10-K 1 v370684_10k.htm FORM 10-K

 

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

 

For the fiscal year ended December 31, 2013

 

Commission File Number: 0-18832

 

FIRST FINANCIAL SERVICE CORPORATION

(Exact name of registrant as specified in its charter)

 

Kentucky   61-1168311
(State or other jurisdiction of incorporation   (I.R.S. Employer
or organization)   Identification No.)
     
2323 Ring Road, Elizabethtown, Kentucky   42701
(Address of principal executive offices)   Zip Code

 

Registrant's telephone number, including area code: (270) 765-2131

 

Securities registered pursuant to Section 12(b) of the Act:

 

Common Stock, par value $1.00 per share

(Title of Class)

 

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 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 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 ninety days. Yes x  No¨

 

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

 

Large Accelerated Filer¨ Accelerated Filer¨ Non-Accelerated Filer ¨ Smaller Reporting Companyx

 

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 (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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. ¨

 

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

 

The aggregate market value of the outstanding voting stock held by non-affiliates of the registrant based on a June 28, 2013 closing price of $3.39 as quoted on the NASDAQ Global Market was $13,200,718. Solely for purposes of this calculation, the shares held by directors and executive officers of the registrant and by any stockholder beneficially owning more than 5% of the registrant's outstanding common stock are deemed to be shares held by affiliates.

 

As of March 17, 2014 there were issued and outstanding 4,878,959 shares of the registrant's common stock.

 

 
 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

1.Portions of the Registrant’s Definitive Proxy Statement for the 2014 Annual Meeting of Shareholders to be held May 21, 2014 are incorporated by reference into Part III of this Form 10-K.

 

 
 

 

FIRST FINANCIAL SERVICE CORPORATION

2013 ANNUAL REPORT AND FORM 10-K

 

TABLE OF CONTENTS

 

PART I.
 
ITEM 1. Business 4
     
ITEM 1A. Risk Factors 15
     
ITEM 1B. Unresolved Staff Comments 21
     
ITEM 2. Properties 22
     
ITEM 3. Legal Proceedings 22
     
ITEM 4. Mine Safety Disclosures  22
 
PART II.
 
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities  23
     
ITEM 6. Selected Financial Data  25
     
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations  25
     
ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk  46
     
ITEM 8. Financial Statements and Supplementary Data  48
     
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 98
     
ITEM 9A. Controls and Procedures  98
     
ITEM 9B. Other Information 98
     
PART III.
     
ITEM 10. Directors and Executive Officers of the Registrant 98
     
ITEM 11. Executive Compensation 98
     
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 98
     
ITEM 13. Certain Relationships and Related Transactions 99
     
ITEM 14. Principal Accountant Fees and Services 99
     
PART IV.    
     
ITEM 15. Exhibits and Financial Statement Schedules 99
     
SIGNATURES 101

 

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PRELIMINARY NOTE REGARDING

FORWARD-LOOKING STATEMENTS

 

Statements in this report that are not statements of historical fact are forward-looking statements. First Financial Service Corporation (the “Corporation”) may make forward-looking statements in future filings with the Securities and Exchange Commission (“SEC”), in press releases, and in oral and written statements made by or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements. Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.

 

Various risks and uncertainties may cause actual results to differ materially from those indicated by our forward-looking statements. In addition to those risks described under “Item 1A Risk Factors,” of this report and our Annual Report on Form 10-K, the following factors could cause such differences: changes in general economic conditions and economic conditions in Kentucky and the markets we serve, any of which may affect, among other things, our level of non-performing assets, charge-offs, and provision for loan loss expense; changes in interest rates that may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposits; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”); competition with other local and regional commercial banks, savings banks, credit unions and other non-bank financial institutions; our ability to grow core businesses; our ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks.

 

Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of any such statement.

 

PART I

 

ITEM 1. BUSINESS

 

General Business Overview

 

First Financial Service Corporation was incorporated in August 1989 under Kentucky law and became the holding company for First Federal Savings Bank of Elizabethtown (the “Bank”), effective on June 1, 1990. Since that date, we have engaged in no significant activity other than holding the stock of the Bank and directing, planning and coordinating its business activities. Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its wholly owned subsidiary, the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

 

We are headquartered in Elizabethtown, Kentucky. The Bank was originally founded in 1923 as a state-chartered institution and became federally chartered in 1940. In 1987, the Bank became a federally chartered savings bank and converted from mutual to stock form. The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Cincinnati and, since converting to a state charter in 2003, has been subject to regulation, examination and supervision by the FDIC and the KDFI. Our deposits are insured by the Deposit Insurance Fund administered by the FDIC.

 

We serve the needs and cater to the economic strengths of the local communities in which we operate, and we strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.

 

Our full complement of lending services includes:

 

§a broad array of residential mortgage products, both fixed and adjustable rate;
§consumer loans, including home equity lines of credit, auto loans, recreational vehicle, and other secured and unsecured loans;
§specialized financing programs to support community development;
§mortgages for multi-family real estate;
§commercial real estate loans;
§commercial loans to businesses, including revolving lines of credit and term loans;
§real estate development;
§construction lending; and
§agricultural lending.

 

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We also provide a broad selection of deposit instruments. These include:

 

§multiple checking accounts for both personal and business accounts;
§various savings accounts, including those for minors;
§money market accounts;
§tax qualified deposit accounts such as Health Savings Accounts and Individual Retirement Accounts; and
§a broad array of certificate of deposit products.

 

We also support our customers by providing services such as:

 

§providing access to merchant bankcard services;
§supplying various forms of electronic funds transfer;
§providing cash management services;
§providing debit cards and credit cards; and
§providing mobile and Internet banking.

 

Through our personal investment financial counseling services, we offer a wide variety of non-insured investments including mutual funds, equity investments, and fixed and variable annuities. We invest in the wholesale capital markets to manage a portfolio of securities and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, collateralized mortgage obligations and corporate securities.

 

Our results of operations depend primarily on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Our operations are also affected by non-interest income, such as service charges, loan fees, gains and losses from the sale of mortgage loans and revenue earned from bank owned life insurance. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense, FDIC insurance premiums, costs associated with other real estate and provisions for loan losses.

 

REGULATORY MATTERS

 

Since January 2011, the Bank has operated under Consent Orders with the FDIC and KDFI. In the most recent Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date the Bank has not received such a written direction. The Consent Order also prohibits the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and requires the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. A copy of the most recent Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

 

At December 31, 2013, the Bank’s Tier 1 capital ratio was 7.96% and the total risk-based capital ratio was 13.48%, compared to the minimum 9.00% and 12.00% capital ratios required by the Consent Order and compared to 6.53% and 12.21% at December 31, 2012. For the fifth consecutive quarter, we have achieved and maintained the required total risk-based capital ratio. Our Tier 1 capital ratio also steadily improved, but has yet to reach the Consent Order minimum. We are continuing to explore strategic alternatives to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the Consent Order.

 

The Consent Order requires us to obtain the consent of the FDIC and the KDFI in order for the Bank to pay cash dividends to the Corporation. In addition, due to the Bank’s designation as a “troubled institution,” the Bank cannot accept, renew or rollover brokered deposits, and is restricted in the amount of interest it can pay on deposits.

 

On April 20, 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without the prior approval of the Federal Reserve Bank of St. Louis.

 

Bank regulatory agencies have discretion when an institution does not meet the terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.

 

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Market Area

 

We operate 17 full-service banking centers in six contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area. Our markets range from Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown. Our markets are supported by a diversified industry base and have a regional population of over 1 million. We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky. We control in the aggregate 19% of the deposit market share in our central Kentucky markets outside of Louisville.

 

The following table shows our market share and rank in terms of deposits as of June 30, 2013, in each Kentucky county where we have offices. We have four offices in Jefferson County, which is Louisville, Kentucky. The Louisville metropolitan area has a population of more than one million.

 

County  Number of Offices  FFKY Market Share %   FFKY Rank
Meade  2   45.0   2
Hardin  5   21.0   2
Bullitt  3   18.0   3
Hart  1   16.0   3
Nelson  2   9.0   5
Jefferson  4   0.9   14

 

Lending Activities

 

Commercial Real Estate Lending. At December 31, 2013, we had $279.9 million outstanding in commercial real estate loans. We originate commercial loans that are primarily secured by real estate and primarily in our market area. In recent years, we have put greater emphasis on originating loans for small and medium-sized businesses from our various locations. We make commercial loans to a variety of industries. Substantially all of the commercial real estate loans we originate have adjustable interest rates with maturities of 20 years or less or are loans with fixed interest rates and maturities of five years or less. The security for commercial real estate loans includes retail businesses, warehouses, churches, apartment buildings and motels. In addition, the payment experience of loans secured by income producing properties typically depends on the success of the related real estate project and thus may be more vulnerable to adverse conditions in the real estate market or in the economy generally.

 

Loans secured by multi-family residential property, consisting of properties with more than four separate dwelling units, amounted to $22.9 million of the loan portfolio at December 31, 2013. These loans are included in the $279.9 million outstanding in commercial real estate loans discussed above. We generally do not lend above 75% of the appraised values of multi-family residences on first mortgage loans. The mortgage loans we currently offer on multi-family dwellings are generally one or five year ARMs with maturities of 20 years or less.

 

Residential Real Estate. Residential mortgage loans are secured primarily by single-family homes. The majority of our mortgage loan portfolio is secured by real estate in our markets outside of Louisville and our residential mortgage loans do not have sub-prime characteristics. Fixed rate residential real estate loans we originate have terms ranging from ten to thirty years. Interest rates are competitively priced within the primary geographic lending market and vary according to the term for which they are fixed. At December 31, 2013, we had $99.3 million in residential mortgage loans outstanding.

 

We generally emphasize the origination of adjustable-rate mortgage loans ("ARMs") when possible. We offer seven ARM products with an annual adjustment, which is tied to a national index with a maximum adjustment of 2% annually, and a lifetime maximum adjustment cap of 6%. As of December 31, 2013, approximately 56% of our residential real estate loans were adjustable rate loans with adjustment periods ranging from one to seven years and balloon loans of seven years or less. Originating these ARMs can be more difficult in a low interest rate environment where there is a significant demand for fixed rate mortgages. We limit the maximum loan-to-value ratio on one-to-four-family residential first mortgages to 90% of the appraised value and generally limit the loan-to-value ratio on second mortgages on one-to-four-family dwellings to 90%.

 

Commercial Business Lending. We make secured and unsecured loans for commercial, corporate, business, and agricultural purposes, including issuing letters of credit and engaging in inventory financing and commercial leasing activities. Commercial loans generally are made to small-to-medium size businesses located within our defined market area. Commercial loans generally carry a higher yield and are made for a shorter term than real estate loans. Commercial loans, however, involve a higher degree of risk than residential real estate loans due to potentially greater volatility in the value of the assigned collateral, the need for more technical analysis of the borrower’s financial position, the potentially greater impact that changing economic conditions may have on the borrower’s ability to retire debt, and the additional expertise required for commercial lending personnel. Commercial business loans outstanding at December 31, 2013, totaled $20.6 million.

 

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Consumer Lending. Consumer loans include loans on automobiles, boats, recreational vehicles and other consumer goods, as well as loans secured by savings accounts, home improvement loans, and unsecured lines of credit. As of December 31, 2013, consumer loans outstanding were $67.1 million. Home equity lines of credit as of December 31, 2013, totaled $41.9 million.

 

Our underwriting standards reflect the greater risk in consumer lending than in residential real estate lending. Among other things, the capacity of individual borrowers to repay can change rapidly, particularly during an economic downturn, collection costs can be relatively higher for smaller loans, and the value of collateral may be more likely to depreciate. Our Consumer Lending Policy establishes the appropriate consumer lending authority for all loan officers based on experience, training, and past performance for approving high quality loans. Loans beyond the authority of individual officers must be approved by additional officers, the Executive Loan Committee or the Board of Directors, based on the size of the loan. We require detailed financial information and credit bureau reports for each consumer loan applicant to establish the applicant’s credit history, the adequacy of income for debt retirement, and job stability based on the applicant’s employment records. Co-signers are required for applicants who are determined marginal or who fail to qualify individually under these standards. Adequate collateral is required on the majority of consumer loans. The Executive Credit Committee monitors and evaluates unsecured lending limits by each loan officer.

 

The indirect consumer loan portfolio is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within the service area. Indirect consumer loans are considered to have greater risk of loan losses than direct consumer loans due to, among other things: borrowers may have no existing relationship with us; borrowers may not be residents of the lending area; less detailed financial statement information may be collected at application; collateral values can be more difficult to determine; and the condition of vehicles securing the loan can deteriorate rapidly. All applications are approved by specific lending officers, selected based on experience in this field, who obtain credit bureau reports on each application to assist in the decision. Aggressive collection procedures encourage more timely recovery of late payments. At December 31, 2013, total loans under the indirect consumer loan program totaled $13.0 million.

 

Subsidiary Activities

 

First Service Corporation of Elizabethtown (“First Service”), our licensed brokerage affiliate, provides investment services to our customers and offers tax-deferred annuities, government securities, mutual funds, and stocks and bonds. First Service employs four full-time employees. The net income of First Service was $109,000 for the year ended December 31, 2013.

 

Heritage Properties, LLC, holds real estate acquired through foreclosure that is available for sale. Currently, twenty-six properties valued at $11.6 million are held for sale.

 

We provide title insurance coverage for mortgage borrowers through First Heartland Title, LLC. The subsidiary is a joint venture with a title insurance company in Hardin County and we hold a 48% interest in First Heartland Title. The subsidiary generated $143,000 in income for the year ended December 31, 2012, of which our portion was $69,000.

 

Competition

 

The banking business is highly competitive. We face substantial competition both in attracting and retaining deposits and in lending. Direct competition for deposits comes from commercial banks, savings institutions, and credit unions located in north-central Kentucky, and less directly from money market mutual funds, prepaid card services and from sellers of corporate and government debt securities.

 

The primary competitive factors in lending are interest rates, loan origination fees and the range of services offered by the various financial institutions. Competition for origination of real estate loans normally comes from commercial banks, savings institutions, mortgage bankers, mortgage brokers, and insurance companies. Many of these competitors have substantially greater resources and lending limits than the Bank currently has.

 

We have offices in nine cities in six central Kentucky counties. In addition to the financial institutions with offices in these counties, we compete with several commercial banks and savings institutions in surrounding counties, many of which have assets substantially greater than we have. These competitors attempt to gain market share through their financial product mix, pricing strategies, internet banking and banking center locations. In addition, Kentucky's interstate banking statute, which permits banks in all states to enter the Kentucky market if they have reciprocal interstate banking statutes, has further increased competition for us. We believe that competition from both bank and non-bank entities will continue to remain strong in the near future.

 

Employees

 

As of December 31, 2013, we employed 278 employees, of which 267 were full-time and 11 part-time. None of our employees are subject to a collective bargaining agreement and management considers its relationship with employees to be good.

 

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Regulation

 

General Regulatory Matters. The Bank is a Kentucky chartered commercial bank and is subject to supervision and regulation, which involves regular bank examinations, by both the FDIC and the KDFI. Our deposits are insured by the FDIC. Kentucky’s banking statutes contain a “super-parity” provision that permits certain well-rated Kentucky banks to engage in any banking activity in which a national bank operating in any state, a state bank, thrift or savings bank operating in any other state, or a federally chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.

 

In connection with our conversion, we registered to become a bank holding company under the Bank Holding Company Act of 1956, and are subject to supervision and regulation by the Federal Reserve Board. As a bank holding company, we are required to file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to its operational guidelines. We are subject to the Bank Holding Company Act and other federal laws and regulations regarding the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.

