank is thus subject to FDIC deposit premium assessments.

Currently, the FDIC uses a risk-based assessment system that assigns insured depository institutions to one of four risk categories based on three primary sources of information—supervisory risk ratings for all institutions, financial ratios for most institutions, including the Bank, and long-term debt issuer ratings for large institutions that have such ratings. For institutions assigned to the lowest risk category, the annual assessment rate ranges between 7 and 16 cents per $100 of domestic deposits. For institutions assigned to higher risk categories, assessment rates range from 17 to 77.5 cents per $100 of domestic deposits. These ranges reflect a possible downward adjustment for unsecured debt outstanding and possible upward adjustments for secured liabilities and, in the case of institutions outside the lowest risk category, brokered deposits.

On September 29, 2009, the FDIC announced a uniform three basis points increase effective January 1, 2011, and on November 12, 2009, adopted a rule requiring nearly all FDIC-insured depository institutions, including the Bank, to prepay their DIF assessments for the fourth quarter of 2009 and for the following three years on December 30, 2009. At that time, the FDIC indicated that the prepayment of DIF assessments was in lieu of additional special assessments; however, there can be no guarantee that continued pressures on the DIF will not result in additional special assessments being collected by the FDIC in the future.

Pursuant to the Dodd-Frank Act, the FDIC issued proposed regulations, which are anticipated to become effective April 1, 2011, that amend current regulations to redefine the “assessment base” used for calculating deposit insurance assessments. Rather than the current system, whereby the assessment base is calculated by using an insured depository institution’s domestic deposits less a few allowable exclusions, the new assessment base will be calculated using the average consolidated total assets of an insured depository institution less the

 

15


Table of Contents
Index to Financial Statements

average tangible equity of such institution. In the proposed regulations, the FDIC defines tangible equity as Tier 1 capital. The FDIC continues to utilize a risk-based assessment system in which institutions will be subject to assessment rates ranging from 2.5 to 45 basis points, subject to adjustments for unsecured debt and, in the case of institutions outside the lowest risk category, brokered deposits. The proposed rules eliminate adjustments for secured liabilities.

The proposed rules retain the FDIC Board’s flexibility to, without further notice-and-comment rulemaking, adopt rates that are higher or lower than the stated base assessment rates, provided that the FDIC cannot (i) increase or decrease the total rates from one quarter to the next by more than three basis points, or (ii) deviate by more than three basis points from the stated assessment rates. Although the Dodd-Frank Act requires that the FDIC eliminate its requirement to pay dividends to depository institutions when the reserve ratio exceeds a certain threshold, the FDIC proposes a decreasing schedule of assessment rates that would take effect when the DIF reserve ratio first meets or exceeds 1.15%. As proposed, if the DIF reserve ratio meets or exceeds 1.15%, base assessment rates would range from 1.5 to 40 basis points; if the DIF reserve ratio meets or exceeds 2%, base assessment rates would range from 1 to 38 basis points; and if the DIF reserve ratio meets or exceeds 2.5%, base assessment rates would range from 0.5 to 35 basis points. All base assessment rates would continue to be subject to adjustments for unsecured debt and brokered deposits.

The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of The Financing Corporation (“FICO”). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and in 2010 ranged from 1.06 cents to 1.04 cents per $100 of assessable deposits. These assessments will continue until the debt matures between 2017 and 2019.

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

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

The Debt Guarantee Program: Under the TLGP, the FDIC guaranteed certain newly issued senior unsecured debt issued by participating financial institutions through October 31, 2009. The annualized fee that the FDIC assessed to guarantee the senior unsecured debt varied by the length of maturity of the debt. For debt with a maturity of 180 days or less (excluding overnight debt), the fee was 50 basis points; for debt with a maturity between 181 days and 364 days, the fee was 75 basis points, and for debt with a maturity of 365 days or longer, the fee was 100 basis points. Neither First Security nor FSGBank issued any debt guaranteed by the FDIC under the Debt Guarantee component of the program.

The Transaction Account Guarantee Program: Under the TLGP, the FDIC fully guaranteed funds in non-interest bearing deposit accounts held at participating FDIC-insured institutions, regardless of dollar amount. The temporary guarantee was originally scheduled to expire at the end of 2009, but was subsequently extended to December 31, 2010. Pursuant to the Dodd-Frank Act, beginning on the scheduled termination date for the Transaction Account Guarantee Program, or TAGP, and continuing through December 31, 2012, unlimited insurance coverage will be provided for funds held in non-interest bearing transaction accounts, including Interest on Lawyer Trust Accounts (IOLTAs). During the TAGP extension period, the FDIC imposed a surcharge between 15 and 25 basis points on the daily average balance in excess of $250,000 held in non-interest bearing transaction accounts. Pursuant to the Dodd-Frank Act, however, institutions are no longer separately assessed for the additional coverage, and the unlimited insurance is included in assessments for the overall insurance

 

16


Table of Contents
Index to Financial Statements

program. One distinction from this new insurance and the TAGP, is the exclusion of minimal interest-bearing NOW accounts, which were previously covered under the TAGP. FSGBank did not opt out of the original or extension periods of the Transaction Account Guarantee component of the TLGP, thus providing the maximum available insurance for our customers.

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

Allowance for Loan and Lease Losses. The Allowance for Loan and Lease Losses (“ALLL”) represents one of the most significant estimates in our financial statements and regulatory reports. Because of its significance, we have developed a system by which we develop, maintain and document a comprehensive, systematic and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses. The “Interagency Policy Statement on the Allowance for Loan and Lease Losses” issued on December 13, 2006, encourages all banks to ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the bank’s stated policies and procedures, management’s best judgment and relevant supervisory guidance. Consistent with supervisory guidance, we maintain a prudent and conservative, but not excessive, ALLL, that is at a level that is appropriate to cover estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio. The allowance for loan and lease losses, and our methodology for calculating the allowance, are fully described in Note 1 to our consolidated financial statements under “Allowance for Loan and Lease Losses” on page 97, and in the “Management’s Discussion and Analysis—Statement of Financial Condition—Allowance for Loan and Lease Losses” section on pages 65 through 71.

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

 

   

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

 

   

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

As of December 31, 2010, our CRE concentrations were within the thresholds of the CRE guidance.

Enforcement Powers. The Financial Institution Reform Recovery and Enforcement Act (“FIRREA”) expanded and increased civil and criminal penalties available for use by the federal regulatory agencies against depository institutions and certain “institution-affiliated parties.” Institution-affiliated parties primarily include management, employees, and agents of a financial institution, as well as independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs. These practices can include the failure of an institution to timely file required reports or the filing of false or misleading information or the submission of inaccurate reports. Civil penalties may be as high as $1,100,000 per

 

17


Table of Contents
Index to Financial Statements

day for such violations. Criminal penalties for some financial institution crimes have been increased to 20 years. In addition, regulators are provided with greater flexibility to commence enforcement actions against institutions and institution-affiliated parties.

Possible enforcement actions include the termination of deposit insurance. Furthermore, banking agencies’ power to issue regulatory orders were expanded. Such orders may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the ordering agency to be appropriate. The Dodd-Frank Act increases regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

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

 

   

Truth-In-Savings Act, requiring certain disclosures of consumer deposit accounts:

 

   

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

 

   

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

 

   

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

The Consumer Financial Protection Bureau. The Dodd-Frank Act creates the Consumer Financial Protection Bureau (the “Bureau”) within the Federal Reserve Board. The Bureau is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The Bureau has rulemaking authority over many

 

18


Table of Contents
Index to Financial Statements

of the statutes governing products and services offered to bank consumers. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are more stringent than those regulations promulgated by the Bureau and state attorneys general are permitted to enforce consumer protection rules adopted by the Bureau against state-chartered institutions.

Capital Adequacy

First Security and FSGBank are required to comply with the capital adequacy standards established by the Federal Reserve. The Federal Reserve has established a risk-based and a leverage measure of capital adequacy for member banks and bank holding companies.

The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance-sheet exposure, and to minimize disincentives for holding liquid assets. Assets and off-balance-sheet items, such as letters of credit and unfunded loan commitments, are assigned to broad risk categories, each with appropriate risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance-sheet items.

The minimum guideline for the ratio of total capital to risk-weighted assets, and classification as adequately capitalized, is 8%. A bank that fails to meet the required minimum guidelines is classified as undercapitalized and subject to operating and managerial restrictions. A bank, however, that significantly exceeds its capital requirements and maintains a ratio of total capital to risk-weighted assets of 10% is classified as well capitalized unless it is subject to a regulatory order requiring it to maintain specified capital levels, in which case it is considered adequately capitalized.

Total capital consists of two components: Tier 1 capital and Tier 2 capital. Tier 1 capital generally consists of common stockholders’ equity, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock and a limited amount of qualifying cumulative perpetual preferred stock, less goodwill and other specified intangible assets. Tier 1 capital must equal at least 4% of risk-weighted assets. Tier 2 capital generally consists of subordinated debt, other preferred stock and hybrid capital, and a limited amount of loan loss reserves. The total amount of Tier 2 capital is limited to 100% of Tier 1 capital. FSGBank’s ratio of total capital to risk-weighted assets and ratio of Tier 1 capital to risk-weighted assets were 12.2% and 10.9% at December 31, 2010, respectively, compared 12.8% and 11.5%, as of December 31, 2009.

In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 capital to average assets, less goodwill and other specified intangible assets, of 3% for bank holding companies that meet specified criteria, including having the highest regulatory rating and implementing the Federal Reserve risk-based capital measure for market risk. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%. At December 31, 2010, our leverage ratio was 7.1%, as compared to 9.6% on December 31, 2009. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without reliance on intangible assets. The Federal Reserve considers the leverage ratio and other indicators of capital strength in evaluating proposals for expansion or new activities.

Provisions of the Dodd-Frank Act commonly referred to as the “Collins Amendment” established new minimum leverage and risk-based capital requirements on bank holding companies and eliminated the inclusion of “hybrid capital” instruments in Tier 1 capital by certain institutions.

The Dodd-Frank Act establishes certain regulatory capital deductions with respect to hybrid capital instruments, such as trust preferred securities, that will effectively disallow the inclusion of such instruments in Tier 1 capital if such capital instrument is issued on or after May 19, 2010. However, preferred shares issued to

 

19


Table of Contents
Index to Financial Statements

the U.S. Department of the Treasury (the “Treasury”) pursuant to the TARP Capital Purchase Program (“TARP CPP”) or TARP Community Development Capital Initiative are exempt from the Collins Amendment and are permanently includable in Tier 1 capital.

Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and certain other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements. See “Prompt Corrective Action” above.

The OCC, the Federal Reserve Board, and the FDIC have authority to compel or restrict certain actions if FSGBank’s capital should fall below adequate capital standards as a result of operating losses, or if its regulators otherwise determine that it has insufficient capital. Among other matters, the corrective actions may include, removing officers and directors; and assessing civil monetary penalties; and taking possession of and closing and liquidating the Bank.

Generally, the regulatory capital framework under which the First Security and FSGBank operate is in a period of change with likely legislation or regulation that will continue to revise the current standards and very likely increase capital requirements for the entire banking industry. Pursuant to the Dodd-Frank Act, bank regulators are required to establish new minimum leverage and risk-based capital requirements for certain bank holding companies and systematically important non-bank financial companies. The new minimum thresholds will not be lower than existing regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, be higher once established.