 

Regulators have broad enforcement powers over bank holding companies and banks, including, but not limited to, the power to mandate or restrict particular actions, activities, or divestitures, impose monetary fines and other penalties for violations of laws and regulations, issue consent, cease and desist or removal orders, seek injunctions, publicly disclose such actions and prohibit unsafe or unsound practices. This authority includes both informal actions and formal actions to effect corrective actions or sanctions.

 

Certain regulatory requirements applicable to the Corporation and the Bank are referred to below or elsewhere in this filing. The description of statutory provisions and regulations applicable to banks and their holding companies set forth in this filing does not purport to be a complete description of such statutes and regulations and their effect on the Corporation or the Bank and is qualified in its entirety by reference to the actual laws and regulations.

 

We are required by regulation to maintain adequate levels of capital to support our operations. In its 2012 Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. At December 31, 2013, our Tier 1 capital ratio was 7.96% and our total risk-based capital ratio was 13.48%. We notified the bank regulatory agencies that the Tier 1 capital ratio would not be achieved and that we are continuing to explore our strategic alternatives to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the Consent Order.

 

On April 20, 2011 the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis which requires the Corporation to obtain regulatory approval before declaring any dividends. We also may not redeem shares or obtain additional borrowings without prior approval.

 

Acquisitions, Change in Control and Branching. As a bank holding company, we must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock of a bank, and before engaging in, or acquiring a company that is not a bank but is engaged in certain non-banking activities. In approving these acquisitions, the Federal Reserve Board considers a number of factors, and weighs the expected benefits to the public such as greater convenience, increased competition and gains in efficiency, against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board also considers the financial and managerial resources of the bank holding company, its subsidiaries and any company to be acquired, and the effect of the proposed transaction on these resources. It also evaluates compliance by the holding company's financial institution subsidiaries and the target institution with the Community Reinvestment Act. The Community Reinvestment Act generally requires each financial institution to take affirmative steps to ascertain and meet the credit needs of its entire community, including low and moderate income neighborhoods.

 

Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance and then only if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company, in the absence of a larger shareholder, would constitute an acquisition of control of the bank holding company. In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.

 

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Kentucky law generally permits a Kentucky chartered bank to establish a branch office in any county in Kentucky. A Kentucky bank may also, subject to regulatory approval and certain restrictions, establish a branch office outside of Kentucky. Well-capitalized Kentucky banks that have been in operation at least three years and that satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a branch in Kentucky without the approval of the Commissioner of the KDFI, upon notice to the KDFI and any other state bank with its main office located in the county where the new branch will be located. Branching by all other banks requires the approval of the Commissioner of the KDFI, who must ascertain and determine that the public convenience and advantage will be served and promoted and that there is a reasonable probability of the successful operation of the branch. In any case, the transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.

 

Section 613 of the Dodd-Frank Act effectively eliminated the interstate branching restrictions set forth in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Banks located in any state may now de novo branch in any other state, including Kentucky. Such unlimited branching power will likely increase competition within the markets in which the Corporation and the Bank operate.

 

Other Financial Activities. The Gramm-Leach-Bliley Act of 1999 permits a bank holding company to elect to become a financial holding company, which permits the holding company to conduct activities that are “financial in nature.” To become and maintain its status as a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well managed, and have at least a satisfactory Community Reinvestment Act rating. We have not filed an election to become a financial holding company and are ineligible to do so due to the Bank’s “troubled institution” designation and entering into the Consent Order.

 

Subject to certain exceptions, insured state banks are permitted to control or hold an interest in a financial subsidiary that engages in a broader range of activities than are permissible for national banks to engage in directly, subject to any restrictions imposed on a bank under the laws of the state under which it is organized. Conducting financial activities through a bank subsidiary can impact capital adequacy and regulatory restrictions may apply to affiliate transactions between the bank and its financial subsidiaries.

 

Other Holding Company Regulations. Federal law substantially restricts transactions between financial institutions and their affiliates. As a result, a bank is limited in extending credit to its holding company (or any non-bank subsidiary), in investing in the stock or other securities of the bank holding company or its non-bank subsidiaries, and/or in taking such stock or securities as collateral for loans to any borrower. Moreover, transactions between a bank and a bank holding company (or any non-bank subsidiary) for loans to any borrower must generally be on terms and under circumstances at least as favorable to the bank as those prevailing in comparable transactions with independent third parties or, in the absence of comparable transactions, on terms and under circumstances that in good faith would be available to nonaffiliated companies.

 

Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and to commit resources for their support. Such support may restrict the Corporation’s ability to pay dividends, and may be required at times when, absent this Federal Reserve Board policy, a holding company may not be inclined to provide it. A bank holding company may also be required to guarantee the capital restoration plan of an undercapitalized banking subsidiary. In addition, any capital loans by the Corporation to the Bank are subordinate in right of payment to deposits and to certain other indebtedness of the Bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Dodd-Frank Act codifies the Federal Reserve Board’s existing “source of strength” policy that holding companies act as a source of strength to their insured institution subsidiaries by providing capital, liquidity and other support in times of distress.

 

Regulatory Capital Requirements. The Federal Reserve Board and the FDIC have substantially similar risk-based and leverage capital guidelines applicable to the banking organizations they supervise. Under the risk-based capital requirements, we are generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital (4%) must be composed of common equity, retained earnings and qualifying perpetual preferred stock and certain hybrid capital instruments, less certain intangibles (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital” which, together with Tier 1 capital, composes “total capital”). To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total risk-weighted capital ratio of at least 10% and a Tier 1 risk-weighted ratio of 6% or greater.

 

The Federal Deposit Insurance Corporation Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Due to the losses we have incurred in recent quarters and our elevated levels of non-performing loans and other real estate, the FDIC, KDFI and the Bank entered into the Consent Order described above under “Regulatory Matters.” The Consent Order resulted in the Bank being categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized". The "troubled institution" designation also prohibits the Bank from accepting, renewing or rolling over brokered deposits and restricts the amount of interest the Bank may pay on deposits. Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates .75% above the average rates computed by the FDIC. The Bank has elected not to pursue such a waiver and to adhere to the average rates computed by the FDIC plus the .75% rate cap.

 

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FDICIA also requires the bank regulatory agencies to implement systems for “prompt corrective action” for institutions that fail to meet minimum capital requirements within these five categories, with progressively more severe restrictions on operations, management and capital distributions according to the category in which an institution is placed. Failure to meet capital requirements can also cause an institution to be directed to raise additional capital. FDICIA also mandates that the agencies adopt safety and soundness standards relating generally to operations and management, asset quality and executive compensation, and authorizes administrative action against an institution that fails to meet such standards.

 

In addition, the Federal Reserve Board and the FDIC have each adopted risk-based capital standards that explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by each agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy. In addition to the “prompt corrective action” directives, failure to meet capital guidelines can subject a banking organization to a variety of other enforcement remedies, including additional substantial restrictions on its operations and activities, termination of deposit insurance by the FDIC, and under some conditions the appointment of a conservator or receiver.

 

New Capital Requirements. In December 2010 and January 2011, the Basel Committee on Banking Supervision published the final texts of reforms on capital and liquidity generally referred to as “Basel III.” Although Basel III is intended to be implemented by participating countries for large, internationally active banks, its provisions are likely to be considered by United States banking regulators in developing new regulations applicable to other banks in the United States, including the Bank. For banks in the United States, among the most significant provisions of Basel III concerning capital are the following:

 

A minimum ratio of common equity to risk-weighted assets reaching 4.5%, plus an additional 2.5% as a capital conservation buffer, by 2019 after a phase-in period.

 

A minimum ratio of Tier 1 capital to risk-weighted assets reaching 6.0% by 2019 after a phase-in period.

 

A minimum ratio of total capital to risk-weighted assets, plus the additional 2.5% capital conservation buffer, reaching 10.5% by 2019 after a phase-in period.

 

An additional countercyclical capital buffer to be imposed by applicable national banking regulators periodically at their discretion, with advance notice.

 

Restrictions on capital distributions and discretionary bonuses applicable when capital ratios fall within the buffer zone.

 

Deduction from common equity of deferred tax assets that depend on future profitability to be realized.

 

Increased capital requirements for counterparty credit risk relating to OTC derivatives, repos and securities financing activities.

 

For capital instruments issued on or after January 13, 2013 (other than common equity), a loss-absorbency requirement such that the instrument must be written off or converted to common equity if a trigger event occurs, either pursuant to applicable law or at the direction of the banking regulator. A trigger event is an event under which the banking entity would become nonviable without the write-off or conversion, or without an injection of capital from the public sector. The issuer must maintain authorization to issue the requisite shares of common equity if conversion were required.

 

The Basel III provisions on liquidity include complex criteria establishing a liquidity coverage ratio (“LCR”) and net stable funding ratio (“NSFR”). The purpose of the LCR is to ensure that a bank maintains adequate unencumbered, high quality liquid assets to meet its liquidity needs for 30 days under a severe liquidity stress scenario. The purpose of the NSFR is to promote more medium and long-term funding of assets and activities, using a one-year horizon. Although Basel III is described as a “final text,” it is subject to the resolution of certain issues and to further guidance and modification, as well as to adoption by United States banking regulators, including decisions as to whether and to what extent it will apply to United States banks that are not large, internationally active banks. We are already subject to capital requirements imposed by our Consent Order that are higher than Basel III.

 

Dividends. The Corporation is a legal entity separate and distinct from the Bank. The majority of our revenue is from dividends we receive from the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and a hearing, that the institution cease and desist from such practice. The federal banking agencies have indicated that paying dividends that deplete an institution's capital base to an inadequate level would be an unsafe and unsound banking practice. Under FDICIA, an insured institution may not pay a dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve Board and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings.

 

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Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank's capital surplus equals the amount of its stated capital attributable to its common stock. Moreover, the KDFI Commissioner must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank's total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or if becoming unable to pay debts as they come due. Under the terms of the Consent Order described under “Regulatory Matters” above, the Bank cannot pay any dividends or distributions without prior regulatory approval. The Corporation has also agreed with the Federal Reserve Bank of St. Louis to not pay any dividends or distributions without prior regulatory approval.

 

Consumer Protection Laws. We are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include, among others, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.

 

Home Mortgage Disclosure Act (“HMDA”). HMDA has grown out of public concern over credit shortages in certain urban neighborhoods. One purpose of HMDA is to provide public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics, as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes. HMDA requires institutions to report data regarding applications for loans for the purchase or improvement of single family and multi-family dwellings, as well as information concerning originations and purchases of such loans. Federal bank regulators rely, in part, upon data provided under HMDA to determine whether depository institutions engage in discriminatory lending practices. The appropriate federal banking agency, or in some cases the Department of Housing and Urban Development, enforces compliance with HMDA and implements its regulations. Administrative sanctions, including civil money penalties, may be imposed by supervisory agencies for violations of HMDA.

 

Equal Credit Opportunity Act. This statute prohibits discrimination against an applicant in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs or good faith exercise of any rights under the Consumer Credit Protection Act. Under the Fair Housing Act, it is unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. Among other things, these laws prohibit a lender from denying or discouraging credit on a discriminatory basis, making excessively low appraisals of property based on racial considerations, or charging excessive rates or imposing more stringent loan terms or conditions on a discriminatory basis. In addition to private actions by aggrieved borrowers or applicants for actual and punitive damages, the U.S. Department of Justice and other regulatory agencies can take enforcement action seeking injunctive and other equitable relief or sanctions for alleged violations.

 

Truth in Lending Act (“TILA”). TILA is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As result of TILA, all creditors must use the same credit terminology and expressions of rates, and disclose the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule for each proposed loan. Violations of TILA may result in regulatory sanctions and in the imposition of both civil and, in the case of willful violations, criminal penalties. Under certain circumstances, TILA also provides a consumer with a right of rescission, which if exercised within three business days would require the creditor to reimburse any amount paid by the consumer to the creditor or to a third party in connection with the loan, including finance charges, application fees, commitment fees, title search fees and appraisal fees. Consumers may also seek actual and punitive damages for violations of TILA.

 

Real Estate Settlement Procedures Act (“RESPA”). RESPA requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. RESPA also prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Violations of RESPA may result in imposition of penalties, including: (1) civil liability equal to three times the amount of any charge paid for the settlement services or civil liability of up to $1,000 per claimant, depending on the violation; (2) awards of court costs and attorneys’ fees; and (3) fines of not more than $10,000 or imprisonment for not more than one year, or both.

 

Fair Credit Reporting Act (“FCRA”). FCRA requires the Bank to adopt and implement a written identity theft prevention program, paying particular attention to several identified “red flag” events. The program must assess the validity of address change requests for card issuers and for users of consumer reports to verify the subject of a consumer report in the event of notice of an address discrepancy. FCRA gives consumers the ability to challenge banks with respect to credit reporting information provided by the bank. FCRA also prohibits banks from using certain information it may acquire from an affiliate to solicit the consumer for marketing purposes unless the consumer has been given notice and an opportunity to opt out of such solicitation for a period of five years.

 

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Loans to One Borrower. Under current limits, loans and extensions of credit outstanding at one time to a single borrower and not fully secured generally may not exceed 15% of an institution’s unimpaired capital and unimpaired surplus. Loans and extensions of credit fully secured by certain readily marketable collateral may represent an additional 10% of unimpaired capital and unimpaired surplus.

 

Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

 

The Community Reinvestment Act (“CRA”). This statute requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC's assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board's consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new branch office or to relocate an office. The Federal Reserve Board will also assess the CRA record of the subsidiary banks of a bank holding company in its consideration of any application to acquire a bank or other bank holding company, which may be the basis for denying the application.

 

Bank Secrecy Act (“BSA”). BSA was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities.

 

In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.

 

USA Patriot Act. The Patriot Act contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. The Patriot Act also grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

 

The Corporation and the Bank, like all U.S. companies and individuals, are prohibited from transacting business with certain individuals and entities named on the Office of Foreign Asset Control's ("OFAC") list of Specially Designated Nationals and Blocked Persons. Failure to comply may result in fines and other penalties. OFAC issued guidance for financial institutions in which it asserted that it may, in its discretion, examine institutions determined to be high risk or to be lacking in their efforts to comply with these prohibitions.

 

Federal Deposit Insurance Assessments. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the FDIC and are subject to deposit insurance assessments to maintain that Fund. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank's capital level and supervisory rating.

 

In 2007, the FDIC imposed deposit assessment rates based on the risk category of insured banks.  Risk Category I is the lowest risk category while Risk Category IV is the highest risk category.  Because of favorable loss experience and a healthy reserve ratio in the Bank Insurance Fund of the FDIC at that time, well-capitalized and well-managed banks, have in recent years paid minimal premiums for FDIC insurance.

 

On October 16, 2008, the FDIC published a restoration plan designed to replenish the Deposit Insurance Fund over a period of five years and to increase the deposit insurance reserve ratio, which decreased to 1.01% of insured deposits on June 30, 2008, to the statutory minimum of 1.15% of insured deposits by December 31, 2013.  In order to implement the restoration plan, the FDIC proposed to change both its risk-based assessment system and its base assessment rates.  For the first quarter of 2009 only, the FDIC increased all FDIC deposit assessment rates by 7 basis points. These new rates range from 12 to 14 basis points for Risk Category I institutions to 50 basis points for Risk Category IV institutions.

 

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Under the FDIC's restoration plan, the FDIC proposed to establish new initial base assessment rates that will be subject to adjustment as described below.  Beginning April 1, 2009, the base assessment rates would range from 12 to 16 basis points for Risk Category I institutions to 45 basis points for Risk Category IV institutions.

 

Changes to the risk-based assessment system include increasing premiums for institutions that rely on excessive amounts of brokered deposits, increasing premiums for excessive use of secured liabilities (including Federal Home Loan Bank advances), lowering premiums for smaller institutions with very high capital levels, and adding financial ratios and debt issuer ratings to the premium calculations for banks with over $10 billion in assets, while providing a reduction for their unsecured debt.

 

Either an increase in the Risk Category of our bank subsidiary or adjustments to the base assessment rates could result in a material increase in our expense for federal deposit insurance. Because the Bank entered into the Consent Order and is designated a “troubled institution” it is in a higher risk category and now pays one of the highest deposit assessment rates.

 

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation, a mixed-ownership government corporation established to recapitalize a predecessor to the Deposit Insurance Fund. The current annualized assessment rate is 1.14 basis points, or approximately .285 basis points per quarter. These assessments will continue until the Financing Corporation bonds mature in 2019.

 

The FDIC implemented a five basis point emergency special assessment on insured depository institutions as of June 30, 2009.  The special assessment was paid on September 30, 2009.  This assessment resulted in a cost of $477,000 and is reflected in our income statement for 2009. The interim rule also authorizes the FDIC to impose an additional emergency assessment of up to 10 basis points in respect to deposits for quarters ended after June 30, 2009 if necessary to maintain public confidence in federal deposit insurance. In addition, during the fourth quarter of 2009, the FDIC approved that all banks prepay three and a quarter years worth of FDIC assessments on December 31, 2009.  The prepayment is based on average third quarter deposits.  The prepaid amount will be amortized over the prepayment period.  Our prepayment was $7.5 million and has now been fully amortized.  

 

On February 7, 2011, the FDIC Board of Directors adopted a final rule (with changes that went into effect beginning with the second quarter 2011), which redefined the deposit insurance assessment base as required by the Dodd-Frank Act; made changes to assessment rates; implemented Dodd-Frank’s Deposit Insurance Fund dividend provisions; and revised the risk-based assessment system for all large insured depository institutions, which are generally those institutions with at least $10 billion in total assets. Nearly all of the 7,600-plus institutions with assets less than $10 billion paid smaller assessments as a result of this final rule. The final rule:

 

Redefined the deposit insurance assessment base as average consolidated total assets minus average tangible equity (defined as Tier I Capital);
Made generally conforming changes to the unsecured debt and brokered deposit adjustments to assessment rates;
Created a depository institution debt adjustment;
Eliminated the secured liability adjustment; and
Adopted a new assessment rate schedule effective April 1, 2011, and, in lieu of dividends, other rate schedules when the reserve ratio reaches certain levels.

 

The FDIC is authorized to set the reserve ratio for the Deposit Insurance Fund annually at between 1.15% and 1.50% of estimated insured deposits. The Dodd-Frank Act mandates that the statutory minimum reserve ratio of the Deposit Insurance Fund increase from 1.15% to 1.35% of insured deposits by September 30, 2020. Banks with assets of less than $10 billion are exempt from any additional assessments necessary to increase the reserve fund above 1.15%.

 

The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which would result in termination of the Bank's deposit insurance.

 

Emergency Economic Stabilization Act (“EESA”). Enacted in October 2008, EESA authorized the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (“TARP”). The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department allocated $250 billion towards the TARP Capital Purchase Program (“CPP”). Under the CPP, Treasury purchased debt or equity securities from participating institutions, including us.

 

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TARP also includes direct purchases or guarantees of troubled assets of financial institutions. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. For details regarding our sale of $20 million of Senior Preferred Shares to the Treasury Department through the CPP, see “Item7 Management’s Discussion and Analysis of Financial Condition and Results of Operation Capital and Note 12 of the Notes to Consolidated Financial Statements.” On April 29, 2013, Treasury sold our Senior Preferred Shares to six funds in an auction.  Following the sale, the full $20 million stated value of our Senior Preferred Shares remains outstanding and our obligation to pay deferred and future dividends, currently at an annual rate of 9%, continues until our Senior Preferred Shares are fully retired.

 

EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase was in place until December 31, 2013, and has since been made permanent by the Dodd-Frank Act.

 

American Recovery and Reinvestment Act (“ARRA”). Enacted in February 2009, ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future CPP recipients, including the Corporation, until the institution has repaid the Treasury. ARRA also permits CPP participants to redeem the preferred shares held by the Treasury Department without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency. We have not redeemed any of the preferred shares we issued to the Treasury.

 

Dodd–Frank Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is intended to affect a fundamental restructuring of federal banking regulation. Among other things, the Dodd-Frank Act creates a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. The Dodd-Frank Act additionally creates a new independent federal regulator to administer federal consumer protection laws.

 

The Dodd-Frank Act requires various federal agencies to promulgate numerous and extensive implementing regulations, which has been ongoing since 2010. It is difficult to predict what impact the implementing regulations will have on community banks like the Bank, including their lending and credit practices, until final regulations are adopted. Although the substance and scope of these forthcoming regulations cannot be determined at this time, it is expected that the implementing regulations, particularly those provisions relating to the new Consumer Financial Protection Bureau, will increase our operating and compliance. Among the provisions that affect the Corporation are the following:

 

Transactions with Affiliates and Insiders. The Dodd-Frank Act applies Section 23A and Section 22(h) of the Federal Reserve Act (governing transactions with insiders) to derivative transactions, repurchase agreements and securities lending and borrowing transactions that create credit exposure to an affiliate or an insider. Any such transactions with affiliates must be fully secured. The current exemption from Section 23A for transactions with financial subsidiaries is eliminated. The Dodd-Frank Act additionally prohibits an insured depository institution from purchasing an asset from or selling an asset to an insider unless the transaction is on market terms and, if representing more than 10% of capital, is approved in advance by the disinterested directors.

 

Consumer Financial Protection Bureau. The Dodd-Frank Act creates a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the ECOA, TILA, RESPA, FCRA, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach Bliley Act ("GLBA") and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB, but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive acts or practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations. Federal preemption of state consumer protection law requirements, traditionally an attribute of the federal savings association charter, has also been modified by the Dodd-Frank Act and now requires a case-by-case determination of preemption by the Office of the Comptroller of the Currency (“OCC”) and eliminates preemption for subsidiaries of a bank. Depending on the implementation of this revised federal preemption standard, the operations of the Bank could become subject to additional compliance burdens in the states in which it operates.

 

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Ability to Repay (“ATR) Rule Qualified Mortgage Loans (“QML”s) – On January 10, 2013, the CFPB issued a final rule implementing the ATR requirement in the Dodd-Frank Act. The rule, among other things, requires lenders to consider a consumer's ability to repay a mortgage loan before extending credit to the consumer and limits prepayment penalties. The rule also establishes certain protections from liability for mortgage lenders with regard to QMLs they originate. For this purpose, the rule defines QMLs to include loans with a borrower debt-to-income ratio of less than or equal to 43% or, alternatively, a loan eligible for purchase by the FNMA or Freddie Mac while they operate under Federal conservatorship or receivership, and loans eligible for insurance or guarantee by the Federal Housing Administration (“FHA”), U.S. Department of Veterans Affairs (“VA”) or U.S. Department of Agriculture (“USDA”). Additionally, QMLs may not: (i) contain excess upfront points and fees; (ii) have a term greater than 30 years; or (iii) include interest-only or negative amortization payments. The rule was effective January 10, 2014, and the Bank is currently evaluating its full impact on the Bank’s mortgage operations.

 

On January 17, 2013, the CFPB issued a series of final rules as part of an ongoing effort to address mortgage servicing reforms and create uniform standards for the mortgage servicing industry. The rules increase requirements for communications with borrowers, address requirements around the maintenance of customer account records, govern procedural requirements for responding to written borrower requests and complaints of errors, and provide guidance around servicing of delinquent loans, foreclosure proceedings and loss mitigation efforts, among other measures. These rules were also effective January 10, 2014 and will likely lead to increased costs to service loans across the mortgage industry. The Corporation is continuing to evaluate these rules and their impact on the Bank’s mortgage operations.

 

Deposit Insurance. The Dodd-Frank Act permanently increases the maximum deposit insurance amount for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2009, and extended unlimited deposit insurance to non interest-bearing transaction accounts through December 1, 2012. The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution. As described above, the Dodd-Frank Act requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. The Dodd-Frank Act also eliminates the federal statutory prohibition against the payment of interest on business checking accounts.

 

Capital. Under the Dodd-Frank Act, the proceeds of trust preferred securities are excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by bank or savings and loan holding companies with less than $15 billion of assets. The legislation also establishes a floor for capital of insured depository institutions that cannot be lower than the standards in effect today, and directs the federal banking regulators to implement new leverage and capital requirements within 18 months that take into account off-balance sheet activities and other risks, including risks relating to securitized products and derivatives.

 

Uncertainty remains as to ultimate impact of the Dodd-Frank Act, but the Board and management anticipates that the provisions summarized above, as well as others set forth in the Dodd-Frank Act, could have an adverse impact on the financial services industry as a whole and our business, results of operations and financial condition.

 

Available Information

 

Our internet website address is http://www.ffsbky.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available or may be accessed free of charge through the Investor Relations section of our internet website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission, or SEC.

 

ITEM 1A. RISK FACTORS

 

The risks identified below, as well as in the other cautionary statements made throughout this report, identify factors that could materially and adversely affect our business, financial condition, and/or operating results.

 

We are subject to a consent order with the FDIC and KDFI and a formal agreement with the Federal Reserve that restrict the conduct of our operations and may have a material adverse effect on our business. 

 

Our good standing with bank regulatory agencies is of fundamental importance to our business. The Bank has operated under the terms of a Consent Order imposed by the FDIC and KDFI since January 2011, which required the Bank to achieve a total capital to risk-weighted assets ratio of 12.00% and a Tier 1 capital to average total assets ratio of 9.00% initially by June 30, 2011, and to develop and implement actions to reduce the amount of classified assets and improve earnings.   The Bank’s total capital to risk-weighted assets ratio exceeded 12.00% at December 31, 2013, and its Tier 1 capital to average total assets ratio at that date was 7.96%.

 

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In April 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval of the Federal Reserve Bank of St. Louis.

 

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a regulatory order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any material failures to comply with our regulatory orders would likely result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business. Compliance with these bank regulatory orders will also increase our operating expense, which could adversely affect our financial performance.

 

Regulatory restrictions have prevented us from paying interest on the junior subordinated debentures that relate to our trust preferred securities since the fourth quarter of 2010. If we cannot pay accrued and unpaid interest on these securities for more than twenty consecutive quarters, we will be in default.

 

Our two wholly owned trust subsidiaries have together issued a total of $18 million of trust preferred securities. The subsidiaries loaned the sales proceeds from these issuances to us in exchange for junior subordinated deferrable interest debentures. During the fourth quarter of 2010, we began deferring interest payments on the junior subordinated debentures relating to our trust preferred securities. Deferring these interest payments resulted in the deferral of distributions on our trust preferred securities. Deferred distributions on our trust preferred securities, which totaled $4.4 million as of December 31, 2013, accrue and compound on each subsequent payment date.

 

If we cannot pay all unpaid deferred distributions on our trust preferred securities for more than twenty consecutive quarters, we will be in default, and the holders of our trust preferred securities would become entitled to payment of the full amount of outstanding principal plus accrued and unpaid interest. If as a result of a default we become subject to any liquidation, dissolution or winding up, holders of the trust preferred securities and holders of our senior preferred stock will be entitled to receive the liquidation amounts to which they are entitled, plus all accrued and unpaid distributions and dividends, before any distribution can be made to the holders of common stock.

 

We may not be able to sell stock to raise additional capital to meet the requirements of our consent order.

 

The Bank has agreed with the FDIC and the KDFI to develop a plan to increase its Tier 1 capital to average total assets to 9.00% and its total capital to risk-weighted asset ratio to 12.00%. We continue to evaluate several specific initiatives to increase our regulatory capital and to reduce our total assets, such as selling loans and raising capital by selling stock.

 

Our ability to raise additional capital by selling stock will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. We may not have access to capital on acceptable terms or at all. If we are unable to raise capital through the sale of stock, we may not have the capital and financial resources needed to operate our business or to meet regulatory requirements, which could have a material adverse effect on our business, financial condition and results of operations.

 

Future sales of our common stock or other securities will dilute the ownership interests of our existing shareholders and could depress the market price of our common stock.

 

We are currently evaluating strategies to meet our capital needs and regulatory requirements including the issuance of additional common shares. We can issue common shares without shareholder approval, up to the number of authorized shares set forth in our articles of incorporation. Our Board of Directors may determine to seek additional capital through the issuance and sale of common shares, preferred shares or other securities convertible into or exercisable for our common shares, subject to limitations imposed by the NASDAQ Stock Market and the Federal Reserve. We may not be able to issue common shares at prices or on terms better than or equal to the prices and terms on which our current shareholders acquired their shares. Our future issuance of any additional common shares or other securities may have the effect of reducing the book value or market price of then-outstanding common shares. Our issuance of additional common or securities convertible into or exercisable for common shares will reduce the proportionate ownership and voting power of our existing shareholders.

 

In addition, if our shareholders sell a substantial number of our common shares or securities convertible into or exercisable for our common shares in the public market, or if there is a perception that such sales are likely to occur, it could cause the market price of our common shares to decline. We cannot predict the effect, if any, that either future sales of a substantial volume of our common shares in the market, or the potential for large volumes of sales in the market, would have on the market price of our common shares. However, if the market price of our common shares declines, it could impair our ability to raise capital through sales of stock.

 

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We may not be able to realize the value of our tax losses and deductions.

 

Due to our losses, we have a net operating loss carry-forward of $13.6 million, an AMT credit carry-forward of $196,000, and other net deferred tax assets of $8.8 million. In order to realize the benefit of these tax losses, credits and deductions, we will need to generate substantial taxable income in future periods. We established a 100% valuation allowance for all deferred tax assets in 2010. Our issuance of new shares to raise additional capital could trigger a change in control, as defined by Section 382 of the Internal Revenue Code, which could limit our ability to fully utilize our net operating loss carry-forwards, credit loss carry-forwards, and other net deferred tax assets.

 

Our business has been and may continue to be adversely affected by adverse business and economic conditions both in our markets and in general.

 

Ongoing weakness in business and economic conditions generally or specifically in our markets has had, and could continue to have one or more of the following adverse effects on our business:

 

·A decrease in the demand for loans and other products and services offered by us;
·A decrease in the value of collateral securing our loans;
·An impairment of certain intangible assets, such as core deposit intangibles; and
·An increase in the number of customers who become delinquent, file for protection under bankruptcy laws or default on their loans.

 

The general business environment has had an adverse effect on our business during the past five years. Although conditions have improved, there can be no assurance that such improvement can be sustained. In addition, the improvement of certain economic indicators, such as real estate asset values and rents and unemployment, may vary between geographic markets and may continue to lag behind improvement in the overall economy. These economic indicators typically affect the real estate and financial services industries, in which we have a significant number of customers, more significantly than other economic sectors. Furthermore, we have a substantial lending business that depends upon the ability of borrowers to make debt service payments on loans. Should unemployment or real estate asset values fail to recover for an extended period of time, or if economic conditions worsen or remain volatile, our business, financial condition or results of operations could be adversely affected.

 

Our designation as a “troubled institution” limits our sources of funding. If we cannot borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers.

 

Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies don’t work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers. Our Asset Liability Committee follows established board-approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and medium and long-term debt, which includes Federal Home Loan Bank advances that are collateralized with mortgage-related assets.