Payment of Dividends

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

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

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

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

On February 24, 2009, the Federal Reserve clarified its guidance on dividend policies for bank holding companies through the publication of a Supervisory Letter. As part of the letter, the Federal Reserve encouraged

 

20


Table of Contents
Index to Financial Statements

bank holding companies, particularly those that had participated in the CPP, to consult with the Federal Reserve prior to dividend declarations, and redemption and repurchase decisions even when not explicitly required to do so by federal regulations. The Federal Reserve has indicated that CPP recipients, such as First Security, should consider and communicate in advance to regulatory staff how a company’s proposed dividends, capital repurchases and capital redemptions are consistent with First Security’s obligation to eventually redeem the securities held by the Treasury. This new guidance is largely consistent with prior regulatory statements encouraging bank holding companies to pay dividends out of net income and to avoid dividends that could adversely affect the capital needs or minimum regulatory capital ratios of the bank holding company and its subsidiary bank. Additionally, pursuant to the Agreement, First Security is required to obtain prior written authorization before declaring a dividend.

Restrictions on Transactions with Affiliates

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

 

   

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

 

   

a bank’s investment in affiliates;

 

   

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

 

   

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

 

   

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

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

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

The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.

FSGBank is also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders, and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Within one year of enactment of the Dodd-Frank Act, an insured depository institution will be prohibited from engaging in asset purchases or sales transactions with its officers, directors or principal shareholders unless on market terms and, if the transaction represents greater than 10% of the capital and surplus of the bank, has been approved by a majority of the disinterested directors.

Limitations on Senior Executive Compensation

In June of 2010, federal banking regulators issued guidance designed to help ensure that incentive compensation policies at banking organizations do not encourage excessive risk-taking or undermine the safety and soundness of the organization. In connection with this guidance, the regulatory agencies announced that they will review incentive compensation arrangements as part of the regular, risk-focused supervisory process.

 

21


Table of Contents
Index to Financial Statements

Regulatory authorities may also take enforcement action against a banking organization if its incentive compensation arrangement or related risk management, control, or governance processes pose a risk to the safety and soundness of the organization and the organization is not taking prompt and effective measures to correct the deficiencies. To ensure that incentive compensation arrangements do not undermine safety and soundness at insured depository institutions, the incentive compensation guidance sets forth the following key principles:

 

   

incentive compensation arrangements should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose the organization to imprudent risk;

 

   

incentive compensation arrangements should be compatible with effective controls and risk management; and

 

   

incentive compensation arrangements should be supported by strong corporate governance, including active and effective oversight by the board of directors.

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

 

   

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

 

   

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

 

   

prohibit any golden parachute payments to senior executive officers; and

 

   

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

The Dodd-Frank Act

The Dodd-Frank Act has had a broad impact on the financial services industry, including significant regulatory and compliance changes previously discussed and including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased regulatory examination fees; and (iii) numerous other provisions designed to improve supervision and oversight of, and strengthening safety and soundness for, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve Board, the OCC and the FDIC.

Many of the requirements called for in the Dodd-Frank Act will be implemented over time and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

Proposed Legislation and Regulatory Action

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

 

22


Table of Contents
Index to Financial Statements

Effect of Governmental Monetary Policies

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

 

Item 1A. Risk Factors

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

RISKS ASSOCIATED WITH OUR BUSINESS

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

We incurred a net loss available to common stockholders of $46.4 million, or $2.95 per share, for the year ended December 31, 2010, due primarily to credit losses and associated costs, including a significant provision for loan losses, and the establishment of a $24.6 million deferred tax asset valuation allowance. Although we have taken steps to reduce our credit exposure, we likely will continue to have a higher than normal level of non-performing assets and charge-offs into 2011, which would continue to adversely impact our overall financial condition and results of operations.

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

Like other lenders, we face the risk that our customers will not repay their loans. A customer’s failure to repay us is usually preceded by missed monthly payments. In some instances, however, a customer may declare bankruptcy prior to missing payments, and, following a borrower filing bankruptcy, a lender’s recovery of the credit extended is often limited. Since our loans are secured by collateral, we may attempt to seize the collateral when and if customers default on their loans. However, the value of the collateral may not equal the amount of the unpaid loan, and we may be unsuccessful in recovering the remaining balance from our customers. Rising delinquencies and rising rates of bankruptcy in our market area generally and among our customers specifically can be precursors of future charge-offs and may require us to increase our allowance for loan and lease losses. Higher charge-off rates and an increase in our allowance for loan and lease losses may hurt our overall financial performance if we are unable to increase revenue to compensate for these losses and may also increase our cost of funds.

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

We maintain an allowance for loan and lease losses, which is a reserve established through a provision for loan losses charged to expenses, which represents management’s best estimate of probable credit losses that have been incurred within the existing portfolio of loans. The allowance for loan and lease losses and our methodology for calculating the allowance are fully described in Note 1 to our consolidated financial statements under “Allowance for Loan and Lease Losses” on page 97, and in the “Management’s Discussion and Analysis—

 

23


Table of Contents
Index to Financial Statements

Statement of Financial Condition—Allowance for Loan and Lease Losses” section on pages 65 through 71. In general, an increase in the allowance for loan and lease losses results in a decrease in net income, and possibly risk-based capital, and may have a material adverse effect on our capital, financial condition and results of operations.

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

We continually reassess the creditworthiness of our borrowers and the sufficiency of our allowance for loan and lease losses as part of FSGBank’s credit functions. Our allowance for loan and lease losses increased from 2.78% of total loans at December 31, 2009 to 3.30% at December 31, 2010. We recorded a provision for loan losses during the year ended December 31, 2010 of approximately $33.6 million, which was significantly higher than in previous periods. We charged-off approximately $36.1 million in loans, net of recoveries, during the year ended December 31, 2010, which was also significantly higher than in previous periods. We will likely experience additional classified loans and non-performing assets in the foreseeable future, as well as related increases in loan charge-offs, as the deterioration in the credit and real estate markets causes borrowers to default. Further, the value of the collateral underlying a given loan, and the realizable value of such collateral in a foreclosure sale, likely will be negatively affected by the current downturn in the real estate market, and therefore may result in an inability to realize a full recovery in the event that a borrower defaults on a loan. Any additional non-performing assets, loan charge-offs, increases in the provision for loan losses or the continuation of aggressive charge-off policies or any inability by us to realize the full value of underlying collateral in the event of a loan default, will negatively affect our business, financial condition, and results of operations and the price of our securities. Further, there can be no assurance that our allowance for loan and lease losses at December 31, 2010 will be sufficient to cover future credit losses.

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

We offer land acquisition and development, and construction loans for builders and developers, and as of December 31, 2010, we had $84.2 million in such loans outstanding, representing 88.3% of FSGBank’s total risk-based capital. These land acquisition and development, and construction loans are more risky than other types of loans. The primary credit risks associated with land acquisition and development and construction lending are underwriting and project risks. Project risks include cost overruns, borrower credit risk, project completion risk, general contractor credit risk, and environmental and other hazard risks. Market risks are risks associated with the sale of the completed residential units. They include affordability risk, which means the risk that borrowers cannot obtain affordable financing, product design risk, and risks posed by competing projects. There can be no assurance that losses in our land acquisition and development and construction loan portfolio will not exceed our reserves, which could adversely impact our earnings. Given the current environment, the non-performing loans in our land acquisition and development and construction portfolio are likely to increase during 2011, and these non-performing loans could result in a material level of charge-offs, which would negatively impact our capital and earnings.

 

24


Table of Contents
Index to Financial Statements

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

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2010, approximately 82.4% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized. As a result, if we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

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

At December 31, 2009, we had a total of $15.3 million of OREO, and at December 31, 2010, we had a total of $24.4 million of OREO, reflecting a $9.1 million increase over the past twelve months. This increase in OREO is due, among other things, to the continued deterioration of the residential real estate market and the tightening of the credit market. As the amount of OREO increases, our losses, and the costs and expenses to maintain the real estate likewise increase. Due to the on-going economic downturn, the amount of OREO may continue to increase in the coming months. Any additional increase in losses, and maintenance costs and expenses due to OREO may have material adverse effects on our business, financial condition, and results of operations. Such effects may be particularly pronounced in a market of reduced real estate values and excess inventory, which may make the disposition of OREO properties more difficult, increase maintenance costs and expenses, and may reduce our ultimate realization from any OREO sales.

Our ability to retain, attract and motivate qualified individuals may be limited by our financial and regulatory condition, restrictions on our ability to compensate those individuals, and the need for regulatory non-objection to fill certain positions.

Our success depends on our ability to retain, attract and motivate qualified individuals in key positions throughout the organization. Our financial and regulatory condition may limit our ability to retain, attract and motivate qualified individuals. Among other factors, the decline in our stock price has limited the real and perceived value of our historical stock compensation, and our condition may be viewed as a liability by current and prospective employees.

We are generally prohibited from entering into, amending, or renewing any agreement that provides for golden parachute payments to an institution-affiliated party or from making such golden parachute payments, absent approval from the federal banking regulators. As a participant in the CPP, we are subject to specified limits on the compensation we can pay to certain senior executive officers. The limitations, which include restrictions on bonus and other incentive compensation payable to First Security’s senior executive officers, a prohibition on any “golden parachute” payments and a “clawback” of any bonus that was based on materially inaccurate financial data or other performance metric, could limit our ability to retain, attract and motivate the best executive officers because other competing employers may not be subject to these limitations.

We are also currently required to notify the federal banking regulators in advance of employing any senior executive officer or changing the responsibilities of a senior executive officer. This requirement could prevent us from hiring the individuals of our choosing, could discourage potential applicants, or otherwise delay our ability to fill vacant positions.

If we are unable to retain, attract and motivate qualified individuals in key positions, our business and results of operations could be adversely affected.

 

25


Table of Contents
Index to Financial Statements

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

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

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

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

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

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

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

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

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

As a financial institution, our earnings significantly depend on our net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Therefore, any change in general market interest rates, including changes in the Federal Reserve Board’s fiscal and monetary policies, affects us more than non-financial institutions and can have a significant effect on our net

 

26


Table of Contents
Index to Financial Statements

interest income and total income. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets and liabilities. As a result, an increase or decrease in market interest rates could have material adverse effects on our net interest margin and results of operations.

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

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

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

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

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

The soundness of our financial condition may also affect our competitiveness. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Customers may decide not to do business with us due to our financial condition. In addition, our ability to compete is impacted by the limitations on our activities imposed under the Order and the Agreement. We have and continue to face additional regulatory restrictions that our competitors may not be subject to, including improving the overall risk profile of the Company and restrictions on the amount of interest we can pay on deposit accounts, which could adversely impact our ability to compete and attract and retain customers.

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

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

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

 

27


Table of Contents
Index to Financial Statements

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

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

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

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

Environmental liability associated with lending activities could result in losses.

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

RISKS RELATED TO RECENT MARKET, LEGISLATIVE AND REGULATORY EVENTS

We are subject to an Order that could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock. In addition, addressing the Order will require significant time and attention from our management team, which may increase our costs, impede the efficiency of our internal business processes and adversely affect our profitability in the near-term.

On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order the Bank by and through its Board of Directors consented and agreed to the issuance of a Consent Order by the 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.

While the Company intends to take such actions as may be necessary to enable the Bank to comply with the requirements of the Order, there can be no assurance that the Bank will be able to comply fully with the provisions of the Order, or that efforts to comply with the Order, particularly the limitations on interest rates offered by the Bank, will not have adverse effects on the operations and financial condition of the Company and the Bank.

 

28


Table of Contents
Index to Financial Statements

We are currently deemed not in compliance with the provisions of the Order, including the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. We can provide no assurances that we will be able to comply fully with the Order, that efforts to comply with the Order will not have a material adverse effect on the operations and financial condition of FSGBank, or that further enforcement actions won’t be imposed on FSGBank.

We are not currently in compliance with the capital requirements contained in our Order and may need to raise capital to comply, but that capital may not be available when it is needed or it could be dilutive to our existing stockholders, which could adversely affect our financial condition and our results of operations.

The Order required the Bank to, within 120 days of the effective date of the Order, achieve and thereafter maintain total capital at least equal to 13% of risk-weighted assets and Tier 1 capital at least equal to 9% of adjusted total assets. As of December 31, 2010, the Bank’s total risk-based capital ratio was approximately 12.2% and its leverage ratio was approximately 7.1%. The Company is considering a variety of strategic alternatives intended to achieve and maintain the prescribed capital ratios.

Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. If we need to raise additional capital, there is no guarantee that we will be able to borrow funds or successfully raise capital at all or on terms that are favorable or otherwise not dilutive to existing stockholders. If we cannot raise additional capital when needed, our ability to operate our business could be materially impaired. The failure to satisfy the capital requirements of the Order could result in further enforcement actions by the OCC, including the OCC requiring that the Bank develop a plan to sell, merge or liquidate the Bank.

We are subject to an Agreement that could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock.

On September 7, 2010, First Security entered into an Agreement with the Federal Reserve Bank. The Agreement is designed to enhance the Company’s ability to act as a source of strength to the Bank. Pursuant to the Agreement, the Company will be prohibited from declaring or paying dividends without prior written consent from the Federal Reserve Bank. In addition, pursuant to the Agreement, without the prior written consent of regulators, the Company is prohibited from taking dividends, or any other form of payment representing a reduction of capital, from the Bank; incurring, increasing or guaranteeing any debt; redeeming any shares of the Company’s common stock. The Company will also provide quarterly written progress reports to the Federal Reserve Bank. The Company was also required to submit to the Federal Reserve Bank a written plan designed to maintain sufficient capital at the Company, on a consolidated basis, and at the Bank.

We are currently deemed not in compliance with several provisions of the Agreement, including the submission of an acceptable capital plan. Any material failure to comply with the provisions of the Agreement could result in further enforcement actions by the Federal Reserve Bank. While the Company intends to take such actions as may be necessary to comply with the requirements of the Agreement, there can be no assurance that the Company will be able to comply fully with the provisions of the Agreement, or that efforts to comply with the Agreement, particularly the limitations on dividend payments, will not have adverse effects on the operations and financial condition of the Company and the value of our common stock.

Our inability to accept, renew or roll over brokered deposits without the prior approval of the FDIC could adversely affect our liquidity.

As of December 31, 2010, we had approximately $314.9 million in out of market deposits, including brokered certificates of deposit and CDARS®, which represented approximately 30.0% of our total deposits. Because the Order establishes 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

 

29


Table of Contents
Index to Financial Statements

levels of capital set forth in the Order. As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. As of December 31, 2010, brokered deposits maturing in the next 24 months totaled $125.9 million. Funding sources for the maturing brokered deposits include, among other sources: our cash account at the Federal Reserve Bank of Atlanta; growth, if any, of core deposits from current and new retail and commercial customers; scheduled repayments on existing loans; and the possible pledge or sale of investment securities. As an adequately capitalized institution, the Bank also 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. These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers. The limitations on our ability to accept, renew or roll over brokered deposits, or pay more than 75 basis points above the applicable rate could adversely affect our liquidity.

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

Our long-term success depends upon the growth in population, income levels, deposits and housing starts in our primary market areas. If the communities in which FSGBank operates do not grow, or if prevailing economic conditions locally or nationally are unfavorable, our business may not succeed. The unpredictable economic conditions we have faced over the last 24 months have had an adverse effect on the quality of our loan portfolio and our financial performance. Economic recession over a prolonged period or other economic problems in our market areas could have a material adverse impact on the quality of the loan portfolio and the demand for our products and services. Future adverse changes in the economies in our market areas may have a material adverse effect on our financial condition, results of operations or cash flows. Further, the banking industry in Tennessee and Georgia is affected by general economic conditions such as inflation, recession, unemployment and other factors beyond our control.

Since the third quarter of 2007, the residential construction and commercial development real estate markets have experienced a variety of difficulties and changed economic conditions. As a result, there has been substantial concern and publicity over asset quality among financial institutions due in large part to issues related to subprime mortgage lending, declining real estate values and general economic concerns. As of December 31, 2010, our non-performing assets had increased to $79.2 million, or 6.78% of our total assets, as compared to $64.6 million, or 4.78% as of December 31, 2009. Furthermore, the housing and the residential mortgage markets continue to experience a variety of difficulties and changed economic conditions.

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

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

Negative developments during 2008 in the global credit and derivative markets resulted in uncertainty in the financial markets in general with the expectation of the general economic downturn continuing into 2011. As a result of this “credit crunch,” commercial as well as consumer loan portfolio performances have deteriorated at many institutions and the competition for deposits and quality loans has increased significantly. Global securities

 

30


Table of Contents
Index to Financial Statements

markets, and bank holding company stock prices in particular, have been negatively affected, as has the ability of banks and bank holding companies to raise capital or borrow in the debt markets. If these negative trends continue, our business operations and financial results may be negatively affected.

The FDIC Deposit Insurance assessments that we are required to pay may continue to materially increase in the future, which would have an adverse effect on our earnings.

As a member institution of the FDIC, we are assessed a quarterly deposit insurance premium. Failed banks nationwide have significantly depleted the insurance fund and reduced the ratio of reserves to insured deposits. As a result, we may be required to pay significantly higher premiums or additional special assessments that could adversely affect our earnings.

On April 1, 2009, the FDIC modified the risk-based assessments to account for each institution’s unsecured debt, secured liabilities and use of brokered deposits. Starting with the second quarter of 2009, assessment rates were increased and currently range from 7 to 77.5 basis points (annualized). Further increased FDIC assessment premiums, due to our risk classification, level of brokered deposits, special assessments, or implementation of the modified DIF reserve ratio, could adversely impact our earnings.

The Dodd-Frank Act and related regulations may adversely affect our business, financial condition, liquidity or results of operations.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was enacted on July 21, 2010. The Dodd-Frank Act creates a new Consumer Financial Protection Bureau with power to promulgate and enforce consumer protection laws. Smaller depository institutions, including those with $10 billion or less in assets, will be subject to the Consumer Financial Protection Bureau’s rule-writing authority, and existing depository institution regulatory agencies will retain examination and enforcement authority for such institutions. The Dodd-Frank Act also establishes a Financial Stability Oversight Council chaired by the Secretary of the Treasury with authority to identify institutions and practices that might pose a systemic risk and, among other things, includes provisions affecting (1) corporate governance and executive compensation of all companies whose securities are registered with the SEC, (2) FDIC insurance assessments, (3) interchange fees for debit cards, which would be set by the Federal Reserve under a restrictive “reasonable and proportional cost” per transaction standard and (4) minimum capital levels for bank holding companies, subject to a grandfather clause for financial institutions with less than $15 billion in assets.

At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting regulations may adversely impact us. However, compliance with these new laws and regulations may increase our costs, limit our ability to pursue attractive business opportunities, cause us to modify our strategies and business operations and increase our capital requirements and constraints, any of which may have a material adverse impact on our business, financial condition, liquidity or results of operations.

RISKS ASSOCIATED WITH AN INVESTMENT IN OUR COMMON STOCK

If we fail to continue to meet all applicable continued listing requirements of the Nasdaq Global Select Market and Nasdaq determines to delist our common stock, the market liquidity and market price of our common stock could decline, and our ability to access the capital markets could be negatively affected.

Our common stock is listed on the Nasdaq Global Select Market. To maintain that listing, we must satisfy minimum financial and other continued listing requirements. For example, Nasdaq rules require that we maintain a minimum bid price of $1.00 per share for our common stock. This requirement is deemed breached when the bid price of an issuer’s common shares closes below $1.00 per share for 30 consecutive trading days.

On April 4, 2010, we were notified by Nasdaq that we were not in compliance with the minimum bid price rule. We have until October 3, 2011 to regain compliance with the minimum bid price rule by having our common

 

31


Table of Contents
Index to Financial Statements

stock close at or above $1.00 per share for at least ten consecutive business days. In the event we do not regain compliance, Nasdaq may commence delisting proceedings, permit us to transfer listing of our common stock to the Nasdaq Capital Market, or provide additional time to regain compliance.

We intend to actively monitor the bid price of our stock and will consider available options to regain compliance with the Nasdaq requirements. While we intend to maintain our listing on Nasdaq, if we fail to meet the requirements for continued listing or we are unable to cure the events of noncompliance in a timely or effective manner, our common stock could be delisted.

The perception or possibility that our common stock could be delisted in the future could negatively affect its liquidity and price. Delisting would have an adverse effect on the liquidity of the common shares and, as a result, the market price for the common stock might become more volatile. Delisting could also make it more difficult for us to raise additional capital, if needed, on terms acceptable to us or at all. Although quotes for our common stock would continue to be available on the OTC Bulletin Board or on the “Pink Sheets” in the event of a delisting from Nasdaq, such alternatives are generally considered to be less efficient markets, and the stock price, as well as the liquidity of the common stock, may be adversely affected as a result.

We have discovered a material weakness in our internal control over financial reporting, causing a reasonable possibility that material misstatements of our financial statements will not be prevented or detected on a timely basis.

During the preparation of our financial statements for 2010, our management identified a material weakness related to our entity level controls. Specifically, we did not maintain an effective control environment. As a result, there is a reasonable possibility that material misstatements of the financial statements will not be prevented or detected on a timely basis.

Management will continue to monitor and evaluate the effectiveness of our disclosure controls and procedures and our internal controls over financial reporting on an ongoing basis and is committed to taking further action and implementing additional enhancements or improvements, as necessary. Although our management and audit committee intend for the new policies and procedures to provide sufficient assurance of future compliance, we are unable to determine at this time whether the new policies and procedures will be fully effective in correcting this weakness.

Any failure to maintain required controls could result in additional material weaknesses, which could result in errors in our financial statements that could result in restatements of our financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information. Although we believe the actions we have taken will remediate these significant deficiencies during 2011, we may fail to do so or could experience unforeseen difficulties causing new significant deficiencies or material weaknesses. In addition, we may need to operate for an extended period of time with the new or revised controls in place before these significant deficiencies will be determined to be remediated. If we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to express an opinion on the effectiveness of our internal controls, we could lose investor confidence in the accuracy and completeness of our financial reports, which would cause the price of our common stock to decline.

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

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

 

32


Table of Contents
Index to Financial Statements

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

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

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

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

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

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

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

On January 27, 2010, our Board of Directors elected to suspend the dividend on our common stock and elected to defer the dividend payment on our Series A Preferred Stock for the first quarter of 2010; our Board of Directors similarly elected on a quarterly basis to defer the three other scheduled dividend payments on our Series A Preferred Stock during 2010 and the first scheduled dividend payment of 2011. We may not pay dividends on common stock unless all dividends have been paid on the securities issued to the Treasury under the CPP; having deferred these dividend payments, we are prohibited on paying any future dividends on our common stock until all dividends payable to the Treasury under the CPP have been paid in full.