 

As long as the Consent Order remains in effect, the Bank will not be able to rely on brokered deposits (including deposits through the CDARs program) for its liquidity needs. The designation of the Bank as a "troubled institution" in connection with the issuance of the Consent Order prohibits the Bank from accepting new brokered deposits or renewing or rolling over any existing brokered deposits at the Bank. The Bank is also restricted in the amount of interest it may pay on core deposits. See Part I, Item I –Business – Regulation – Regulatory Capital Requirements for a description of the Bank's interest rate restrictions. The Bank's designation as a "troubled institution" may also limit the amount of additional advances available from the FHLB. The Bank currently has sufficient collateral to borrow, approximately, an additional $20.2 million in advances from the FHLB.

 

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including the sale or securitization of loans, the ability to acquire additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions. If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital. For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

We may not be able to meet the cash flow requirements and operating cash needs of the Corporation due to restrictions on the Bank’s ability to pay dividends.

 

The Corporation is a separate and distinct legal entity from the Bank. Historically, the Corporation has received substantially all of its revenue in the form of dividends from the Bank. Due to the losses we have incurred in recent years, the Bank is not allowed to pay any dividends to the Corporation without prior regulatory approval. At December 31, 2013, the Corporation’s liquid assets consisted of $147,000 in cash. With no sources of revenue other than dividends paid by the Bank, the Corporation will be constrained to meet to meet its cash flow requirements and operating cash needs.

 

17
 

 

Regulatory and contractual restrictions currently prevent us from paying cash dividends on our common stock.

 

We historically paid quarterly cash dividends on our common stock until we suspended dividend payments in December 2009. We will not be able to pay cash dividends on our common stock in the future until we first pay all unpaid dividends on the senior preferred stock and all deferred distributions on our trust preferred securities.

 

The dividend payable on our outstanding senior preferred stock increased in January 2014.

 

We currently have issued and outstanding $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (“senior preferred stock”). On January 9, 2014, the dividends accruing on the senior preferred stock increased from 5% (approximately $1 million annually) to 9% (approximately $1.8 million annually). Depending on market conditions and our financial performance, this increase in dividends could adversely impact our capital, liquidity and earnings available to common shareholders.

 

Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations.

 

We maintain an allowance for loan losses at a level we believe is adequate to absorb any probable incurred losses in our loan portfolio based on historical loan loss experience, specific problem loans, value of underlying collateral and other relevant factors. If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual loan losses, which would require us to increase our provision for loan losses and adversely affect our operating results. Our estimates are subjective and their accuracy depends on the outcome of future events. Changes in economic, operating and other conditions that are generally beyond our control could cause the financial condition of our borrowers to deteriorate and our actual loan losses to increase significantly. In addition, bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies have from time to time required us to increase our provision for loan losses or to recognize further loan charge-offs when their judgment has differed from ours, and they may do so in the future, which could have a material negative impact on our operating results.

 

Our relatively high concentration of loans collateralized by real estate increases our risk if real estate values decline.

 

Approximately 90% of our loan portfolio as of December 31, 2013 was comprised of loans collateralized by real estate. An adverse change in the economy such as we have recently experienced which depresses values of real estate in our primary markets could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. When real estate values decline, it becomes more likely that we would be required to increase our allowance for loan losses as we did in 2011 and 2010. If during a period of depressed real estate values we are required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

 

The Volcker Rule collateralized loan obligation provisions could result in adverse consequences for us, including lower earnings, lower tangible capital and/or lower regulatory capital.

 

The so-called “Volcker Rule” provisions of the Dodd-Frank Act restrict the ability of affiliates of insured depository institutions, such as the Bank, to sponsor or invest in private funds or to engage in certain types of proprietary trading. The Federal Reserve adopted final rules implementing the Volcker Rule in December 2013. We are continuing to evaluate the impact of the Volcker Rule and the final rules adopted thereunder. While there may be additional regulatory guidance, similar to the interim final rule issued on January 14, 2014, that provided relief to banks that hold certain Trust Preferred Collateralized Debt Obligations, or a legislative ruling that, if they occur, would eliminate the requirement that we dispose of these securities prior to July 2015, we may be able to develop structural solutions that can be applied to our collateralized loan obligation (‘CLO”) securities to bring them into compliance with the final Volcker Rule.

 

At December 31, 2013, we own $34.5 million of CLO securities with a weighted average yield of 2.3% that are subject to the Volcker Rule. If we decide to sell or are required to sell these securities, our future net interest income and regulatory capital ratios could be adversely impacted.

 

Our profitability depends significantly on local economic conditions.

 

Because most of our business activities are conducted in central Kentucky, and most of our credit exposure is in that region, we are at risk from adverse economic or business developments affecting this area, including declining regional and local business activity, a downturn in real estate values and agricultural activities and natural disasters. To the extent the central Kentucky economy remains weak, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio will likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by economic conditions or a localized natural disaster. The economic downturn has had a negative impact on our financial results and may continue to have a negative impact on our business, financial condition, results of operations and future prospects.

 

18
 

 

Our target market is small to medium-sized businesses, who may have fewer resources to weather a downturn in the economy.

 

Our strategy includes lending to small and medium-sized businesses and other commercial enterprises. Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small or medium-sized business often depends on the management talents and efforts of one person or a small group, and the death, disability or resignation of one or more key individuals could have a material adverse impact on the business and its ability to repay our loan. A continued economic downturn could have a more pronounced negative impact on our target market, which could cause us to incur substantial credit losses that could materially harm our operating results.

 

Our profitability is vulnerable to fluctuations in interest rates.

 

Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially

on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Factors beyond our control, such as inflation, recession, unemployment, and money supply may also affect interest rates. If as a result of decreasing interest rates, our interest-earning assets mature or re-price more quickly than our interest-bearing liabilities in a given period, then our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or re-price more quickly than interest-earning assets in a given period as a result of increasing interest rates.

 

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to re-pricing before assets become subject to re-pricing. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates.

 

The economic downturn that began in 2008 triggered a series of cuts in interest rates. Since fiscal 2010, the Federal Open Market Committee has kept the target federal funds rate between 0% and 0.25%. The current low interest rate environment has compressed our net interest spread and reduced our spread-based revenues. In addition, there may be an increase in prepayments on loans, particularly if the borrowers refinance their adjustable-rate loans to lower fixed rate loans, which could reduce net interest income and adversely affect our financial results.

 

We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.

 

We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds and other mutual funds. Our competition in making loans comes principally from other commercial banks, credit unions, mortgage banking firms and consumer finance companies. Competition is increasing in our markets, which may adversely affect our ability to maintain our market share.

 

Competition in the banking industry may also limit our ability to attract and retain banking customers. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete. Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:

 

·offer higher interest rates on deposits and lower interest rates on loans than we can;
·offer a broader range of services than we do;
·maintain more branch locations than we do; and
·mount extensive promotional and advertising campaigns.

 

In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking customers may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.

 

19
 

 

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect our financial performance and our ability to implement our growth and operating strategies.

 

We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, which is described under “Item 1 Business – Regulation.” Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance fund and the banking system as a whole, not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably. Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations and policies or to maintain our capital requirements affects our ability to pay dividends on common stock, our ability to grow through the development of new offices and our ability to make acquisitions. We currently may not pay a dividend from the Bank to the Corporation without the prior written consent of our primary banking regulators, which limits our ability to pay dividends on our common stock. These limitations may also prevent us from successfully implementing our growth and operating strategies.

 

In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans. Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board, the Consumer Financial Protection Bureau and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.

 

Recent legislation regarding the financial services industry will increase our cost of regulatory compliance and have a significant adverse effect on our operations.

 

The Dodd-Frank Act implemented significant changes to the U.S. financial system, including among other things:

 

·new requirements on banking, derivative and investment activities, including the repeal of the prohibition on the payment of interest on business demand accounts and debit card interchange fee requirements;
·the creation of a new Consumer Financial Protection Bureau with supervisory authority;
·the creation of a Financial Stability Oversight Council with authority to identify institutions and practices that might pose a systemic risk;
·provisions affecting corporate governance and executive compensation of all companies subject to the reporting requirements of the Securities and Exchange Act of 1934, as amended; and
·a provision that would broaden the base for FDIC insurance assessments.

 

It is difficult to gauge the ultimate impact of certain provisions of the Dodd-Frank Act because many implementing regulations have only recently taken effect, and other regulations have yet to be adopted. For example, the CFPB is given the power to adopt new regulations to protect consumers and is given control over existing consumer protection regulations adopted by federal banking regulators. The effect on our Bank of new regulations and the enforcement of existing regulations by a new agency is not yet known.

 

The provisions of the Dodd-Frank Act and any rules adopted to implement those provisions as well as any additional legislative or regulatory changes may impact the profitability of our business activities and costs of operations, require that we change certain of our business practices, materially affect our business model or affect retention of key personnel, require us to raise additional regulatory capital, including additional Tier 1 capital, and could expose us to additional costs (including increased compliance costs). These and other changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our results of operations or financial condition.

 

20
 

 

Our information systems may experience an interruption or security breach.

 

Failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers, including as a result of cyber attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. As a large financial institution, we depend on our ability to process, record and monitor a large number of customer transactions on a continuous basis. As customer, public and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions and breakdowns. Our business, financial, accounting, data processing systems or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors including events that are wholly or partially beyond our control. For example, there could be sudden increases in customer transaction volume; electrical or telecommunications outages; natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and, as described below, cyber attacks. Although we have business continuity plans and other safeguards in place, our business operations may be adversely affected by significant and widespread disruption to our physical infrastructure or operating systems that support our businesses and customers. 

 

Information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, the proliferation of identity theft, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As noted above, our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. In addition, to access our products and services, our customers may use personal smart phones, tablet PC’s, and other mobile devices that are beyond our control systems. Although we believe we have robust information security procedures and controls, our technologies, systems, networks, and our customers’ devices may become the target of cyber attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our customers’ confidential, proprietary and other information or that of our customers, or otherwise disrupt the business operations of ourselves, our customers or other third parties.

 

Third parties with which we do business or that facilitate our business activities, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Although to date we have not experienced any material losses relating to cyber attacks or other information security breaches, there can be no assurance that we will not suffer such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats and the prevalence of Internet and mobile banking. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and customers, or cyber attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in customer attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our business, results of operations or financial condition.

 

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer losses from operational risk in the future.

 

Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions. However, there can be no assurance that we will be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

 

We process large volumes of transactions on a daily basis and are exposed to numerous types of operation risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

 

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.

 

ITEM 1B. Unresolved Staff Comments

 

We have no unresolved SEC staff comments.

 

21
 

 

ITEM 2. PROPERTIES

 

Our executive offices and principal support are located at 2323 Ring Road in Elizabethtown, Kentucky. Our operational functions are located at 2323 Ring Road and 101 Financial Place in Elizabethtown, Kentucky. All of our banking centers are located in Kentucky. The location of our 17 full-service banking centers and an operations building, whether owned or leased, and their respective approximate square footage are described in the following table.

 

      APPROXIMATE 
   OWNED OR  SQUARE 
BANKING CENTERS IN KENTUCKY  LEASED  FOOTAGE 
        
ELIZABETHTOWN        
2323 Ring Road  Owned   57,295 
325 West Dixie Avenue  Owned   5,880 
2101 North Dixie Avenue  Owned   3,150 
101 Financial Place  Owned   20,619 
RADCLIFF        
475 West Lincoln Trail  Owned   2,728 
1671 North Wilson Road  Owned   3,479 
BARDSTOWN        
401 East John Rowan Blvd.  Owned   4,500 
315 North Third Street  Owned   1,271 
MUNFORDVILLE        
925 Main Street  Owned   2,928 
SHEPHERDSVILLE        
395 N. Buckman Street  Owned   7,600 
1707 Cedar Grove Road,  Suite 1  Leased   3,425 
MT. WASHINGTON        
279 Bardstown Road  Owned   6,310 
BRANDENBURG        
416 East Broadway  Leased   4,395 
FLAHERTY        
4055 Flaherty Road  Leased   1,216 
LOUISVILLE        
11810 Interchange Drive  Owned   4,675 
3650 South Hurstbourne Parkway  Owned   4,428 
12629 Taylorsville Road  Owned   3,479 
301 Blakenbaker Parkway  Owned   3,479 

 

ITEM 3.LEGAL PROCEEDINGS

 

On June 21, 2012, a borrower and its guarantor filed a lawsuit filed against the First Financial Savings Bank in Jefferson County, Kentucky circuit court alleging fraud, negligent misrepresentation, failure to fund various loans, breach of fiduciary duty and breach of the duty of good faith and fair dealing. Plaintiffs sought compensatory and punitive damages, pre-judgment interest, costs and equitable relief. The Bank filed a counterclaim to enforce the commercial lending documents against the borrower and its guarantor. On September 13, 2013, the court granted a partial summary judgment in favor of the Bank on all its counterclaims. Subsequently, the plaintiffs and the Bank reached a settlement resolving all issues between themselves, and the parties’ claims and counterclaims were dismissed on November 26, 2013.

 

On February 11, 2013, seven plaintiffs filed a lawsuit against the Bank and two co-defendants in federal district court in Louisville, Kentucky. On the defendant parties’ motion, plaintiffs’ complaint was dismissed on November 19, 2013. On November 22, 2013, the same plaintiffs filed a complaint in Kentucky state courts in an action styled William P. Miller, et al. v. First Federal Savings Bank of Elizabethtown, Inc., et. al., Civil Action No. 13-CI-1955. Plaintiffs invested in two companies organized by one of the co-defendants, which companies purchased commercial property in Addison, Illinois. Plaintiffs also guaranteed loans made by the Bank to the two companies in the principal amount of $3,125,622.74. Plaintiffs allege that the Bank and the co-defendants violated Kentucky’s statutes; committed common law fraud, negligence, and negligence per se; and breached fiduciary duties. Plaintiffs seek to rescind the lending documents and recover damages, including punitive damages. The Bank filed a counterclaim to enforce the guaranty contracts. Thereafter, all the defendant parties filed motions to dismiss, which are pending. In addition, simultaneously with the earlier federal court action, the Bank had filed its own foreclosure lawsuit in Illinois state courts seeking to enforce its lending documents against the borrower and to sell the subject real estate collateral. First Federal Savings Bank v. Addent, LLC, et. al., No. 2013-CH-000570 (Illinois Circuit Court, DuPage County). On January 6, 2014, the Illinois court entered judgment in the Bank’s favor. The Bank intends to vigorously defend its interests in the Kentucky lawsuit and to collect from the guarantors, and to pursue to conclusion the Illinois foreclosure action in order to sell the collateral real estate.

 

ITEM 4.MINE SAFETY DISCLOSURES

 

Not applicable.

 

22
 

 

PART II

 

ITEM 5.MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

(a)   Market Information

 

Our common stock is traded on the Nasdaq Global Market (“NASDAQ”) under the symbol “FFKY”. The following table shows the high and low closing prices of our Common Stock and the dividends paid.

 

       Quarter Ended     
2013:  3/31   6/30   9/30   12/31 
                 
High  $3.54   $3.53   $4.00   $5.95 
Low   2.01    2.83    3.31    3.83 
Cash dividends   -    -    -    - 
                     
2012:  3/31   6/30   9/30   12/31 
                 
High  $4.10   $4.05   $3.65   $3.00 
Low   1.50    2.05    1.61    1.80 
Cash dividends   -    -    -    - 

 

(b)   Holders

 

At December 31, 2013, the number of shareholders was approximately 1,421.