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

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

 

33


Table of Contents
Index to Financial Statements

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

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

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

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

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

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

If we continue to defer dividends, as we expect, the holders of the Series A Preferred Stock will have the right to elect two directors to our Board of Directors.

Through February 15, 2011, we had deferred five quarterly dividend payments on our Series A Preferred Stock. The next quarterly dividend payment will be due May 15, 2011. We do not anticipate declaring a dividend on our Series A Preferred Stock payable on May 15, 2011, and would require the approval of the Federal Reserve Bank to make such a declaration. Accordingly, as of May 15, 2011, we anticipate that we will have failed to pay dividends on our Series A Preferred Stock for six quarterly dividend periods. The Treasury has requested, and First Security anticipates agreeing to permit, an observer employed by the Treasury to attend meetings of First Security’s Board of Directors.

 

34


Table of Contents
Index to Financial Statements

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

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

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

 

Item 1B. Unresolved Staff Comments

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

 

Item 2. Properties

During 2010, we conducted our business primarily through our corporate headquarters located at 531 Broad Street, Chattanooga, Hamilton County, Tennessee.

 

35


Table of Contents
Index to Financial Statements

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

 

Office Address

   Date Opened    Owned/Leased    Square
Footage
   Use of
Office

401 South Thornton Avenue

Dalton, Whitfield County, Georgia

   September 17, 1999    Owned    16,438    Branch

1237 North Glenwood Avenue

Dalton, Whitfield County, Georgia

   September 17, 1999    Owned    3,300    Branch

761 New Highway 68

Sweetwater, Monroe County, Tennessee

   June 26, 2000    Owned    3,000    Branch

1740 Gunbarrel Road

Chattanooga, Hamilton County, Tennessee

   July 3, 2000    Leased    3,400    Branch

4227 Ringgold Road

East Ridge, Hamilton County, Tennessee

   July 28, 2000    Leased    3,400    Branch

835 South Congress Parkway

Athens, McMinn County, Tennessee

   November 6, 2000    Owned    3,400    Branch

4535 Highway 58

Chattanooga, Hamilton County, Tennessee

   May 7, 2001    Owned    3,400    Branch

820 Ridgeway Avenue

Signal Mountain, Hamilton County, Tennessee

   May 29, 2001    Owned    2,500    Branch

1409 Cowart Street

Chattanooga, Hamilton County, Tennessee

   October 22, 2001    Building Owned

Land Leased

   1,000    Branch

9217 Lee Highway

Ooltewah, Hamilton County, Tennessee

   July 8, 2002    Owned    3,400    Branch

2905 Maynardville Highway

Maynardville, Union County, Tennessee

   July 20, 2002    Owned    12,197    Branch

216 Maynardville Highway

Maynardville, Union County, Tennessee

   July 20, 2002    Leased    2,000    Branch

2918 East Walnut Avenue

Dalton, Whitfield County, Georgia

   March 31, 2003    Owned    10,337    Branch

715 South Thornton Avenue

Dalton, Whitfield County, Georgia

   March 31, 2003    Building Owned

Land Leased

   4,181    Branch

2270 Highway 72 N

Loudon, Loudon County, Tennessee

   June 30, 2003    Owned    1,860    Branch

35 Poplar Springs Road

Ringgold, Catoosa County, Georgia

   July 14, 2003    Owned    3,400    Branch

167 West Broadway Boulevard

Jefferson City, Jefferson County, Tennessee

   October 14, 2003    Owned    3,743    Branch

705 East Broadway

Lenoir City, Loudon County, Tennessee

   October 27, 2003    Owned    3,610    Branch

301 North Main Street

Sweetwater, Monroe County, Tennessee

   December 4, 2003    Owned    4,650    Branch

 

36


Table of Contents
Index to Financial Statements

Office Address

   Date Opened    Owned/Leased    Square
Footage
   Use of
Office

215 Warren Street

Madisonville, Monroe County, Tennessee

   December 4, 2003    Owned    8,456    Branch

405 Highway 165

Tellico Plains, Monroe County, Tennessee

   December 4, 2003    Owned    3,565    Branch

155 North Campbell Station Road

Knoxville, Knox County, Tennessee

   March 2, 2004    Building Owned

Land Leased

   3,743    Branch

1013 South Highway 92

Dandridge, Jefferson County, Tennessee

   April 5, 2004    Owned    3,500    Branch

307 Lovell Road

Knoxville, Knox County, Tennessee

   August 16, 2004    Building Owned

Land Leased

   3,500    Branch

1111 Northshore Drive, Suite S600

Knoxville, Knox County, Tennessee

   October 1, 2004    Leased    9,867    Loan &
Leasing

1111 Northshore Drive, Suite P-100

Knoxville, Knox County, Tennessee

   July 25, 2005    Leased    1,105    Branch

307 Hull Avenue

Gainesboro, Jackson County, Tennessee

   August 31, 2005    Owned    9,662    Branch

6766 Granville Highway

Granville, Jackson County, Tennessee

   August 31, 2005    Owned    2,880    Branch

3261 Jennings Creek Highway

Whitleyville, Jackson County, Tennessee

   August 31, 2005    Building Owned

Land Leased

   1,368    Branch

340 South Jefferson Avenue

Cookeville, Putnam County, Tennessee

   August 31, 2005    Owned    3,220    Branch

376 West Jackson Street

Cookeville, Putnam County, Tennessee

   August 31, 2005    Owned    14,780    Branch

301 Keith Street SW

Cleveland, Bradley County, Tennessee

   October 31, 2005    Leased    3,072    Branch

3895 Cleveland Road

Varnell, Whitfield County, Georgia

   November 11, 2005    Owned    1,860    Branch

531 Broad Street

Chattanooga, Hamilton County, Tennessee

   December 11, 2006    Owned    39,700    Branch &
Headquarters

614 West Main Street

Algood, Putnam County, Tennessee

   April 10, 2007    Owned    1,936    Branch

52 Mouse Creek Road

Cleveland, Bradley County, Tennessee

   May 14, 2007    Owned    1,256    Branch

5188 Highway 153

Knoxville, Knox County, Tennessee

   May 22, 2009    Owned    4,194    Branch

As of December 31, 2010, we owned one additional plot of land. The vacant lot is located at 1020 South Highway 92, Dandridge, Jefferson County, Tennessee (1.0 acres). The lot is currently available for sale and is included in our other real estate owned portfolio. We originally purchased this site for bank purposes.

 

37


Table of Contents
Index to Financial Statements

We closed the branch located at 4215 Highway 411, Madisonville, Monroe County, Tennessee on April 30, 2010. Since we own the branch, it is included in our other real estate owned portfolio and is currently available for sale.

Additionally, we closed leased branch locations at 2709 Chattanooga Road, Suite 5, Rocky Face, Whitfield County, Georgia on October 15, 2010 and 817 Broad Street, Chattanooga, Hamilton County, Tennessee on February 25, 2011.

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

 

Item 3. Legal Proceedings

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

 

Item 4. [Removed and Reserved.]

 

38


Table of Contents
Index to Financial Statements

PART II

 

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

Since August 10, 2005, our common stock has been traded on the Nasdaq Global Select Market under the symbol FSGI. On March 18, 2011, there were 1,090 registered holders of record of our common stock. The high and low prices per share were as follows:

 

Quarter

   High      Low      Dividend  

2010

        

4th Quarter

   $ 1.69       $ 0.55       $ —     

3rd Quarter

     2.06         1.00         —     

2nd Quarter

     3.43         1.90         —     

1st Quarter

     2.63         2.07         —     

2009

        

4th Quarter

   $ 3.91       $ 1.82       $ 0.01   

3rd Quarter

     4.10         3.35         0.01   

2nd Quarter

     4.54         3.25         0.01   

1st Quarter

     5.14         2.80         0.05   

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

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

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

On July 23, 2008, our Board of Directors approved a loan, which was subsequently amended on January 28, 2009, in the amount of $12.7 million from First Security Group, Inc. to First Security Group, Inc. 401(k) and

 

39


Table of Contents
Index to Financial Statements

Employee Stock Ownership Plan (the “401(k) and ESOP Plan”). The purpose of the loan is to purchase Company shares in open market transactions. The shares will be used for future Company matching contributions within the 401(k) and ESOP Plan. As of December 31, 2010, the plan held 577,723 unallocated shares at a weighted average price of $9.01. The purchase program concluded on December 31, 2009.

LOGO

 

     Period Ending  

Index

   12/31/05      12/31/06      12/31/07      12/31/08      12/31/09      12/31/10  

First Security Group, Inc.

     100.00         119.68         95.01         50.20         26.47         10.01   

NASDAQ Composite

     100.00         110.39         122.15         73.32         106.57         125.91   

SNL Bank NASDAQ

     100.00         112.27         88.14         64.01         51.93         61.27   

SNL Southeast Bank

     100.00         117.26         88.33         35.76         35.90         34.86   

 

40


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

Our selected financial data is presented below as of and for the years ended December 31, 2006 through 2010. The selected financial data presented below as of December 31, 2010 and 2009 and for each of the years in the three-year period ended December 31, 2010, are derived from our audited financial statements and related notes included in this Annual Report on Form 10-K and should be read in conjunction with the consolidated financial statements and related notes, along with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 47. The selected financial data as of December 31, 2008, 2007 and 2006 and for the two years ended December 31, 2007 have been derived from our audited financial statements that are not included in this Annual Report on Form 10-K. Certain of the measures set forth below are non-GAAP financial measures under the rules and regulations promulgated by the SEC. For a discussion of management’s reasons to present such data and a reconciliation to GAAP, please see “GAAP Reconciliation and Management Explanation for Non-GAAP Financial Measures” on page 43.