 

(c)   Dividends

 

Historically, the Corporation has depended upon dividends it received from the Bank to pay cash dividends to its shareholders. Currently, the Bank cannot pay such dividends without prior approval of the FDIC and KDFI. For additional discussion regarding dividends, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity.”

 

(d)  Securities Authorized for Issuance Under Equity Compensation Plans

 

The following table summarizes the securities authorized for issuance under our equity compensation plans as of December 31, 2013. We have no equity compensation plans that have not been approved by our shareholders.

 

   Number of securities             
   to be issued   Weighted-average   Number of   Number of securities 
   upon exercise of   exercise price of   securities to be   remaining available for 
   outstanding options,   outstanding options,   issued upon vesting   future issuance under 
Plan category  warrants and rights   warrants and rights   of restricted shares   equity compensation plans 
Equity compensation plans approved by security holders   376,300   $3.13    127,835    179,130 

 

See Note 17 of the Notes to Consolidated Financial Statements for additional information required by this item.

 

(e)Issuer Purchases of Equity Securities

 

We did not repurchase any shares of our common stock during the quarter ended December 31, 2013.

 

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(f)Performance Graph

 

The graph below compares the cumulative total return on the common stock of the Corporation between December 31, 2008 through December 31, 2013 with the cumulative total return of the NASDAQ Composite Index and a peer group index over the same period. Dividend reinvestment has been assumed. The graph was prepared assuming that $100 was invested on December 31, 2008 in the common stock of the Corporation and in the indexes. The stock price performance shown on the graph below is not necessarily indicative of future stock performance.

 

 

First Financial Service Corporation

 

 

   Period Ending 
Index  12/31/08   12/31/09   12/31/10   12/31/11   12/31/12   12/31/13 
First Financial Service Corp.   100.00    79.00    35.49    13.34    17.18    42.81 
NASDAQ Composite   100.00    145.36    171.74    170.38    200.63    281.22 
FFKY Peer Group Index*   100.00    91.67    118.31    100.07    123.42    169.09 

 

*FFKY Peer Group index consists of BB&T Corp. (BBT), Fifth Third Bancorp (FITB), First Horizon National Corp. (FHN), Huntington Bancshares Inc. (HBAN), KeyCorp (KEY), M&T Bank Corp. (MTB), PNC Financial Services Group (PNC), Regions Financial Corp. (RF), SunTrust Banks Inc. (STI), Synovus Financial Corp. (SNV), Zions Bancorp.  (ZION)

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA

 

(Dollars in thousands, except per share data)  At December 31, 
   2013   2012   2011   2010   2009 
Financial Condition Data:                         
Total assets  $858,617   $1,007,062   $1,228,778   $1,319,507   $1,209,504 
Total loans (1)   466,862    524,835    737,365    884,531    994,926 
Allowance for loan losses (2)   9,576    17,265    17,464    22,665    17,719 
Investments   269,282    354,131    313,801    196,153    46,931 
Deposits   783,487    922,620    1,122,794    1,173,908    1,049,815 
Borrowings   30,389    30,596    45,736    70,532    72,245 
Stockholders' equity   32,819    44,372    53,463    71,311    85,132 
                          
Number of:                         
Offices   17    17    22    22    22 
Full time equivalent employees   273    274    316    325    324 

 

   Year Ended December 31, 
   2013   2012   2011   2010   2009 
Operations Data:                         
Interest income  $32,422   $41,721   $53,529   $59,565   $58,856 
Interest expense   8,828    15,359    20,700    23,485    21,792 
Net interest income   23,594    26,362    32,829    36,080    37,064 
Provision for loan losses   (3,086)   6,797    21,210    16,881    9,524 
Non-interest income   8,092    10,959    474    7,304    8,519 
Non-interest expense   34,028    38,935    38,237    34,119    43,917 
Income tax expense/(benefit)   3    (18)   (2,983)   1,786    (1,149)
Net income/(loss) attributable to common shareholders   (313)   (9,447)   (24,215)   (10,456)   (7,741)
                          
Earnings/(loss) per common share:                         
Basic   (0.06)   (1.98)   (5.11)   (2.21)   (1.65)
Diluted   (0.06)   (1.98)   (5.11)   (2.21)   (1.65)
Book value per common share   2.63    5.12    7.07    10.89    13.87 
Dividends paid per common share   -    -    -    -    0.43 
                          
Return on average assets   .08%   (.75)%   (1.85)%   (.74)%   (.61)%
Average equity to average assets   4.15%   4.42%   5.19%   6.77%   8.56%
Return on average equity   1.97%   (16.93)%   (35.52)%   (10.99)%   (7.18)%
Efficiency ratio (3)   107%   104%   115%   79%   70%

 

 

(1)Includes loans held for sale in probable branch divestiture and probable loan sale for 2011
(2)Includes allowance allocated to loans held for sale in probable branch divestiture for 2011
(3)Excludes goodwill impairment in 2009

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of our balance sheets and statements of operations. This section should be read in conjunction with our Consolidated Financial Statements and accompanying Notes and other detailed information.

 

OVERVIEW

 

Net loss attributable to common shareholders for the year ended December 31, 2013 was $313,000 or $0.06 per diluted common share compared to a net loss attributable to common shareholders of $9.4 million or $1.98 per diluted common share for the same period in 2012.

 

While still elevated, the level of non-performing assets is now at manageable levels not seen since the second quarter of 2009. Compared to December 31, 2012, non-performing loans declined $4.0 million or 19%, non-performing assets declined $13.2 million or 30%, and classified and criticized assets declined $19.4 million or 26%. We sold thirty-six OREO properties totaling $17.1 million during the 2013 period. Non-performing assets were $30.6 million or 3.56% of total assets at December 31, 2013 compared to $43.8 million or 4.35% of total assets at December 31, 2012. The decrease in non-performing assets is mainly attributable to a $10.6 million decrease in real estate acquired through foreclosure. Six properties totaling $17.0 million make up 55% of the total non-performing assets. The properties range in value from $931,000 to $6.2 million and have an aggregate specific reserve for $1.4 million.

 

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We anticipate that our level of real estate acquired through foreclosure will continue to decrease over the next several quarters as we continue to sell these properties, while inflow has slowed down substantially compared to 2010, 2011 and 2012. The lower values on the appraisals and reviews of properties appraised within 2013 resulted in $2.2 million in write downs on OREO compared to $5.1 million in total write downs recorded during 2012. We believe that we have written down OREO values to levels that will facilitate their liquidation, as indicated by recent sales.

 

As economic conditions improved and collateral values stabilized in 2012 and 2013, our provision for loan losses during this period has been much lower than in 2011. The allowance for loan losses to total loans was 2.05% at December 31, 2013 while net charge-offs to average loans totaled .93% for 2013 compared to 1.06% for 2012 and 3.25% in 2011. Net charge-offs for 2013 were driven by charging off the specific reserves on three large commercial real estate relationships. Non-performing loans were $17.4 million or 3.73% of total loans at December 31, 2013 compared to $21.5 million, or 4.09% of total loans for December 31, 2012. The allowance for loan losses to non-performing loans, which excludes restructured loans on accrual status, was 55% at December 31, 2013 compared to 80% at December 31, 2012.

 

The net interest margin improved to 2.82% for the year ended December 31, 2013 compared to 2.55% for the year ended December 31, 2012. The main driver to the improvement in the net interest margin for 2013 compared to 2012 is the intentional decrease of $179.8 million in average certificates of deposits that resulted in a reduction of $5.1 in related interest expense during the period. We continue to anticipate modest improvement to the net interest margin over the next several quarters, as we continue to focus on restructuring the balance sheet to decrease our cost of funds, improve interest income, and reduce our interest rate risk exposure. However, the balance sheet restructuring may be impacted by the acceleration of loan repayments. Low interest rates, coupled with a competitive lending environment, continue to prove to be challenging.

 

REGULATORY MATTERS

 

Since January 2011, the Bank has operated under Consent Orders with the FDIC and KDFI. In the most recent Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date the Bank has not received such a written direction. The Consent Order also prohibits the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and requires the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. A copy of the most recent Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

 

At December 31, 2013, the Bank’s Tier 1 capital ratio was 7.96% and the total risk-based capital ratio was 13.48%, compared to the minimum 9.00% and 12.00% capital ratios required by the Consent Order and compared to 6.53% and 12.21% at December 31, 2012. For the fifth consecutive quarter, we have achieved and maintained the required total risk-based capital ratio. Our Tier 1 capital ratio also steadily improved, but has yet to reach the Consent Order minimum. We are continuing to explore strategic alternatives to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the Consent Order.

 

One such strategic alternative was to sell branches located outside of our core market. On July 6, 2012, we sold our four banking centers in Southern Indiana, receiving a 3.65% premium on the $102.3 million of consumer and commercial deposits at closing. The buyer assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received no premium or discount. On July 6, 2012, we also sold approximately $30.4 million in performing loans at a discount of 0.80%. Other assets sold included vault cash of $367,000 and fixed assets of $887,000. The Indiana branch sale resulted in a gain of $3.1 million.

 

Our plans for 2014 include the following:

 

·Continuing to evaluate available strategic options to meet regulatory capital levels and all other requirements of our Consent Order.

 

·Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner.

 

·Continuing to reduce expenses and improve our ability to operate in a profitable manner.

 

·Continuing to reduce our lending concentration in commercial real estate through expected maturities and repayments. We have implemented loan diversification initiatives in place that we believe should improve the loan portfolio. Increased emphasis on retail lending, small business lending and Small Business Administration (“SBA”) lending are all expected to boost non-interest fee income. We have already reallocated resources that that we believe should contribute to the successful execution of all of these efforts. Our mortgage and consumer lending operations have maintained strong credit quality metrics throughout the economic downturn.

 

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·Enhancing our resources dedicated to special asset dispositions, both on a permanent and temporary basis, to accelerate our efforts to dispose of problem assets. Our objective is reduce the involvement of our commercial lenders in the special asset area, allowing them to shift their focus to their existing loan customer base and generate new business that supports our diversification efforts while stemming some of the loan roll-off.

 

·Continuing to reduce our inventory of other real estate owned properties.

 

While our concerns about economic conditions in our market continue, we are working towards our long-range objectives including building additional core customer relationships, maintaining sufficient liquidity and capital levels, improving shareholder value, remediating our problem assets and building upon the sustained success of our retail franchise.

 

CRITICAL ACCOUNTING POLICIES

 

Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could change as our estimates, assumptions, and judgments change. Certain policies inherently rely more heavily on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. We consider our critical accounting policies to include the following:

 

Allowance for Loan LossesWe maintain an allowance we believe to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Management, which is comprised of senior officers and certain accounting and credit associates, evaluates the allowance for loan losses on a monthly basis.  We estimate the amount of the allowance using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, and current economic conditions.  While we estimate the allowance for loan losses based in part on historical losses within each loan category, estimates for losses within the commercial real estate portfolio depend more on credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. 

 

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience for certain categories adjusted for current factors. Allowance estimates are developed with actual loss experience adjusted for current economic conditions. Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.

 

Based on our calculation, an allowance of $9.6 million or 2.05% of total loans was our estimate of probable incurred losses within the loan portfolio as of December 31, 2013.  Accordingly, we recorded a net reversal of provision for loan losses on the income statement of $3.1 million for the 2013 period.  If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could materially increase.

 

Impairment of Investment Securities We review all unrealized losses on our investment securities to determine whether the losses are other-than-temporary. We evaluate our investment securities on at least a quarterly basis, and more frequently when economic or market conditions warrant, to determine whether a decline in their value below amortized cost is other-than-temporary. We evaluate a number of factors including, but not limited to: valuation estimates provided by investment brokers; how much fair value has declined below amortized cost; how long the decline in fair value has existed; the financial condition of the issuer; significant rating agency changes on the issuer; and management’s assessment that we do not intend to sell or will not be required to sell the security for a period of time sufficient to allow for any anticipated recovery in fair value.

 

At December 31, 2013, we own Collateralized Loan Obligations (“CLOs”), subject to the Volcker Rule (Rule), with an amortized cost of $34.5 million and an unrealized loss of $635,000. Absent changes to the Rule, we could be required to dispose of these securities prior to July 2015. We believe the unrealized loss reflected results not from credit risk but from interest rate changes and to the uncertainty created by the Rule. We did not intend to sell these securities at year end 2013 and we believe it is more likely than not that we will not be required to sell these securities prior to their recovery. We expect there may be additional regulatory guidance, similar to the interim final rule issued on January 14, 2014 that provided relief to banks to hold certain Trust Preferred Collateralized Debt Obligations, or a legislative ruling that, if they occur, would eliminate the requirement that we dispose of these securities prior to July 2015, or that we will be able to develop structural solutions that can be applied to our CLO securities to bring them into compliance with the final Volcker Rule. In February and March of 2014, we sold 4 of our CLOs to confirm their marketability and evaluate our assessment about their market values. These CLOs had an amortized cost of $14.4 million and an unrealized loss of $233,000 at year end 2013. We realized a loss of $83,000 on these sales. This loss is not reflected in our 2013 financial statements as it is not significant. We do not currently intend to sell additional CLOs and continue to believe that it is more likely than not that we will not be required to sell these securities prior to their recovery.

 

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The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the possibility for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the cost basis of the security is written down to fair value and a charge to earnings is recognized for the credit component and the non-credit component is recorded to other comprehensive income.

 

Real Estate OwnedThe estimation of fair value is significant to real estate owned-acquired through foreclosure. These assets are recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets when available. The value may be subsequently reduced if the estimated fair value declines below the value recorded at the time of foreclosure. Appraisals are performed at least annually, if not more frequently. Typically, appraised values are discounted for the projected sale below appraised value in addition to the selling cost. With certain appraised values where management believes a solid liquidation value has been established, the appraisal has been discounted only by the selling cost. We have dedicated a team of associates and management focused on the continued resolution and work out of OREO. Appropriate policies, committees and procedures have been put in place to ensure the proper accounting treatment and risk management of this area.

 

Income Taxes The provision for income taxes is based on income/(loss) as reported in the financial statements. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future. The deferred tax assets and liabilities are computed based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. An assessment is made as to whether it is more likely than not that deferred tax assets will be realized. A valuation allowance is established when necessary to reduce deferred tax assets to an amount more likely than not expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. Tax credits are recorded as a reduction to the tax provision in the period for which the credits may be utilized.

 

A full valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a full valuation allowance, we considered various factors including our five year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and operating results in 2013, 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order. Based on this assessment, we concluded that a valuation allowance was necessary at December 31, 2013 and December 31, 2012.

 

RESULTS OF OPERATIONS

 

Net loss attributable to common shareholders for the year ended December 31, 2013 was $313,000 or $0.06 per diluted common share compared to a net loss attributable to common shareholders of $9.4 million or $1.98 per diluted common share for the same period in 2012. Factors contributing to the net loss for 2013 included the following

 

·declining net interest income mainly driven by a decline of $8.8 million in loan interest income as a result of a decline of $139.3 million in average loan balances combined with the continuing low interest rate environment;
·a decrease in net gains of $2.0 million on the sale of securities available for sale, and
·a decline of $536,000 in securities interest income mainly due to the continued low interest rate environment.

 

These factors were partially offset by the following:

 

·a $9.9 million decrease in provision for loans losses due to the improvement in specific reserves allocated to several relationships based upon improved credit quality, declining historical loss rates, a reduction in the loans migrating downward in risk grade classification and the decline in the size of the loan portfolio;
·a decline of $6.1 million in deposit interest expense mainly as a result of an intentional decrease of $179.8 million in average certificates of deposits and other time deposits balances combined with a decline of 39 basis points in the cost of these deposits;
·a $3.7 million decrease in write downs and sale losses on other real estate owned (“OREO”),
·a $2.5 million decrease in real estate acquired through foreclosure expense and loan expense, the result of lower loan workout and loan portfolio management expenses as our level of non-performing assets has decreased, and
·a $635,000 increase in gains recorded on the sale of OREO.