 

     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share amounts and full-time
equivalent employees)
 

Earnings:

          

Net interest income

   $ 34,681      $ 42,209      $ 45,227      $ 48,922      $ 47,982   

Provision for loan and lease losses

   $ 33,613      $ 25,404      $ 15,753      $ 2,155      $ 2,184   

Non-interest income

   $ 9,503      $ 10,335      $ 11,682      $ 11,300      $ 10,617   

Non-interest expense

   $ 45,234      $ 68,847      $ 40,382      $ 41,441      $ 40,017   

Dividends and accretion on preferred stock

   $ 2,029      $ 1,954      $ —        $ —        $ —     

Net (loss) income available to common stockholders

   $ (46,371   $ (35,409   $ 1,361      $ 11,356      $ 11,112   

Earnings—Normalized

          

Non-interest expense, excluding goodwill impairment

   $ 45,234      $ 41,691      $ 40,382      $ 41,441      $ 40,017   

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

   $ (46,371   $ (10,647   $ 1,361      $ 11,356      $ 11,112   

Per Share Data:

          

Net (loss) income, basic

   $ (2.95   $ (2.28   $ 0.08      $ 0.67      $ 0.64   

Net (loss) income, diluted

   $ (2.95   $ (2.28   $ 0.08      $ 0.66      $ 0.63   

Cash dividends declared on common shares

   $ —        $ 0.08      $ 0.20      $ 0.20      $ 0.13   

Book value per common share

   $ 3.76      $ 6.69      $ 8.78      $ 8.80      $ 8.15   

Tangible book value per common share

   $ 3.67      $ 6.57      $ 6.98      $ 6.99      $ 6.39   

Per Share Data—Normalized:

          

Net (loss) income, excluding goodwill impairment, basic

   $ (2.95   $ (0.68   $ 0.08      $ 0.67      $ 0.64   

Net (loss) income excluding goodwill impairment, diluted

   $ (2.95   $ (0.68   $ 0.08      $ 0.66      $ 0.63   

Performance Ratios:

          

Return on average assets1

     -3.55     -2.81     0.11     0.97     1.03

Return on average common equity1

     -46.81     -25.92     0.92     7.75     7.91

Return on average tangible assets1

     -3.55     -2.86     0.11     1.00     1.06

Return on average tangible common equity1

     -47.62     -31.00     1.15     9.81     10.22

Net interest margin, taxable equivalent

     2.92     3.75     4.07     4.79     5.09

Efficiency ratio

     102.38     131.03     70.96     68.81     68.29

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

     21.51     19.67     20.53     18.76     18.12

 

41


Table of Contents
Index to Financial Statements
     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share amounts and full-time
equivalent employees)
 

Performance Ratios—Normalized:

          

Return on average assets, excluding goodwill impairment1

     -3.55     -0.85     0.11     0.97     1.03

Return on average common equity, excluding goodwill impairment1

     -46.81     -7.79     0.92     7.75     7.91

Return on average tangible assets, excluding goodwill impairment1

     -3.55     -0.86     0.11     1.00     1.06

Return on average tangible common equity, excluding goodwill impairment1

     -47.62     -9.32     1.15     9.81     10.22

Capital & Liquidity:

          

Total equity to total assets

     7.99     10.43     11.30     12.19     12.82

Tangible equity to tangible assets

     7.88     10.30     9.20     9.93     10.33

Tangible common equity to tangible assets

     5.16     7.98     9.20     9.93     10.33

Tier 1 risk-based capital ratio

     11.20     12.68     9.85     10.76     12.04

Total risk-based capital ratio

     12.47     13.94     11.10     11.81     13.10

Tier 1 leverage ratio

     7.27     10.59     8.74     9.74     10.50

Dividend payout ratio

     nm        nm        239.02     30.06     19.50

Total loans to total deposits

     69.33     80.50     93.99     105.59     91.93

Asset Quality:

          

Net charge-offs

   $ 36,081      $ 16,273      $ 9,300      $ 1,129      $ 2,215   

Net loans charged-off to average loans

     4.27     1.66     0.93     0.12     0.28

Non-accrual loans

   $ 54,082      $ 45,454      $ 18,453      $ 3,372      $ 2,653   

Other real estate owned

   $ 24,399      $ 15,312      $ 7,145      $ 2,452      $ 1,982   

Repossessed assets

   $ 763      $ 3,881      $ 1,680      $ 1,834      $ 2,231   

Non-performing assets (NPA)

   $ 79,244      $ 64,647      $ 27,278      $ 7,658      $ 6,866   

NPA to total assets

     6.78     4.78     2.14     0.63     0.61

Loans 90 days past due

   $ 4,838      $ 4,524      $ 2,706      $ 2,289      $ 1,325   

NPA + loans 90 days past due to total assets

     7.20     5.11     2.35     0.82     0.72

Non-performing loans (NPL)

   $ 58,920      $ 49,978      $ 21,159      $ 5,661      $ 3,978   

NPL to total loans

     8.10     5.25     2.09     0.59     0.47

Allowance for loan and lease losses to total loans

     3.30     2.78     1.72     1.15     1.18

Allowance for loan and lease losses to NPL

     40.73     53.01     82.16     193.53     250.63

Period End Balances:

          

Loans

   $ 727,091      $ 952,018      $ 1,011,584      $ 953,105      $ 847,593   

Allowance for loan and lease losses

   $ 24,000      $ 26,492      $ 17,385      $ 10,956      $ 9,970   

Intangible assets

   $ 1,461      $ 1,918      $ 29,560      $ 30,356      $ 31,341   

Assets

   $ 1,168,548      $ 1,353,399      $ 1,276,227      $ 1,211,955      $ 1,129,803   

Deposits

   $ 1,048,723      $ 1,182,673      $ 1,076,286      $ 902,629      $ 922,001   

Common stockholders’ equity

   $ 61,657      $ 109,825      $ 144,244      $ 147,693      $ 144,788   

Total stockholders’ equity

   $ 93,374      $ 141,164      $ 144,244      $ 147,693      $ 144,788   

Common stock market capitalization

   $ 14,776      $ 39,075      $ 75,860      $ 150,640      $ 204,796   

Full-time equivalent employees

     311        347        361        371        369   

Common shares outstanding

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

 

42


Table of Contents
Index to Financial Statements
     As of and for the Years Ended December 31,  
     2010      2009      2008      2007      2006  
     (in thousands, except per share amounts and full-time
equivalent employees)
 

Average Balances:

              

Loans

   $ 845,945       $ 977,758       $ 997,371       $ 904,490       $ 796,866   

Intangible assets

   $ 1,691       $ 22,382       $ 29,948       $ 30,838       $ 31,699   

Earning assets

   $ 1,213,145       $ 1,150,337       $ 1,132,962       $ 1,041,078       $ 960,966   

Assets

   $ 1,306,831       $ 1,258,662       $ 1,258,469       $ 1,165,948       $ 1,081,375   

Deposits

   $ 1,147,724       $ 1,057,090       $ 956,994       $ 924,587       $ 887,319   

Common stockholders’ equity

   $ 99,067       $ 136,598       $ 148,655       $ 146,582       $ 140,467   

Total stockholders’ equity

   $ 130,579       $ 166,803       $ 148,655       $ 146,582       $ 140,467   

Common shares outstanding, basic—wtd

     15,740         15,550         16,021         16,959         17,315   

Common shares outstanding, diluted—wtd

     15,740         15,550         16,143         17,293         17,680   

 

1 

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

GAAP Reconciliation and Management Explanation for Non-GAAP Financial Measures

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

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

 

   

“Non-interest expense, excluding goodwill impairment” is defined as non-interest expense reduced by the effect of goodwill impairment. “Net (loss) income available to common stockholders, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax. “Net (loss) income, excluding goodwill impairment per share” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by total common shares outstanding. Our management includes these measures because it believes that they are important when measuring First Security’s performance exclusive of the effects of impairment of goodwill. As of September 30, 2009, the annual assessment of goodwill indicated a full impairment of goodwill; accordingly, no further goodwill remains on the books of First Security. The goodwill impairment is a

 

43


Table of Contents
Index to Financial Statements
 

one-time, non-cash accounting adjustment that has no effect on First Security’s cash flows, liquidity, tangible capital, or ability to conduct business and as such, management believes excluding this charge is appropriate to properly measure First Security’s performance. These three non-GAAP financial measures exclude the effect of the goodwill impairment on the most comparable GAAP measures: non-interest expense (to measure the overall level of First Security’s recurring non-interest related expenses); net (loss) income available to common stockholders (to reflect the recurring overall net income available to stockholders collectively); and net (loss) income per share (to reflect the recurring overall net income available to stockholders on a per share basis).

 

   

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

 

   

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

 

   

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

 

44


Table of Contents
Index to Financial Statements

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

 

     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share data)  

Return on average assets

     -3.55     -2.81     0.11     0.97     1.03

Effect of intangible assets

     —          -0.05     —          0.03     0.03
                                        

Return on average tangible assets

     -3.55     -2.86     0.11     1.00     1.06
                                        

Return on average assets

     -3.55     -2.81     0.11     0.97     1.03

Effect of goodwill impairment

     —          1.96     —          —          —     
                                        

Return on average assets, excluding goodwill impairment

     -3.55     -0.85     0.11     0.97     1.03

Effect of average intangible assets

     —          -0.01     —          0.03     0.03
                                        

Return on average tangible assets, excluding goodwill impairment

     -3.55     -0.86     0.11     1.00     1.06
                                        

Return on average common equity

     -46.81     -25.92     0.92     7.75     7.91

Effect of goodwill impairment

     —          18.13     —          —          —     
                                        

Return on average common equity, excluding goodwill impairment

     -46.81     -7.79     0.92     7.75     7.91

Effect on average intangible assets

     -0.81     -1.53     0.23     2.06     2.32
                                        

Return on average tangible common equity, excluding goodwill impairment

     -47.62     -9.32     1.15     9.81     10.22
                                        

Total equity to total assets

     7.99     10.43     11.30     12.19     12.82

Effect of intangible assets

     -0.11     -0.13     -2.10     -2.26     -2.49
                                        

Tangible equity to tangible assets

     7.88     10.30     9.20     9.93     10.33
                                        

Effect of preferred stock

     -2.72     -2.32     —          —          —     
                                        

Tangible common equity to tangible assets

     5.16     7.98     9.20     9.93     10.33
                                        

Non-interest expense

   $ 45,234      $ 68,847      $ 40,382      $ 41,441      $ 40,017   

Effect of goodwill impairment

     —          (27,156     —          —          —     
                                        

Non-interest expense, excluding goodwill impairment

   $ 45,234      $ 41,691      $ 40,382      $ 41,441      $ 40,017   
                                        

Net (loss) income available to common stockholders

   $ (46,371   $ (35,409   $ 1,361      $ 11,356      $ 11,112   

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

     —          24,762        —          —          —     
                                        

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

   $ (46,371   $ (10,647   $ 1,361      $ 11,356      $ 11,112   
                                        

Total stockholders’ equity

   $ 93,374      $ 141,164      $ 144,244      $ 147,693      $ 144,788   

Effect of preferred stock

     (31,717     (31,339     —          —          —     
                                        

Common stockholders’ equity

   $ 61,657      $ 109,825      $ 144,244      $ 147,693      $ 144,788   
                                        

Average assets

   $ 1,306,831      $ 1,258,662      $ 1,258,469      $ 1,165,948      $ 1,081,375   

Effect of average intangible assets

     (1,691     (22,382     (29,948     (30,838     (31,699
                                        

Average tangible assets

   $ 1,305,140      $ 1,236,280      $ 1,228,521      $ 1,135,110      $ 1,049,676   
                                        

 

45


Table of Contents
Index to Financial Statements
     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share data)  

Average total stockholders’ equity

   $ 130,579      $ 166,803      $ 148,655      $ 146,582      $ 140,467   

Effect of average preferred stock

     (31,512     (30,205     —          —          —     
                                        

Average common stockholders’ equity

     99,067        136,598        148,655        146,582        140,467   
                                        

Effect of average intangible assets

     (1,691     (22,382     (29,948     (30,838     (31,699
                                        

Average tangible common stockholders’ equity

   $ 97,376      $ 114,216      $ 118,707      $ 115,744      $ 108,768   
                                        

Per Share Data

          

Book value per common share

   $ 3.76      $ 6.69      $ 8.78      $ 8.80      $ 8.15   

Effect of intangible assets

     (0.09     (0.12     (1.80     (1.81     (1.76
                                        

Tangible book value per common share

   $ 3.67      $ 6.57      $ 6.98      $ 6.99      $ 6.39   
                                        

Net (loss) income, basic

   $ (2.95   $ (2.28   $ 0.08      $ 0.67      $ 0.64   

Effect of goodwill impairment, net of tax

     —          1.60        —          —          —     
                                        

Net (loss) income, excluding goodwill impairment, basic

   $ (2.95   $ (0.68   $ 0.08      $ 0.67      $ 0.64   
                                        

Net (loss) income, diluted

   $ (2.95   $ (2.28   $ 0.08      $ 0.66      $ 0.63   

Effect of goodwill impairment, net of tax

     —          1.60        —          —          —     
                                        

Net (loss) income, excluding goodwill impairment, diluted

   $ (2.95   $ (0.68   $ 0.08      $ 0.66      $ 0.63   
                                        

 

46


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

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

Year Ended December 31, 2010

The following discussion and analysis sets forth the major factors that affected First Security’s financial condition as of December 31, 2010 and 2009, and results of operations for the three years ended December 31, 2010 as reflected in the audited financial statements.

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   

 

47


Table of Contents
Index to Financial Statements

Strategic Initiative

  

Current and/or Potential Impact

   Actual/Expected
Implementation
 

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.

Recent Regulatory Events

Effective September 7, 2010, First Security entered into an Agreement with the Federal Reserve Bank. 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.

We are currently deemed not in compliance with several provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve Bank. We can provide no assurances that we will be able to comply fully with the Agreement, that efforts to comply with the Agreement will not have a material adverse effect on the operations and financial condition of First Security, or that further enforcement actions won’t be imposed on First Security.

Effective April 28, 2010, FSGBank reached an agreement with its primary regulator, the OCC, regarding the issuance of a Consent Order. The Order is a result of the OCC’s regular examination of FSGBank in the fall of

 

48


Table of Contents
Index to Financial Statements

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.

We are currently deemed not in compliance with the provisions of the Order, including the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. We can provide no assurances that we will be able to comply fully with the Order, that efforts to comply with the Order will not have a material adverse effect on the operations and financial condition of FSGBank, or that further enforcement actions won’t be imposed on FSGBank.

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. We believe the successful execution of our strategic initiatives will ultimately result in full compliance with the Order and position us for long-term growth and a return to profitability.

The OCC is currently working with the Board and management to address certain items within the previously submitted strategic and capital plans, as well as other policy revisions required by the order. The Order required FSGBank to maintain certain capital ratios within 120 days of it execution. The December 31, 2010 Call Report was the second public financial statement related to a period subsequent to the 120 day requirement. As of December 31, 2010, the Bank’s total capital to risk-weighted assets was 12.2% and the Tier 1 capital to adjusted total assets was 7.1%. The Bank has notified the OCC of the non-compliance. The Bank anticipates submitting revised earnings and capital plans to the OCC during the second quarter of 2011.

Going Concern Discussion

Our independent registered public accounting firm has included language in its audit opinion related to our ability to continue as a going concern. As discussed in Note 2 to our consolidated financial statements, we recognize that the losses recorded during 2009 and 2010 have significantly impacted our operating results for those two years. Our ability to continue as a going concern is contingent upon our ability to devise and successfully execute a management plan to develop profitable operations, satisfy the requirements of the regulatory actions detailed above, and lower the level of problem assets to an acceptable level.

We are developing 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 an adequate allowance for loan losses, (5) actively working to maintain appropriate liquidity while reducing reliance on non-core sources of funding and (6) evaluating strategic and capital opportunities.

We believe that the successful execution of the strategic initiatives will ultimately result in full compliance with the regulatory requirements and position us for long-term growth and a return to profitability.

Overview

Market Conditions

Most indicators point toward the overall U.S. economy improving during 2011. As our financial results can be a reflection of our regional economy, we closely monitor and evaluate local and regional economic trends.

Announced in 2010, Amazon.com is building two distribution centers in our markets. Both facilities are anticipated to be operational by August or September 2011. The $139 million investments will create more than 1,400 full-time jobs in Hamilton and Bradley counties along with more than 2,000 seasonal jobs.

 

49


Table of Contents
Index to Financial Statements

Announced in 2008, the $1 billion Volkswagen automotive production facility will be producing the all-new 2012 Passat. As of March 9, 2011, Volkswagen had hired over 1,500 of the 2,000 plus estimated direct jobs. Volkswagen anticipates 400 white-collar jobs and an additional 9,500 supplier-related jobs to the region. Also announced in 2008, Wacker Chemical is building a $1.45 billion polysilicon production plant for the solar power industry near Cleveland, Tennessee. The plant is expected to create an additional 650 jobs for our market area. 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 December 2010, than the Tennessee rate of 9.1%. 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 12.7% (as of December 2010) compared to the Georgia rate of 10.2%. For the Chattanooga and Knoxville MSAs, the number of unemployed workers is decreasing and, as of December 2010, has declined by 16.8% in Chattanooga and 21.3% in Knoxville since the peak in June 2009. We believe these positive employment trends will continue into 2011.

Our market area has also benefited from a relatively stable housing environment. According to the National Association of REALTORS, the median sales prices of existing single-family homes declined by less than 1% for the Chattanooga MSA and the Knoxville MSA year-over-year. The decline in the median sales price from 2008 to 2010 was 6.0% for the Chattanooga MSA and 5.5% for the Knoxville MSA compared to 11.9% decrease for the nation and a 9.3% decline for the census region identified as the South as of December 31, 2010. We anticipate median home prices to begin to stabilize and possibly increase during 2011.

CPP Investment

On January 9, 2009, as part of the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP), we agreed to issue and sell, and the Treasury agreed to purchase (1) 33,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock (Preferred Shares), Series A, having a liquidation preference of $1,000 per share and (2) a ten-year warrant to purchase up to 823,627 shares of our common stock, $0.01 par value, at an exercise price of $6.01 per share, for an aggregate purchase price of $33 million in cash. The Preferred Shares qualify as Tier 1 capital and pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Dividends are payable quarterly on February 15, May 15, August 15 and November 15 of each year.

Currently, we have deferred five consecutive Preferred Stock dividend payments. Upon the sixth deferred dividend payment, the Treasury will be entitled to elect two members to our Board of Directors at the next annual meeting. Currently, the Treasury has requested, and we anticipate agreeing to permit, an observer employed by the Treasury to attend meetings of our Board of Directors.

Financial Results

As of December 31, 2010, we had total consolidated assets of $1.2 billion, total loans of $727.1 million, total deposits of $1.0 billion and stockholders’ equity of $93.4 million. In 2010, our net loss available to common stockholders was $46.4 million, resulting in a net loss of $2.95 per share (basic and diluted). During 2010, we recognized $33.6 million in provision for loan and lease losses as well as a deferred tax asset valuation allowance of $24.6 million.

As of December 31, 2009, we had total consolidated assets of $1.4 billion, total loans of $952.0 million, total deposits of $1.2 billion and stockholders’ equity of $141.2 million. In 2009, our net loss available to common stockholders was $35.4 million, resulting in net loss of $2.28 per share (basic and diluted). During 2009, we recognized a goodwill impairment of $27.2 million, or $24.8 million after-tax. Excluding the goodwill

 

50


Table of Contents
Index to Financial Statements

impairment, our net loss available to common stockholders was $10.6 million, or $0.68 per share (basic and diluted). The goodwill impairment represents a one-time, non-cash accounting adjustment and had no impact on cash flows, liquidity, tangible capital or our ability to conduct business.

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

Net interest income for 2010 declined by $7.5 million compared to 2009 primarily as a result of the reduction in the loan portfolio as well as the negative spread created by the issuance of brokered deposits and the associated increase in interest bearing cash. The provision for loan and lease losses increased $8.2 million as a result of the increased level of charge-offs. Noninterest income declined by $832 thousand primarily a result of lower deposit fees and lower mortgage loan and related fee income. Noninterest expense, excluding the 2009 goodwill impairment of $27.2 million, increased by $3.5 million. The increase was largely due to increases in write-downs on OREO and repossessions, higher FDIC insurance expense and higher professional fees, partially offset by reductions in salary and benefit expense. Full-time equivalent employees were 311 at December 31, 2010, compared to 347 at December 31, 2009.

Net interest income for 2009 declined by $3.0 million from 2008, primarily as a result of the reductions to the target federal funds rate by the Federal Reserve Board that began in September 2007 and ended in December 2008. The weighted average target fund rate for 2008 was 1.76% compared to 0.25% for 2009. The provision for loan and lease losses increased $9.7 million as a result of declining asset quality and general economic conditions. Noninterest income decreased by $1.3 million, primarily a result of lower deposit fees and lower mortgage loan and related fee income. Noninterest expense, excluding the goodwill impairment of $27.2 million, increased 3.2%, or $1.3 million. Full-time equivalent employees were 347 at December 31, 2009, compared to 361 at December 31, 2008.

Our efficiency ratio, excluding the goodwill impairment, increased to 102.4% in 2010 versus 79.3% in 2009 and 71.0% in 2008. The efficiency ratio for 2010 increased as a result of the combined $8.4 million decline in net interest income and noninterest income and the $3.5 million increase in noninterest expense, excluding the goodwill impairment. The stabilization and improvement of our efficiency ratio to more historical levels is dependent on our ability to stabilize the loan portfolio and reduce expenses associated with nonperforming assets.

Net interest margin in 2010 was 2.92%, or 83 basis points lower, compared to the prior period of 3.75%. The net interest margin of our peer group (as reported on the December 31, 2010 Uniform Bank Performance Report) was 3.69% and 3.50% for 2010 and 2009, respectively. During the fourth quarter of 2009 and first quarter of 2010, we issued over $255 million in brokered deposits to build excess cash reserves to reduce liquidity risk resulting from deteriorating asset quality and the Consent Order. Average other earning assets increased to $217.4 million in 2010 from $30.6 million in 2009. The impact of the excess liquidity is estimated to have reduced our net interest margin by approximately 100 basis points. We anticipate that our margin will improve during 2011 as brokered deposits mature and the excess liquidity declines. Our expectations are dependent on our ability to raise core deposits, our loan and deposit pricing, and any possible actions by the Federal Reserve Board to the target federal funds rate.

Critical Accounting Policies

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

 

51


Table of Contents
Index to Financial Statements

used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.

Allowance for Loan and Lease Losses

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

Estimates of Fair Value

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

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

Changes in fair value could materially impact our financial results. Refer to Note 18, “Fair Value Measurements” in the notes to our consolidated financial statements for a discussion of our methodology of calculating fair value.

Goodwill

Our policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. Impairment is a condition that exists when the carrying amount of goodwill exceeds its implied fair value. As more fully described below, we recorded a full goodwill impairment during 2009.

Income Taxes

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

 

52


Table of Contents
Index to Financial Statements

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

We periodically evaluate our uncertain tax positions and estimate the appropriate level of tax reserves related to each of these positions. Additionally, we evaluate our deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 13, “Income Taxes,” in the notes to our consolidated financial statements as well as the Income Taxes section of MD&A for more information.

Results of Operations

We reported a net loss available to common stockholders for 2010 of $46.4 million versus $35.4 million for 2009 and net income for 2008 of $1.4 million. In 2010, the net loss per share was $2.95 (basic and diluted) on approximately 15.7 million weighted average shares outstanding. Excluding the goodwill impairment of $24.8 million after-tax, or $27.2 million before-tax, our 2009 net loss was $10.6 million, or $0.68 per share (basic and diluted). In 2008, the net income of $1.4 million resulted in net income of $0.08 per share (basic and diluted) on approximately 16.0 million weighted average basic shares and 16.1 million weighted average diluted shares.