 

Net loss attributable to common shareholders was also increased by dividends accrued on preferred shares. Our book value per common share decreased from $5.12 at December 31, 2012 to $2.63 at December 31, 2013 largely as a result of unrealized losses on available-for-sale securities driven by increased market rates, compared to unrealized gains in 2012.

 

Net loss attributable to common shareholders for the period ended December 31, 2012 was $9.4 million or $1.98 per diluted common share compared to net loss attributable to common shareholders of $24.2 million or $5.11 per diluted common share for the same period in 2011. Factors contributing to the net loss for 2012 included the following:

 

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·declining net interest income driven by a decline in earning assets and interest bearing liabilities and impacted by the continuing low interest rate environment;
·write downs and losses on OREO totaling $6.1 million;
·a $1.5 million fee paid to terminate a property investment and management agreement on a residential development held as OREO, and
·$1.5 million in penalties for prepaying FHLB advances, which prepayment decreased our cost of funds and improved net interest income.

 

These factors were partially offset by the following:

 

·a $14.4 million decrease in provision for loans losses;
·a gain of $3.1 million on the sale of our four Indiana banking centers;
·a net gain of $2.3 million on the sale of securities available for sale, as we increased our cash position to prepare for the branch sale and restructured our balance sheet;
·gains of $1.3 million on the sale of real estate acquired through foreclosure;
·a decrease of $991,000 in FDIC insurance premiums, and
·a gain of $175,000 on the sale of our last lot held for development.

 

Net loss attributable to common shareholders was also increased by dividends accrued on preferred shares. Our book value per common share decreased from $7.07 at December 31, 2011 to $5.12 at December 31, 2012.

 

Net Interest Income – The largest component of our net income is our net interest income. Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

 

The majority of our assets are interest-earning and our liabilities are interest-bearing.  Accordingly, changes in interest rates may impact our net interest margin. The Federal Open Markets Committee (“FOMC”) uses the federal funds rate, which is the interest rate used by banks to lend to each other, to influence interest rates and the national economy. Changes in the federal funds rate have a direct correlation to changes in the prime rate, the underlying index for most of the variable-rate loans we issue.  The FOMC has held the target federal funds rate at a range of 0-25 basis points since December 2008.  As we are asset sensitive, continued low rates will negatively impact our earnings and net interest margin.

 

The large decline in the volume of interest earning assets and the change in the mix of interest earning assets reduced net interest income by $2.8 million for 2013 compared to the prior year period. Average interest earning assets decreased $201.2 million for 2013 compared to 2012 primarily driven by a decrease in average loans. The decrease in average loans was due to loans sold in connection with the branch sale during the third quarter of 2012, loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to OREO properties. In addition, due to the higher regulatory capital ratios required by our consent order, we elected not to replace much of this loan run-off in accordance with our efforts to reduce our level of assets and risk-weighted assets. The average loan yield was 5.18% for 2013 compared to an average loan yield of 5.42% for 2012.

 

Average interest bearing liabilities decreased $206.9 million for the 2013 period compared to 2012 driven by a decrease in average certificates of deposit and NOW and money market account balances. The decrease in average deposits was due to the sale of deposits included in the branch sale during the third quarter of 2012 and an intentional decrease in certificates of deposit as we focus on restructuring the balance sheet to decrease our cost of funds and improve net interest income.

 

The tax equivalent yield on earning assets averaged 3.86% for 2013 compared to 4.01% for 2012. The decline in the yields on interest earning assets were more than offset by a decrease in our cost of funds, which averaged 1.13% for 2013 compared to an average cost of funds of 1.56% for 2012. Net interest margin as a percent of average earning assets increased 27 basis points to 2.82% for the year ended December 31, 2013 compared to 2.55% for 2012. We anticipate being able to continue taking advantage of the continued low interest rate environment to reduce our cost of funds, as term deposits re-price at more favorable terms.

 

Comparative information regarding net interest income follows:

 

               2013/2012   2012/2011 
(Dollars in thousands)  2013   2012   2011   Change   Change 
Net interest income, tax equivalent basis  $23,856   $26,701   $33,371    -10.7%   -20.0%
Net interest spread   2.73%   2.45%   2.74%   28bp   (29)bp
Net interest margin   2.82%   2.55%   2.85%   27bp   (30)bp
Average earnings assets  $846,957   $1,048,169   $1,171,652    -19.2%   -10.5%
Average bearing liabilities  $778,971   $985,912   $1,109,287    -21.0%   -11.1%

 

bp = basis point = 1/100th of a percent

 

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AVERAGE BALANCE SHEETS

 

The following table provides information relating to our average balance sheet and reflects the average yield on assets and average cost of liabilities for the indicated periods. Yields and costs for the periods presented are derived by dividing income or expense by the average balances of assets or liabilities, respectively.

 

   Year Ended December 31, 
   2013   2012   2011 
(Dollars in thousands)  Average       Average   Average       Average   Average       Average 
   Balance   Interest   Yield/Cost   Balance   Interest   Yield/Cost   Balance   Interest   Yield/Cost 
                                     
ASSETS                                    
Interest earning assets:                                             
U.S. Treasury and agencies  $1,911   $28    1.47%  $16,126   $321    1.99%  $92,726   $1,376    1.48%
Mortgage-backed securities   248,243    4,529    1.82%   289,709    5,596    1.93%   153,838    4,871    3.17%
Equity securities   -    -    -%    -    -    -%    269    41    15.24%
State and political subdivision securities (1)   14,072    770    5.47%   14,905    992    6.66%   23,150    1,594    6.89%
Trust Preferred Securities   -    -    -%    1,034    50    4.84%   1,095    63    5.75%
Corporate bonds   50,785    1,398    2.75%   10,331    245    2.37%   -    -    -% 
Loans (2) (3) (4)   496,155    25,711    5.18%   635,472    34,474    5.42%   812,192    45,727    5.63%
FHLB stock   4,493    190    4.23%   4,805    208    4.33%   4,851    200    4.12%
Interest bearing deposits   31,298    58    0.19%   75,787    174    0.23%   83,531    199    0.24%
Total interest earning assets   846,957    32,684    3.86%   1,048,169    42,060    4.01%   1,171,652    54,071    4.61%
Less:  Allowance for loan losses   (15,371)             (17,610)             (19,897)          
Non-interest earning assets   76,091              90,817              103,570           
Total assets  $907,677             $1,121,376             $1,255,325           
                                              
LIABILITIES AND STOCKHOLDERS' EQUITY                                             
Interest bearing liabilities:                                             
Savings accounts  $88,933   $184    0.21%  $89,169   $265    0.30%  $102,833   $501    0.49%
NOW and money market accounts   266,470    545    0.20%   289,968    1,463    0.50%   285,200    2,253    0.79%
Certificates of deposit and other time deposits   386,608    6,197    1.60%   566,417    11,273    1.99%   675,313    15,431    2.29%
FHLB advances   18,960    538    2.84%   22,358    914    4.09%   27,941    1,142    4.09%
Subordinated debentures   18,000    1,364    7.58%   18,000    1,444    8.02%   18,000    1,373    7.63%
Total interest bearing liabilities   778,971    8,828    1.13%   985,912    15,359    1.56%   1,109,287    20,700    1.87%
                                              
Non-interest bearing liabilities:                                             
Non-interest bearing deposits   79,619              78,679              77,367           
Other liabilities   11,419              7,208              3,472           
Total liabilities   870,009              1,071,799              1,190,126           
                                              
Stockholders' equity   37,668              49,577              65,199           
Total liabilities and stockholders' equity  $907,677             $1,121,376             $1,255,325           
                                              
Net interest income       $23,856             $26,701             $33,371      
Net interest spread             2.73%             2.45%             2.74%
Net interest margin             2.82%             2.55%             2.85%
Ratio of average interest earning assets to average interest bearing liabilities             108.73%             106.31%             105.62%

 

(1)Taxable equivalent yields are calculated assuming a 34% federal income tax rate.
(2)Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.
(3)Calculations include non-accruing loans in the average loan amounts outstanding.
(4)Includes loans held for sale.

 

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RATE/VOLUME ANALYSIS

 

The table below shows changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (change in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.

 

   Year Ended   Year Ended 
   December 31,   December 31, 
   2013 vs. 2012   2012 vs. 2011 
   Increase (decrease)   Increase (decrease) 
   Due to change in   Due to change in 
(Dollars in thousands)          Net           Net 
   Rate   Volume   Change   Rate   Volume   Change 
                         
Interest income:                              
U.S. Treasury and agencies  $(68)  $(225)  $(293)  $356   $(1,411)  $(1,055)
Mortgage-backed securities   (298)   (769)   (1,067)   (2,413)   3,138    725 
Equity securities   -    -    -    -    (41)   (41)
State and political subdivision securities   (169)   (53)   (222)   (52)   (550)   (602)
Trust preferred securities   -    (50)   (50)   (10)   (3)   (13)
Corporate bonds   45    1,108    1,153    -    245    245 
Loans   (1,486)   (7,277)   (8,763)   (1,614)   (9,639)   (11,253)
FHLB stock   (5)   (13)   (18)   10    (2)   8 
Interest bearing deposits   (29)   (87)   (116)   (7)   (18)   (25)
                               
Total interest earning assets   (2,010)   (7,366)   (9,376)   (3,730)   (8,281)   (12,011)
                               
Interest expense:                              
Savings accounts   (80)   (1)   (81)   (176)   (60)   (236)
NOW and money market accounts   (808)   (110)   (918)   (827)   37    (790)
Certificates of deposit and other time deposits   (1,929)   (3,147)   (5,076)   (1,848)   (2,310)   (4,158)
FHLB advances   (251)   (125)   (376)   -    (228)   (228)
Subordinated debentures   (80)   -    (80)   71    -    71 
                               
Total interest bearing liabilities   (3,148)   (3,383)   (6,531)   (2,780)   (2,561)   (5,341)
                               
Net change in net interest income  $1,138   $(3,983)  $(2,845)  $(950)  $(5,720)  $(6,670)

 

NON-INTEREST INCOME AND NON-INTEREST EXPENSE

 

The following tables compare the components of non-interest income and expenses for the years ended December 31, 2013, 2012 and 2011. The tables show the dollar and percentage change from 2012 to 2013 and from 2011 to 2012. Below each table is a discussion of significant changes and trends.

 

               2013/2012   2012/2011 
(Dollars in thousands)  2013   2012   2011   Change   %   Change   % 
Non-interest income                                   
Customer service fees on deposit accounts  $5,306   $5,466   $6,125   $(160)   -2.9%  $(659)   -10.8%
Gain on sale of mortgage loans   938    1,653    1,200    (715)   -43.3%   453    37.8%
Gain on sale of investments   1,257    3,384    995    (2,127)   -62.9%   2,389    240.1%
Loss on sale and calls of investments   (1,031)   (1,131)   (149)   100    -8.8%   (982)   659.1%
Net impairment losses recognized in earnings   -    (26)   (168)   26    -100.0%   142    -84.5%
Loss on sale and write downs of real estate acquired through foreclosure   (2,336)   (6,051)   (9,568)   3,715    -61.4%   3,517    -36.8%
Writedowns on other real estate owned-bank lots   (219)   -    -    (219)   100.0%   -    0.0%
Gain on branch divestiture   -    3,124    -    (3,124)   -100.0%   3,124    100.0%
Gain on sale of premises and equipment   -    344    -    (344)   -100.0%   344    100.0%
Gain on sale on real estate acquired through foreclosure   1,953    1,318    231    635    48.2%   1,087    470.6%
Gain on sale of real estate held for development   -    175    -    (175)   -100.0%   175    100.0%
Other income   2,224    2,703    1,808    (479)   -17.7%   895    49.5%
   $8,092   $10,959   $474   $(2,867)   -26.2%  $10,485    2212.0%

 

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Non-Interest Income Comparison-2013 to 2012

 

We originate qualified Veterans Affairs (VA), Kentucky Housing Corporation (KHC), Rural Housing Corporation (RHC) and conventional secondary market loans and sell them into the secondary market with servicing rights released. Gain on sale of mortgage loans decreased for 2013 due to a decrease in the volume and the yield earned on loans refinanced, originated and sold compared to 2012.

 

We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others. During 2013 we recorded a net gain on the sale of debt investment securities of $226,000 compared to a net gain on sale of debt investment securities of $2.3 million for the 2012 period.

 

We recognized other-than-temporary impairment charges of $26,000 for the expected credit loss during the 2012 period on one of our trust preferred securities. The 2012 impairment charge was related to Preferred Term Security VI which was called for early redemption in July 2012. Management believes this impairment was primarily attributable to the current economic environment in which the financial condition of some of the issuers deteriorated.

 

Non-interest income for 2013 was reduced by $2.3 million in losses on the sale and write down of real estate owned properties due to the decline in market value of properties held in this portfolio. We also wrote down to fair value three bank lots which had been held for future branch expansion but are now held for sale. Offsetting the losses and write downs were recorded gains of $2.0 million on the sale of twenty-two real estate owned properties. Non-interest income was also impacted by write downs taken on three bank lots that are held for sale.

 

During the third quarter of 2012, we sold four banking centers located in Indiana. The transaction resulted in a gain of $3.1 million. During the second quarter of 2012 we recorded $175,000 in gains from the sale of the last of nine lots we held for sale in an office park adjacent to our home office. We also recorded a gain of $344,000 on the sale of two properties held by the Bank as possible new banking center locations in Clarksville, Indiana and Elizabethtown, Kentucky.

 

The decrease in other income for the 2013 period was the result of decreases in income received on real estate owned properties due to the sale of these properties.

 

Non-Interest Income Comparison-2012 to 2011

 

Customer service fees on deposit accounts decreased during 2012 primarily due to a decline in customer deposits following the sale of deposit accounts from our four Indiana banking centers. Gain on sale of mortgage loans increased for 2012 due to an increase in the volume of loans refinanced, originated and sold compared to 2011.

 

During 2012 we recorded a gain on the sale of debt investment securities of $3.4 million. Offsetting this gain was a loss on the sales of debt investment securities of $1.1 million. The recorded loss on sale was primarily related to the sale of our trust preferred securities. The sale of debt investment securities during 2012 is mainly related to the restructuring of the balance sheet and the branch sale that closed on July 6, 2012 as the sale of the branches was settled in cash.

 

We recognized other-than-temporary impairment charges of $26,000 for the expected credit loss during the 2012 period on one of our trust preferred securities, compared to $168,000 of impairment charges for 2011. The 2012 impairment charge was related to Preferred Term Security VI. Management believes this impairment was primarily attributable to the current economic environment in which the financial condition of some of the issuers deteriorated. Preferred Term Security VI was called for early redemption in July 2012. We received principal and interest of $209,000 and recorded a gain on sale of $192,000. We sold Preferred Term Security XXII in the third quarter of 2012 receiving principal of $39,000 and recording a loss on sale of $52,000. In the fourth quarter we sold the remaining three trust preferred securities receiving total principal of $548,000 and recording a loss on sale of $452,000.

 

Reducing non-interest income for 2012 was $6.1 million in losses on the sale and write down of real estate owned properties due to the decline in market value of properties held in this portfolio. Offsetting the losses and write downs were recorded gains of $1.3 million on the sale of twenty-five real estate owned properties.

 

During the third quarter of 2012, we successfully sold four banking centers located in Corydon, Elizabeth, Lanesville and Georgetown, Indiana. The transaction resulted in a gain of $3.1 million. During the second quarter of 2012 we recorded $175,000 in gains from the sale of the last of nine lots we held for sale in an office park adjacent to our home office. We also recorded a gain of $344,000 on the sale of two properties held as possible banking center locations. The increase in other income for the 2012 period was the result of increases in income received on real estate owned properties.

 

32
 

 

               2013/2012   2012/2011 
(Dollars in thousands)  2013   2012   2011   Change   %   Change   % 
Non-interest expenses                                   
Employee compensation and benefits  $15,247   $15,138   $16,015   $109    0.7%  $(877)   -5.5%
Office occupancy expense and equipment   2,728    3,035    3,201    (307)   -10.1%   (166)   -5.2%
Outside services and data processing   3,751    3,389    3,535    362    10.7%   (146)   -4.1%
Bank franchise tax   951    1,361    1,320    (410)   -30.1%   41    3.1%
FDIC insurance premiums   2,109    2,247    3,238    (138)   -6.1%   (991)   -30.6%
Amortization of intangible assets   -    172    370    (172)   -100.0%   (198)   -53.5%
Real estate acquired through foreclosure expense   1,764    3,723    1,879    (1,959)   -52.6%   1,844    98.1%
Loan expense   1,447    1,997    2,546    (550)   -27.5%   (549)   -21.6%
FHLB advance prepayment penalty   -    1,548    -    (1,548)   -100.0%   1,548    100.0%
Other expense   6,031    6,325    6,133    (294)   -4.6%   192    3.1%
   $34,028   $38,935   $38,237   $(4,907)   -12.6%  $698    1.8%

 

Non-Interest Expense Comparison-2013 to 2012

 

Office occupancy and equipment expense decreased during 2013 primarily due to a reduction in incurred costs related to the sale of our four Indiana banking centers in 2012.

 

Outside services expense increased for 2013 primarily due to incurred costs related to the sale of our $20 million stated value of our Senior Preferred Shares to six funds in an auction and due to incurred costs related to a new credit builder checking product.

 

Bank franchise tax is paid to the Commonwealth of Kentucky and represents taxes paid based on capital. Bank franchise expense decreased during 2013 compared to 2012 primarily due to a decrease in our capital for the period.

 

FDIC insurance premiums are based on the FDIC’s assessment base and rate structure. The assessment base is defined as the average consolidated total assets less average Tier I Capital. As a result of the decrease in total deposits for 2013, FDIC insurance premiums have been reduced.

 

Amortization of intangible assets decreased due to the sale of our four Indiana banking centers in 2012 in which the related intangible assets were fully amortized.

 

Real estate acquired through foreclosure expense and loan expense decreased due to a reduction in loan workout and loan portfolio management expenses as a result of fewer non-performing assets. Real estate acquired through foreclosure expense was also higher in 2012 due to a $1.5 million termination fee paid to terminate property investment and management agreement on a residential development held in other real estate owned.    

 

During the third quarter of 2012, we prepaid a $10.0 million convertible fixed rate advance and we also prepaid a $5.0 million convertible fixed rate advance. In connection with these transactions, we incurred $1.5 million in prepayment penalties. The decrease in other expense for the 2013 period relates to decreases in the amortization of our low income housing tax investments.

 

Non-Interest Expense Comparison-2012 to 2011

 

Employee compensation and benefits decreased for 2012 due to higher insurance claims recorded in 2011 under our self-funded insurance plan and a decrease in the number of employees. Full time equivalent employees decreased from 316 at December 31, 2011 to 274 at December 31, 2012. FDIC insurance premiums decreased for the period mainly due to the change in the FDIC’s assessment base and rate structure that went into effect during the second quarter of 2011.

 

The increase in real estate acquired through foreclosure expense was primarily due to a $1.5 million fee paid to terminate a property investment and management agreement on a residential development held in OREO. Loan expense decreased for 2012 due to the cost of obtaining new appraisals on real estate securing some of our commercial real estate loans and higher loan portfolio management expenses in 2011. During 2011, we had substantially all of our non-performing assets appraised or reappraised.

 

During the third quarter of 2012, we prepaid FHLB advances to decrease our cost of funds and improve net interest income. We prepaid a $10.0 million convertible fixed rate advance with an interest rate of 3.99% and a scheduled maturity date of 2014. We also prepaid a $5.0 million convertible fixed rate advance with an interest rate of 4.22% and a scheduled date of 2017. In connection with these transactions, we incurred $1.5 million in prepayment penalties.

 

33
 

 

Income Taxes

 

The provision for income taxes includes federal and state income taxes and in 2013, 2012 and 2011 reflects a full valuation allowance against all of our deferred tax assets. The effective tax rate for the year ended December 31, 2011 was a benefit of 11%. The effective tax rate for the years ended December 31, 2013 and 2012 is not meaningful due to the reduction of income tax benefit as the result of maintaining a full deferred tax valuation allowance. Our 2011 tax benefit is entirely due to gains in other comprehensive income that are presented in current operations in accordance with applicable accounting standards. Historically, the fluctuations in effective tax rates reflect the effect of permanent differences in the inclusion or deductibility of certain income and expenses, respectively, for income tax purposes.

 

A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a valuation allowance, we considered all positive and negative evidence including our five year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and operating results in 2013, 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order. Based on this assessment, we concluded that a valuation allowance was necessary at December 31, 2013 and December 31, 2012. Our future effective income tax rate will fluctuate based on the mix of taxable and tax free investments we make and, to a greater extent, the impact of changes in the required amount of valuation allowance recorded against our net deferred tax assets and our overall level of taxable income.

 

Recording a valuation allowance does not have any impact on our liquidity, nor does it preclude us from using the tax losses, tax credits or other timing differences in the future. To the extent that we generate taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense. Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once we can demonstrate a sustainable return to profitability and conclude that it is more likely than not the deferred tax asset will be utilized prior to expiration. See Note 13 of the Notes to Consolidated Financial Statements for additional discussion of our income taxes.

 

ANALYSIS OF FINANCIAL CONDITION

 

Total assets at December 31, 2013 decreased $148.4 million compared to total assets at December 31, 2012. The decrease was primarily attributable to a decline of $84.8 million in available-for-sale securities and a decline of $57.9 million in total loans. Total deposits decreased $139.1 million due to an intentional decrease in certificates of deposit as we focus on restructuring the balance sheet to decrease our cost of funds and improve net interest income.

 

Loans

 

Total loans decreased $57.9 million to $466.9 million at December 31, 2013 compared to $524.8 million at December 31, 2012. Our commercial real estate portfolio decreased $40.9 million to $279.9 million at December 31, 2013. Our residential mortgage loan, consumer and home equity and indirect consumer portfolios also decreased for the 2013 period. The decline in the total loan portfolio is primarily the result of pay-offs, charge-offs, and loans being transferred to real estate acquired through foreclosure for commercial real estate loans, which together exceeded the volume of new loans originated. Charge-offs made up $5.0 million or 8.7% of this decrease. The decline in the loan portfolio was also due, in part, to our ongoing efforts to resolve problem loans. In addition, we have elected not to replace much of this loan run-off in order to reduce asset size and increase capital in light of the higher regulatory capital ratios imposed by our consent order.

 

Loan Portfolio Composition. The following table presents a summary of the loan portfolio, net of deferred loan fees, by type. There are no foreign loans in our portfolio and other than the categories noted; there is no concentration of loans in any industry exceeding 10% of total loans.

 

   December 31, 
(Dollars in thousands)  2013   2012   2011   2010   2009 
   Amount   %   Amount   %   Amount   %   Amount   %   Amount   % 
Type of Loan:                                                  
Real Estate:                                                  
Residential  $99,336    21.28%  $110,048    20.97%  $151,954    20.61%  $164,164    18.56%  $179,130    18.00%
Commercial   279,936    59.96    320,885    61.14    463,710    62.89    568,798    64.31    642,355    64.57 
Consumer and                                                  
home equity   54,010    11.57    57,888    11.03    69,971    9.49    77,822    8.80    74,844    7.52 
Indirect consumer   13,041    2.79    16,211    3.09    21,892    2.97    29,588    3.34    36,628    3.68 
Commercial, other   20,539    4.40    19,803    3.77    29,838    4.04    44,159    4.99    61,969    6.23 
                                                   
Total loans   466,862    100.00    524,835    100.00    737,365    100.00    884,531    100.00    994,926    100.00 
                                                   
Less: Loans held for sale in probable branch divesture and probable loan sale   -    -    -    -    (46,112)   -    -    -    -    - 
                                                   
Total loans, net of loans held for sale in probable branch divesture and probable loan sale  $466,862    100.00%  $524,835    100.00%  $691,253    100.00%  $884,531    100.00%  $994,926    100.00%

 

34
 

 

Loan Maturity Schedule. The following table shows at December 31, 2013, the dollar amount of loans, net of deferred loan fees, maturing in the loan portfolio based on their contractual terms to maturity.

 

       Due after         
   Due during   1 through   Due after 5     
   the year ended   5 years after   years after     
   December 31,   December 31,   December 31,   Total 
   2014   2013   2013   Loans 
   (Dollars in thousands) 
                 
Residential mortgage  $9,622   $11,668   $78,046   $99,336 
Real estate commercial   103,411    138,228    38,297    279,936 
Consumer & home equity   5,964    16,070    31,976    54,010 
Indirect consumer   619    10,201    2,221    13,041 
Commercial, other   6,479    13,043    1,017    20,539 
Total  $126,095   $189,210   $151,557   $466,862 

 

The following table breaks down loans maturing after one year, by fixed and adjustable rates.

 

       Floating or     
   Fixed Rates   Adjustable Rates   Total 
             
   (Dollars in thousands) 
                
Residential mortgage  $39,383   $50,331   $89,714 
Real estate commercial   143,112    33,413    176,525 
Consumer & home equity   10,091    37,955    48,046 
Indirect consumer   12,422    -    12,422 
Commercial, other   12,505    1,555    14,060 
Total  $217,513   $123,254   $340,767 

 

Allowance and Provision for Loan Losses

 

Our financial performance depends on the quality of the loans we originate and management’s ability to assess the degree of risk in existing loans when it determines the allowance for loan losses. An increase in loan charge-offs or non-performing loans or an inadequate allowance for loan losses could reduce net interest income, net income and capital, and limit the range of products and services we can offer.

 

Management, which is comprised of senior officers and certain accounting and credit associates, evaluates the allowance for loan losses monthly to maintain a level it believes to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Periodic provisions to the allowance are made as needed. The allowance is determined by applying loss estimates to graded loans by categories, as described below. When appropriate, a specific reserve will be established for individual impaired loans based upon the risk classification and the estimated potential for loss. In accordance with our credit management processes, we obtain new appraisals on properties securing our non-performing commercial and commercial real estate loans and use those appraisals to determine specific reserves within the allowance for loan losses. The Loan Appraisal Committee determines appraisals to be ordered and reviews appraisals once received. The Loan Appraisal Committee also reviews all non-accrual and restructured loan relationships. As we receive new appraisals on properties securing non-performing loans, we recognize charge-offs and adjust specific reserves as appropriate. In addition, management, which is comprised of senior officers and certain accounting and credit associates, analyzes such factors as changes in lending policies and procedures; real estate market conditions; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.

 

Declines in collateral values, including commercial real estate, may impact our ability to collect on certain loans when borrowers are dependent on the values of the real estate as a source of cash flow. While we anticipate that challenges will continue in the foreseeable future as we manage the overall level of our credit quality, we believe that credit quality appears to be stabilizing as compared to the significant changes observed in real estate values prior to 2012. As a result of the relative stabilization in real estate values during 2012 and 2013, our provision for loan losses decreased.

 

As discussed in the Overview to this section, we have entered into a Consent Order with bank regulatory agencies. In addition to increasing capital ratios, we agreed to maintain adequate reserves for loan losses, develop and implement plans to reduce the level of non-performing assets and concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures, and report our progress to the regulators.

 

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The following table analyzes loan loss experience for the periods indicated.

 

   Year Ended December 31, 
(Dollars in thousands)  2013   2012   2011   2010   2009 
                     
Balance at beginning of period  $17,265   $17,181   $22,665   $17,719   $13,565 
Loans charged-off:                         
Residential mortgage   318    88    438    222    127 
Consumer & home equity   328    468    434    535    778 
Commercial & commercial real estate   4,381    6,608    26,080    11,438    4,721 
Total charge-offs   5,027    7,164    26,952    12,195    5,626 
Recoveries:                         
Residential mortgage   32    -    8    -    2 
Consumer & home equity   181    190    189    188    205 
Commercial & commercial real estate   211    261    344    72    49 
Total recoveries   424    451    541    260    256 
                          
Net loans charged-off   4,603    6,713    26,411    11,935    5,370 
                          
Provision for loan losses   (3,086)   6,797    21,210    16,881    9,524 
                          
Balance at end of period   9,576    17,265    17,464    22,665    17,719 
                          
Less: Allowance allocated to loans held for sale in probable branch divestiture   -    -    283    -    - 
                          
Balance at end of period, net  $9,576   $17,265   $17,181   $22,665   $17,719 
                          
Allowance for loan losses to total loans (1) (2)   2.05%   3.29%   2.37%   2.56%   1.78%
Net charge-offs to average loans outstanding   0.93%   1.06%   3.25%   1.25%   0.55%
Allowance for loan losses to total non-performing loans (2)   55%   80%   44%   54%   63%

 

(1)Includes loans held for sale in probable branch divestiture and probable loan sale for 2011
(2)Includes allowance allocated to loans held for sale in probable branch divestiture for 2011

 

Provision for loan loss decreased $9.9 million for 2013 compared to 2012. We recorded a reversal of provision expense for 2013 due to a decline in the size of our loan portfolio, a lower level of classified loans when compared to 2012, declining historical loss rates and a reduction in the specific reserves allocated to several relationships based upon improved credit quality.

 

The allowance for loan losses was $9.6 million at December 31, 2013, a decrease of $7.7 million compared to 2012. The decrease was driven by a reversal of provision expense and net charge-offs of $4.6 million taken during the year, including specific reserves of $3.6 million charged off on our collateral dependent loans of which $4.9 million had been reserved for at December 31, 2012. The allowance for loan losses as a percent of total loans was 2.05% for December 31, 2013 compared to 3.29% at December 31, 2012. Specific reserves allocated to substandard loans made up 29% of the total allowance for loan loss at December 31, 2013 compared to 46% at December 31, 2012. Net charge-offs for the 2013 period included $3.6 million in partial charge-offs compared to partial charge-offs of $4.2 million for the 2012 period.

 

Allowance for loan losses to total non-performing loans decreased to 55% at December 31, 2013 from 80% at December 31, 2012. The decline in the coverage ratio for 2013 was related to the decrease in the allowance for loan losses for loans evaluated individually for impairment. The allowance for loan loss for loans evaluated individually for impairment as a percentage of loans evaluated individually for impairment declined from 17.7% at December 31, 2012 to 7.5% at December 31, 2013 as specific reserves were charged off related to loans evaluated individually for impairment and deemed collateral dependent during the period. Once charged down to net realizable value, our impairment analysis for these individually evaluated collateral-dependent loans indicated that no additional reserves were required.