The net loss available to common shareholders in 2010 was above the 2009 level predominately as a result of the deferred tax asset valuation allowance of $24.6 million, higher provision expense and a decrease in net interest income. As of December 31, 2010, we had 37 banking offices, including the headquarters and 311 full time equivalent employees.

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

 

    Condensed Consolidated Statements of Income
For the Years Ended December 31,
 
    2010     Change
From
Prior
Year
    Percent
Change
    2009     Change
From
Prior
Year
    Percent
Change
    2008     Change
From
Prior
Year
    Percent
Change
 
    (in thousands, except percentages)  

Interest income

  $ 54,916      $ (9,091     (14.2 )%    $ 64,007      $ (12,081     (15.9 )%    $ 76,088      $ (7,435     (8.9 )% 

Interest expense

    20,235        (1,563     (7.2 )%      21,798        (9,063     (29.4 )%      30,861        (3,740     (10.8 )% 
                                                                       

Net interest income

    34,681        (7,528     (17.8 )%      42,209        (3,018     (6.7 )%      45,227        (3,695     (7.6 )% 

Provision for loan and lease losses

    33,613        8,209        32.3     25,404        9,651        61.3     15,753        13,598        631.0
                                                                       

Net interest income after provision for loan and lease losses

    1,068        (15,737     (93.6 )%      16,805        (12,669     (43.0 )%      29,474        (17,293     (37.0 )% 

Noninterest income

    9,503        (832     (8.1 )%      10,335        (1,347     (11.5 )%      11,682        382        3.4

Noninterest expense

    45,234        (23,613     (34.3 )%      68,847        28,465        70.5     40,382        (1,059     (2.6 )% 
                                                                       

Net (loss) income before income taxes

    (34,663     7,044        (16.9 )%      (41,707     (42,481     (5,488.5 )%      774        (15,852     (95.3 )% 

Income tax provision (benefit)

    9,679        17,931        217.3     (8,252     (7,665     1,305.8     (587     (5,857     (111.1 )% 
                                                                       

Net (loss) income

    (44,342     (10,887     (32.5 )%      (33,455     (34,816     (2,558.1 )%      1,361        (9,995     (88.0 )% 

Preferred stock dividends and discount accretion

    2,029        75        3.8     1,954        1,954        100.0     —          —          —     
                                                                       

Net (loss) income available to common stockholders

  $ (46,371   $ (10,962     (31.0 )%    $ (35,409   $ (36,770     (2,701.7 )%    $ 1,361      $ (9,995     (88.0 )% 
                                                                       

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

 

53


Table of Contents
Index to Financial Statements

Net Interest Income

Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. In 2010, net interest income was $34.7 million, or 17.8% less than the 2009 level of $42.2 million, which was 6.7% less than the 2008 level of $45.2 million.

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

The following table summarizes net interest income on a fully tax-equivalent basis and average yields and rates paid for the years ended December 31, 2010, 2009 and 2008.

Average Consolidated Balance Sheets and Net Interest Analysis

Fully Tax-Equivalent Basis

 

    For the Years Ended,  
    2010     2009     2008  
    Average
Balance
    Income/
Expense
    Yield/
Rate
    Average
Balance
    Income/
Expense
    Yield/
Rate
    Average
Balance
    Income/
Expense
    Yield/
Rate
 
    (in thousands, except percentages)  
    (fully tax-equivalent basis)  

ASSETS

                 

Earning assets:

                 

Loans, net of unearned
income1,2

  $ 845,945      $ 49,127        5.81   $ 977,758      $ 57,784        5.91   $ 997,371      $ 69,863        7.00

Debt securities—taxable

    111,526        3,919        3.51     98,797        4,613        4.67     89,711        4,647        5.18

Debt securities—non-taxable 2

    38,232        2,156        5.64     43,134        2,457        5.70     42,780        2,452        5.73

Federal funds sold and other earning assets

    217,442        517        0.24     30,648        72        0.23     3,100        49        1.58
                                                                       

Total earning assets

    1,213,145        55,719        4.59     1,150,337        64,926        5.64     1,132,962        77,011        6.80
                                                     

Allowance for loan losses

    (26,698         (20,582         (12,030    

Intangible assets

    1,691            22,382            29,948       

Cash & due from banks

    8,117            15,292            23,280       

Premises & equipment

    32,362            33,753            34,429       

Other assets

    78,214            57,480            49,880       
                                   

Total assets

  $ 1,306,831          $ 1,258,662          $ 1,258,469       
                                   

LIABILITIES AND STOCKHOLDERS’ EQUITY

                 

Interest bearing liabilities:

                 

NOW accounts

  $ 65,809      $ 186        0.28   $ 61,501      $ 190        0.31   $ 62,911      $ 327        0.52

Money market accounts

    133,298        1,315        0.99     126,219        1,567        1.24     103,137        2,139        2.07

Savings deposits

    38,582        102        0.26     35,986        101        0.28     35,120        146        0.42

Time deposits less than $100 thousand

    228,907        4,673        2.04     244,912        7,183        2.93     256,664        10,549        4.11

Time deposits > $100 thousand

    184,432        4,049        2.20     203,052        6,265        3.09     214,705        9,310        4.34

Brokered CDs and CDARS®

    335,416        9,372        2.79     157,717        5,317        3.37     121,736        4,735        3.89

Brokered money markets and NOWs

    6,561        57        0.87     77,683        653        0.84     4,975        74        1.49

Federal funds purchased

    —          —          —       335        4        1.19     23,710        689        2.91

Repurchase agreements

    18,435        475        2.58     20,828        498        2.39     34,513        835        2.42

Other borrowings

    85        6        7.06     1,723        20        1.16     78,108        2,057        2.63
                                                                       

Total interest bearing liabilities

    1,011,525        20,235        2.00     929,956        21,798        2.34     935,579        30,861        3.30
                                                     

Net interest spread

    $ 35,484        2.59     $ 43,128        3.30     $ 46,150        3.50
                                   

Noninterest bearing demand deposits

    154,719            150,020            157,746       

Accrued expenses and other liabilities

    10,018            11,883            16,489       

Stockholders’ equity

    124,825            160,375            144,622       

Accumulated other comprehensive gain (loss)

    5,744            6,428            4,033       
                                   

Total liabilities and stockholders’ equity

  $ 1,306,831          $ 1,258,662          $ 1,258,469       
                                   

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

        0.33         0.45         0.57
                                   

Net interest margin

        2.92         3.75         4.07
                                   

 

54


Table of Contents
Index to Financial Statements

 

1 

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

 

2 

Interest income from securities and loans includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for all years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $803 thousand, $919 thousand and $923 thousand for the years ended December 31, 2010, 2009 and 2008, respectively.

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

Change in Interest Income and Expense on a Tax Equivalent Basis

 

    2010 compared to 2009 increase
(decrease) in interest income and
expense due to changes in:
    2009 compared to 2008 increase
(decrease) in interest income and
expense due to changes in:
 
    Volume     Rate     Total     Volume     Rate     Total  
    (in thousands)  

Earning assets:

           

Loans, net of unearned income

  $ (7,927   $ (730   $ (8,657   $ (1,561   $ (10,518   $ (12,079

Debt Securities—taxable

    580        (1,274     (694     457        (491     (34

Debt Securities—non-taxable

    (285     (16     (301     14        (9     5   

Federal funds sold and other earning assets

    437        8        445        434        (411     23   
                                               

Total earning assets

    (7,195     (2,012     (9,207     (656     (11,429     (12,085
                                               

Interest bearing liabilities:

           

NOW accounts

    13        (17     (4     (8     (129     (137

Money market accounts

    83        (335     (252     472        (1,044     (572

Savings deposits

    7        (6     1        3        (48     (45

Time deposits less than $100 thousand

    (488     (2,022     (2,510     (511     (2,855     (3,366

Time deposits > $100

    (590     (1,626     (2,216     (529     (2,516     (3,045

Brokered CDs and CDARS®

    5,960        (1,905     4,055        1,383        (801     582   

Brokered money market accounts

    (598     2        (596     1,078        (499     579   

Federal funds purchased

    (4     —          (4     (679     (6     (685

Repurchase agreements

    (58     35        (23     (332     (5     (337

Other borrowings

    (19     5        (14     (2,012     (25     (2,037
                                               

Total interest bearing liabilities

    4,306        (5,869     (1,563     (1,135     (7,928     (9,063
                                               

Increase (decrease) in net interest income

  $ (11,501   $ 3,857      $ (7,644   $ 479      $ (3,501   $ (3,022
                                               

Net Interest Income—Volume and Rate Changes

Interest income in 2010 was $54.9 million, a 14% decrease from the 2009 level of $64.0 million, which was a 16% decrease from the 2008 level of $76.1 million. For 2010, average loans declined by $131.8 million, or 13.5%. The decline in average loans was fully offset by a $186.8 million increase in other earning assets. The largest component of other earning assets is our interest bearing account at the Federal Reserve Bank of Atlanta that averaged $213.4 million in 2010 compared to $23.0 million during 2009. This account yields approximately 25 basis points. The net impact for changes in volumes of interest-earning assets in 2010 reduced interest income by $7.2 million. For 2009, average interest-earning assets increased 2% to $1.2 billion. However, the associated

 

55


Table of Contents
Index to Financial Statements

increase in earnings from the higher volumes was offset by the decline in the yields of earning assets and a shift in earning assets, as discussed in additional detail below. Average loans in 2009 were $977.8 million, a decrease of $19.6 million, or 2%. Average taxable debt securities increased $9.1 million, or 10%. Other earning assets increased $27.5 million to $30.6 million. The increase in average taxable debt securities and other earning assets was funded by the reductions in loans and increases in brokered deposits. The impact on interest income from the decline in average loans fully offset the increases in the other categories of earning assets. The total impact on interest income from changes in volume was a reduction of $656 thousand comparing 2009 to 2008.

The reduction in yield of average earning assets reduced interest income by $2.0 million in 2010. The tax equivalent yield on earning assets decreased 105 basis points in 2010 to 4.59% from 5.64% in 2009. The reduction in yield on earning assets was primarily related to the shifting of assets from high yielding loans to interest bearing cash. For 2009, the reduction in yield of average earnings assets reduced interest income by $11.4 million, accounting for 95% of the total decline, on a fully tax equivalent basis from 2008 to 2009. The tax equivalent yield on earning assets decreased 116 basis points in 2009 to 5.64% from 6.80% in 2008. The reduction in yield on loans for 2009 was 109 basis points, which was a result of the full impact of the 2008 cuts in the federal funds rate. From September 2007 to December 2008, the Federal Reserve Board reduced the target federal funds rate by 500 basis points to a target rate of 0.25%. We continue to maintain an asset sensitive balance sheet, which means that earning assets reprice faster than interest bearing liabilities and thus interest income declines faster than interest expense in a declining rate environment.

Total interest expense was $20.2 million in 2010 compared to $21.8 million in 2009 and $30.9 million in 2008. During the fourth quarter of 2009 and first quarter of 2010, we issued over $255 million in brokered deposits to reduce the increasing liquidity risk associated with our declining asset quality. The bulk of these funds were placed in our interest-bearing account at the Federal Reserve Bank of Atlanta. These funds will serve as excess liquidity to fund contractual obligations or prudent investments. Average brokered deposits increased by $106.6 million in 2010, adding $5.4 million in interest expense. Reductions in retail and jumbo CDs of $16.0 million and $18.6 million, respectively, reduced interest expense by $1.1 million. For 2010, the net impact on changes in volume of interest bearing liabilities resulted in a $4.3 million increase to interest expense.

For 2009, interest expense decreased due to the reduced cost of funds as well as reduced volumes of interest bearing liabilities. Interest expense for 2008 decreased due to the reduced cost of funds despite the additional volumes of interest bearing liabilities. During 2009, we replaced non-deposit liabilities, primarily short-term other borrowings, with long-term brokered deposits. Average interest bearing liabilities, excluding average deposits, declined by $113.4 million while average brokered deposits increased $108.7 million. In-market certificates of deposits declined by $23.4 million, or 5%, while money markets increased $23.1 million, or 22%. The total impact on the changes in volume of average interest bearing liabilities during 2009 was a decline in interest expense of $1.1 million.

Deposit pricing, especially for time deposits, typically lags changes in the target federal funds rate, and therefore we realized a consistent but gradual reduction in our costs of deposits throughout 2009 and 2010. The reduction of costs on interest bearing liabilities reduced interest expense by $5.9 million in 2010 and $7.9 million in 2009. The average rate paid on interest bearing liabilities for 2010 decreased by 34 basis points from 2.34% to 2.00%. The average rate paid on in-market CDs declined by 89 basis points, resulting in a savings of $3.6 million. The average rate paid on brokered deposits declined by 58 basis points to 2.79% during 2010, resulting in a savings of $1.9 million.

For 2009, the average rate paid on interest bearing liabilities decreased by 96 basis points from 3.30% to 2.34%. Beginning in the second half of 2008 and continuing into 2009, we decided to fortify our balance sheet and improve our contingent funding plans so we significantly reduced our overnight borrowings and replaced them with brokered deposits. During the fourth quarter of 2009, we took advantage of historically low rates and further extended our brokered CD ladder. We issued approximately $161.1 million of brokered CDs during the fourth quarter of 2009 with a weighted average maturity of 41 months and weighted average rate of 2.72%.

 

56


Table of Contents
Index to Financial Statements

We expect average loans to stabilize in 2011 while other earnings assets begin to decrease as brokered deposits mature. The average yield on loans in 2011 should be comparable to 2010 as we do not currently anticipate significant changes to interest rates during 2011. We expect average brokered deposits to decline during 2010 while all other interest bearing liabilities to be comparable or increase during 2011. Rates paid on deposits are expected to be consistent with 2010 rates.

Net Interest Income—Net Interest Spread and Net Interest Margin

The banking industry uses two key ratios to measure relative profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The net interest rate spread does not consider the impact of noninterest bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest bearing deposits in earning assets.

First Security’s net interest rate spread (on a tax equivalent basis) was 2.59% in 2010, 3.30% in 2009 and 3.50% in 2008, while the net interest margin (on a tax equivalent basis) was 2.92% in 2010, 3.75% in 2009 and 4.07% in 2008. The decrease in the net interest spread and net interest margin for 2010 was primarily due to reductions in our loan portfolio as well as the negative spread created by the issuance of brokered deposits in late 2009 and early 2010 and the associated increase in our interest bearing cash account at the Federal Reserve Bank of Atlanta. Additionally, average noninterest bearing deposits increased 3.1% while average earning assets increased by 5.5%. Accordingly, noninterest bearing deposits contributed 33 basis points to the margin during 2010 compared to 45 basis points in 2009.

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

In prior years, we terminated two sets of interest rate swaps. The combined gains at termination were $7.8 million, which are being accreted into income over the remaining life of the originally hedged items. The swaps added $2.0 million, $2.3 million and $1.9 million in interest income for the years ended December 31, 2010, 2009 and 2008, respectively. For 2011, we estimate the terminated swaps will add approximately $1.8 million to interest income.

We anticipate our net interest spread and net interest margin to stabilize and improve during 2011. 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 to adjust the target federal funds rate.

Provision for Loan and Lease Losses

The provision for loan and lease losses charged to operations during 2010 increased $8.2 million to $33.6 million compared to $25.4 million in 2009 and $15.8 million in 2008. Net charge-offs totaled $36.1 million for 2010, $16.3 million for 2009 and $9.3 million for 2008. Net charge-offs as a percentage of average loans were 4.27% in 2010, 1.66% in 2009 and 0.93% in 2008 and our Bank’s peer group averages (as reported in the December 31, 2010 Uniform Bank Performance Report) were 1.27%, 1.53% and 0.80% in 2010, 2009 and 2008, respectively.

 

57


Table of Contents
Index to Financial Statements

The increase in our provision for loan and lease losses in 2010 relative to 2009 was a result of our analysis of inherent risks in the loan portfolio in relation to the portfolio’s growth, the level of impaired, past due, charged-off, classified and non-performing loans, as well as increased environmental risk factors due to the general economic conditions. During 2010, we experienced significantly higher charge-offs while continuing to increase the ratio of the allowance to total loans from 2.78% to 3.30%. In 2009, we significantly increased our allowance for loan and lease losses from 1.72% of total loans as of December 31, 2008 to 2.78% of total loans as of December 31, 2009. The provision expense associated with the reserve-building was approximately $3.8 million in 2010 and $10.1 million in 2009. As of December 31, 2010, we determined our allowance of $24.0 million was adequate to provide for credit losses, which we describe more fully below in the Allowance for Loan and Lease Loss section of MD&A.

We will continue to provide provision expense to maintain an allowance level adequate to absorb known and estimated losses inherent in our loan portfolio. As the determination of provision expense is a function of the adequacy of the allowance for loan and lease losses, we cannot reasonably estimate the provision expense for 2011. Furthermore, the provision expense could materially increase or decrease in 2011 depending on a number of factors, including, among others, the level of net charge-offs, the amount of classified loans and the value of collateral associated with impaired loans.

Noninterest Income

Total noninterest income for 2010 was $9.5 million compared to $10.3 million in 2009 and $11.7 million in 2008. The following table presents the components of noninterest income for years ended December 31, 2010, 2009 and 2008.

Noninterest Income

 

     For the Years Ended  
     2010      Percent
Change
    2009      Percent
Change
    2008  
     (in thousands, except percentages)  

Non-sufficient funds (NSF) fees

   $ 2,973         (16.3 )%    $ 3,550         (14.1 )%    $ 4,135   

Service charges on deposit accounts

     939         (14.0 )%      1,092         (5.0 )%      1,149   

Point-of-sale (POS) fees

     1,270         12.8     1,126         7.2     1,050   

Mortgage loan and related fees

     909         (11.3 )%      1,025         (29.0 )%      1,443   

Bank-owned life insurance income

     1,032         2.6     1,006         4.0     967   

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

     57         100.0     —           (100.0 )%      146   

Other income

     2,323         (8.4 )%      2,536         (9.2 )%      2,792   
                                          

Total noninterest income

   $ 9,503         (8.1 )%    $ 10,335         (11.5 )%    $ 11,682   
                                          

Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including non-sufficient funds (NSF) fees, were $3.9 million, or 41% of total noninterest income for 2010, compared with $4.6 million, or 45% of total noninterest income for 2009, and $5.3 million, or 45% for 2008. 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 13% to $1.3 million in 2010 compared to 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 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.

 

58


Table of Contents
Index to Financial Statements

Mortgage loan and related fees for 2010 were $909 thousand, compared to $1.0 million in 2009 and $1.4 million in 2008. As discussed in Note 19 to our consolidated financial statements, we began electing the fair value option under applicable accounting guidance to our held for sale loan originations in February 2008. This election impacted the timing and recognition of origination fees and costs, as well as the value of the servicing rights. The recognition of the income is now concurrent with the origination of the loan. We believe the fair value option improves financial reporting by better aligning the underlying economic changes in value of the loans and related hedges to the reported results. Additionally, the election eliminates the complexities and inherent difficulties of achieving hedge accounting.

Our process to originate and sell a conforming mortgage in the secondary market typically takes 30 to 60 days from the date of mortgage origination to the date the mortgage is sold to an investor in the secondary market. Due to the normal processing time, we will have a certain amount of held for sale loans at any time. We sell these loans with the right to service the loan being released to the purchaser for a fee. Mortgages originated for sale in the secondary markets totaled $46.2 million for 2010, $61.1 million for 2009 and $67.0 million in 2008. Mortgages sold in the secondary market totaled $44.9 million for 2010, $61.5 million for 2009 and $69.8 million in 2008. We do not originate sub-prime loans. For 2011, we anticipate mortgage loan production to increase, however, provisions of the Dodd-Frank financial reform legislation may impact the pricing and competitive landscape of the mortgage market.

Bank-owned life insurance income remained stable at $1.0 million for 2010 compared to 2009 and increased from $967 thousand for 2008. The Company is the owner and beneficiary of these contracts. The income generated by the cash value of the insurance policies accumulates on a tax-deferred basis and is tax free to maturity. Additionally, the insurance death benefit will be a tax free payment to the Company. This tax-advantaged asset enables us to provide benefits to our employees. On a fully tax equivalent basis, the weighted average interest rate earned on the policies was 5.3% during 2010.

During 2010, we sold approximately $14.8 million of investment securities for a net gain of $57 thousand. During 2009, we did not sell any available-for-sale securities. During 2008, we sold approximately $13.1 million in senior unsecured debt issued by Freddie Mac and Fannie Mae for a gain of $146 thousand.

Other income for 2010 was $2.3 million, compared to the 2009 level of $2.5 million and the the 2008 level of $2.8 million. The components of other income primarily consist of ATM fee income, trust fee income, underwriting revenue, safe deposit box fee income and gains on sales of other real estate, repossessions, leased equipment and premises and equipment. Gains on sales declined $171 thousand and trust fees increased $30 thousand in 2010 compared to 2009. We anticipate our other income to be consistent or to increase in 2011.

Noninterest Expense

Total noninterest expense for 2010 was $45.2 million, compared to $68.8 million in 2009 and $40.4 million in 2008. Noninterest expense for 2009 included a full impairment to goodwill of $27.2 million. Excluding this one-time, non-cash expense, noninterest expense for 2009 was $41.7 million. For 2010, increases in FDIC insurance, losses and write-downs on nonperforming assets and professional fees offset the savings in salaries and benefits, furniture and equipment and other expense categories. The following table represents the components of noninterest expense for the years ended December 31, 2010, 2009 and 2008.

 

59


Table of Contents
Index to Financial Statements

Noninterest Expense

 

     For the Years Ended  
     2010      Percent
Change
    2009      Percent
Change
    2008  
     (in thousands, except percentages)  

Salaries and benefits

   $ 18,926         (6.5 )%    $ 20,246         (6.2 )%    $ 21,577   

Occupancy

     3,493         2.2     3,418         (2.5 )%      3,505   

Furniture and equipment

     2,032         (17.8 )%      2,473         (19.2 )%      3,059   

Professional fees

     3,144         47.8     2,127         22.0     1,744   

FDIC insurance

     3,803         103.8     1,866         196.7     629   

Data processing

     1,462         1.2     1,445         (1.2 )%      1,463   

Write-downs on other real estate owned and repossessions

     3,539         167.9     1,321         34.1     985   

Losses on other real estate owned, repossessions and fixed assets

     1,162         92.7     603         72.8     349   

OREO and repossession holding costs

     1,637         48.3     1,104