 

The allowance for loan losses remained relatively constant for the 2012 period compared to 2011. Net charge-offs of $6.7 million included specific reserves of $5.6 million on our collateral dependent loans of which $2.6 million was previously reserved for at December 31, 2011. The allowance for loan losses as a percent of total loans, including loans held for sale and the related discounts allocated to those loans in a probable branch divestiture, was 3.29% for December 31, 2012 compared to 2.37% at December 31, 2011. Continuing our efforts to ensure the adequacy of the allowance for loan losses, we added specific reserves to two large commercial real estate relationships based on updated appraisals of the underlying collateral. Specific reserves as allocated to substandard loans made up 46% of the total allowance for loan loss at December 31, 2012 compared to 25% at December 31, 2011. Net charge-offs for the 2012 period included $4.2 million in partial charge-offs compared to partial charge-offs of $19.3 million for the same period in 2011. Allowance for loan losses to total non-performing loans increased to 80% at December 31, 2012 from 44% at December 31, 2011. The increase in the coverage ratio for 2012 was primarily due to a decrease in non-accrual loans and restructured loans on non-accrual for the period.

 

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Provision for loan loss decreased $14.4 million to $6.8 million for 2012 compared to 2011. The smaller provision was due to a lower level of charge-offs and improvement in our security and position of certain classified loans during the period. Our provision for loan loss was higher in 2011 due to our efforts to ensure the adequacy of the allowance by adding specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. The higher provision for 2011 was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the general credit quality trend and the higher level of charge-offs.

 

The following table depicts management’s allocation of the allowance for loan losses by loan type. Allowance and allocation is based on management’s current evaluation of risk in each category, economic conditions, past loss experience, loan volume, past due history and other factors. Since these factors and management’s assumptions are subject to change, the allocation is not a prediction of future portfolio performance.

 

   December 31, 
   2013   2012   2011   2010   2009 
   Amount of   Percent of   Amount of   Percent of   Amount of   Percent of   Amount of   Percent of   Amount of   Percent of 
(Dollars in thousands)  Allowance   Total loans   Allowance   Total loans   Allowance   Total loans   Allowance   Total loans   Allowance   Total loans 
                                         
Residential mortgage  $292    21%  $501    21%  $1,159    21%  $751    19%  $517    19%
Consumer & home equity   386    14    712    14    1,046    12    1,504    12    1,634    11 
Commercial & commercial real estate   8,898    65    16,052    65    15,259    67    20,410    69    15,568    70 
Total (1)  $9,576    100%  $17,265    100%  $17,464    100%  $22,665    100%  $17,719    100%

 

(1)Includes $283 allowance allocated to loans held for sale in probable branch divestiture for 2011

 

Federal regulations require banks to classify their own assets on a regular basis. The regulations provide for three categories of classified loans -- substandard, doubtful and loss. In addition, we also classify loans as criticized. Loans classified as criticized have a potential weakness that deserves management’s close attention.

 

The following table provides information with respect to criticized and classified loans for the periods indicated:

 

   December 31,   December 31,   December 31,   December 31,   December 31, 
(Dollars in thousands)  2013   2012   2011   2010   2009 
Criticized Loans:                         
Total Criticized  $18,329   $24,869   $31,427   $28,309   $63,456 
                          
Classified Loans:                         
Substandard  $37,479   $50,320   $80,691   $95,663   $65,408 
Doubtful   -    -    30    583    370 
Loss   -    -    -    64    1,178 
Total Classified  $37,479   $50,320   $80,721   $96,310   $66,956 
                          
Total Criticized and Classified  $55,808   $75,189   $112,148   $124,619   $130,412 

 

Total criticized and classified loans declined by $19.4 million or 26% from December 31, 2012 and by $56.3 million or 50% from December 31, 2011. Approximately $33.0 million or 88% of the total classified loans at December 31, 2013 were related to commercial real estate loans in our market area. Classified consumer loans totaled $584,000, classified mortgage loans totaled $3.1 million and classified commercial loans totaled $862,000. Our decision to record a reversal of a portion of the allowance for loan losses during 2013 resulted from the application of a consistent allowance methodology that is driven by risk ratings and historical loss trends adjusted for qualitative factors. For more information on collection efforts, evaluation of collateral and how loss amounts are estimated, see “Non-Performing Assets,” below.

 

Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for charge-offs. We develop our allowance estimates based on actual loss experience adjusted for current economic conditions. Allowance estimates represent a prudent measurement of the risk in the loan portfolio, which we apply to individual loans based on loan type. If economic conditions continue to put stress on our borrowers going forward, this may require higher provisions for loan losses in future periods. We have allocated additional resources to address credit quality and facilitate the structure and processes to diversify and strengthen our lending function. Credit quality will continue to be a primary focus in 2014 and going forward.

 

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Non-Performing Assets

 

Non-performing assets consist of certain non-accruing restructured loans for which the interest rate or other terms have been renegotiated, loans past due 90 days or more still on accrual, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets. Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection. Loans are considered impaired when we no longer anticipate full principal or interest will be paid in accordance with the contractual loan terms. Impaired loans are carried at the present value of estimated future cash flows discounted at the loan’s effective interest rate, or at the fair value of the collateral less cost to sell if the loan is collateral dependent.

 

Non-accrual loans that have been restructured remain on non-accrual status until we determine the future collection of principal and interest is reasonably assured, which will require that the borrower demonstrate a period of performance in accordance to the restructured terms of six months or more. Accruing loans that have been restructured are evaluated for non-accrual status based on a current evaluation of the borrower’s financial condition and ability and willingness to service the modified debt.

 

We review our loans on a regular basis and implement normal collection procedures when a borrower fails to make a required payment on a loan. If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action. We generally charge off consumer loans when management deems a loan uncollectible and any available collateral has been liquidated. We handle commercial business and real estate loan delinquencies on an individual basis. These loans are placed on non-accrual status upon becoming contractually past due 90 days or more as to principal and interest or where substantial doubt about full repayment of principal and interest is evident.

 

We recognize interest income on loans on the accrual basis except for those loans in a non-accrual of income status. We discontinue accruing interest on impaired loans when management believes, after consideration of economic and business conditions and collection efforts, that the borrowers’ financial condition is such that collection of interest is doubtful, typically after the loan becomes 90 days delinquent. When interest accrual is discontinued, existing accrued interest is reversed and interest income is subsequently recognized only to the extent we receive cash payments and are assured of repayment of all outstanding principal.

 

We require appraisals and perform evaluations on impaired assets upon initial identification.  Thereafter, we obtain appraisals or perform market value evaluations on impaired assets at least annually.  Recognizing the volatility of certain assets, we assess the transaction and market conditions to determine if updated appraisals are needed more frequently than annually. Additionally, we evaluate the collateral condition and value in the event of foreclosure.

 

We classify real estate acquired as a result of foreclosure or by deed in lieu of foreclosure as real estate owned until such time as it is sold. We classify new and used automobile, motorcycle and all-terrain vehicles acquired as a result of foreclosure as repossessed assets until they are sold. When such property is acquired we record it at fair value less estimated selling costs. We charge any write-down of the property at the time of acquisition to the allowance for loan losses. Subsequent gains and losses are included in non-interest income and non-interest expense.

 

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets. The value may be subsequently reduced if the estimated fair value declines below the original appraised value. We monitor market information and the age of appraisals on existing real estate owned properties and obtain new appraisals as circumstances warrant. Real estate acquired through foreclosure was $11.6 million, a decrease of $10.6 million from December 31, 2012 and a decrease of $17.4 million from December 31, 2011. Real estate acquired through foreclosure at December 31, 2013 includes $1.7 million in land development properties and building lots compared to $6.8 million at December 31, 2012. We believe that our level of real estate acquired through foreclosure has stabilized. We anticipate reductions over the next several quarters as we continue to sell OREO properties, while inflow has slowed down substantially compared to 2012 and 2011. All properties held in OREO are listed for sale with various independent real estate agents. Also included in non-performing assets are three lots that were previously held for future branch expansion but at December 31, 2013 were held for sale.

 

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A summary of the real estate acquired through foreclosure activity is as follows:

 

   December 31, 
(Dollars in thousands)  2013   2012   2011 
             
Beginning balance, January 1,  $22,286   $29,083   $25,807 
Additions   8,713    18,100    19,416 
Net proceeds from sale of properties   (17,076)   (19,250)   (6,877)
Writedowns   (2,185)   (5,147)   (9,263)
Change in valuation allowance   (81)   (500)   - 
Ending balance  $11,657   $22,286   $29,083 

 

The following table provides information with respect to non-performing assets for the periods indicated.

 

   December 31, 
(Dollars in thousands)  2013   2012   2011   2010   2009 
                     
Restructured on non-accrual status  $1,310   $9,753   $18,032   $-   $- 
Restructured past due 90 days still on accrual   4,780    -    -    -    - 
Past due 90 days still on accrual   2,226    -    -    -    - 
Loans on non-accrual status   9,096    11,702    21,718    42,169    28,186 
                          
Total non-performing loans   17,412    21,455    39,750    42,169    28,186 
Real estate acquired through foreclosure   11,657    22,286    29,083    25,807    8,428 
Real estate owned-bank lots   1,469    -    -    -    - 
Other repossessed assets   37    34    42    40    103 
Total non-performing assets  $30,575   $43,775   $68,875   $68,016   $36,717 
                          
Interest income that would have been earned on non-performing loans  $902   $1,163   $2,238   $2,429   $1,657 
Interest income recognized on non-performing loans   246    -    -    -    - 
Ratios:  Non-performing loans to total loans (includes loans held for sale in probable branch divestiture and probable loan sale for 2011)   3.73%   4.09%   5.39%   4.77%   2.83%
             Non-performing assets to total loans (includes loans held for sale in probable branch divestiture and probable loan sale for 2011)   6.55%   8.34%   9.34%   7.69%   3.69%

 

Non-performing loans declined by $4.0 million to $17.4 million at December 31, 2013 compared to December 31, 2012. The change in non-accrual loans was due to a the transfer of a non-accrual relationship totaling $1.0 million to restructured status and the transfer of two non-accrual relationships totaling $1.3 million to real estate acquired through foreclosure. We also recorded $2.5 million in partial charge-offs related to loans on non-accrual. Offsetting the decrease in non-accrual loans was the addition of a commercial real estate relationship and a mortgage relationship with a combined balance of $2.2 million. Two commercial real estate relationships, one totaling $2.2 million and the other totaling $4.8 million were added to 90 days past due and still on accrual. The $4.8 million relationship is restructured. Both relationships are contractually past due but performing as to the payment of principal and interest.

 

Restructured loans on nonaccrual status will be placed back on accrual status if we determine that the future collection of principal and interest is reasonably assured, which requires that the borrower demonstrate a period of performance of at least six months in accordance to the restructured terms. A concentration in loans for residential subdivision development in Jefferson and Oldham counties contributed significantly to the increases in our non-performing loans and our non-performing assets during the past four years. At December 31, 2013, substantially all of our residential housing development assets in these counties have been classified as impaired and written down to what we believe to be at or near liquidation value. The remaining residential development credits are smaller and have strong guarantors. All non-performing loans are considered impaired.

 

The following table provides information with respect to restructured loans for the periods indicated.

 

   December 31, 
(Dollar in thousands)  2013   2012   2011   2010   2009 
                     
Restructured loans on non-accrual  $1,310   $9,753   $18,032   $-   $- 
Restructured past due 90 days still on accrual   4,780    -    -    -    - 
Restructured loans on accrual   18,963    22,851    16,047    3,906    9,812 
                          
Total restructured loans  $25,053   $32,604   $34,079   $3,906   $9,812 

 

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The decrease in restructured loans on non-accrual for 2013 resulted from the transfer of two non-accrual relationships totaling $8.1 million to real estate acquired through foreclosure. Restructured loans on accrual decreased during 2013 due to the reclassification of a commercial real estate relationship to past due 90 days still on accrual status and due to the restructuring of three commercial real estate relationships totaling $2.4 million offset by the pay-off of a commercial real estate relationship totaling $724,000. The commercial real estate relationship that was reclassified to past due 90 days still on accrual is contractually past due but is still performing as to the payment of principal and interest.

 

The terms of our restructured loans have been renegotiated to reduce the rate of interest or extend the term, thus reducing the amount of cash flow required from the borrower to service the loans. We anticipate that our level of restructured loans will remain elevated as we identify borrowers in financial difficulty and work with them to modify to more affordable terms. We have worked with customers when feasible to establish “A” and “B” note structures. The “B” note is charged-off on our books but remains an outstanding balance for the customer. These typically carry a very nominal or low rate of interest. The “A” note is a note structured on a proper basis meeting internal policy standards for a performing loan. After six months of performance, the “A” note restructured loan is eligible to be placed back on an accrual basis as a performing troubled debt restructured loan.

 

Investment Securities

 

Interest on securities provides us our largest source of interest income after interest on loans, constituting 20.7% of the total interest income for the year ended December 31, 2013. The securities portfolio serves as a source of liquidity and earnings, and contributes to the management of interest rate risk. We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers' acceptances, and federal funds. We may also invest a portion of our assets in certain commercial paper, collateralized loan obligations and corporate debt securities. We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The investment portfolio decreased by $84.8 million due to the sales of U.S. Treasury and agency securities, government-sponsored mortgage-backed securities, government-sponsored collateralized mortgage obligations, obligations of states and political subdivisions, private asset backed and corporate bonds which sales were offset by the purchases of higher yielding investments. Recent purchases have been high cash flow instruments with short average lives in order to decrease the volatility of the investment portfolio as well as provide cash flow and limit interest rate risk.

 

We evaluate investment securities with significant declines in fair value on a quarterly basis to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary. We consider the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and whether management has the intent to sell the debt security or whether it is more likely than not that we will be required to sell the debt security before its anticipated recovery. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.

 

The unrealized losses on our investment securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2013. See Note 3 – Securities for more information.

 

At December 31, 2013, we own Collateralized Loan Obligations (“CLOs”), subject to the Volcker Rule (Rule), with an amortized cost of $34.5 million and an unrealized loss of $635,000. Absent changes to the Rule, we could be required to dispose of these securities prior to July 2015. We believe the unrealized loss reflected results not from credit risk but from interest rate changes and to the uncertainty created by the Rule. We did not intend to sell these securities at year end 2013 and we believe it is more likely than not that we will not be required to sell these securities prior to their recovery. We expect there may be additional regulatory guidance, similar to the interim final rule issued on January 14, 2014 that provided relief to banks to hold certain Trust Preferred Collateralized Debt Obligations, or a legislative ruling that, if they occur, would eliminate the requirement that we dispose of these securities prior to July 2015, or that we will be able to develop structural solutions that can be applied to our CLO securities to bring them into compliance with the final Volcker Rule. In February and March of 2014, we sold 4 of our CLOs to confirm their marketability and evaluate our assessment about their market values. These CLOs had an amortized cost of $14.4 million and an unrealized loss of $233,000 at year end 2013. We realized a loss of $83,000 on these sales. This loss is not reflected in our 2013 financial statements as it is not significant. We do not currently intend to sell additional CLOs and continue to believe that it is more likely than not that we will not be required to sell these securities prior to their recovery.

 

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The following table provides the carrying value of our securities portfolio at the dates indicated.

 

   December 31, 
(Dollars in thousands)  2013   2012   2011 
             
Securities available-for-sale:               
Government-sponsored collateralized mortgage obligations  $100,816   $150,147   $- 
Government-sponsored mortgage-backed residential   74,324    144,889    264,691 
Corporate bonds   43,698    32,967    - 
Asset backed-collateralized loan obligations   34,478    -    - 
State and municipal   11,923    12,718    23,794 
Commercial mortgage backed   4,043    -    - 
U.S. Treasury and agencies   -    8,278    25,028 
Private asset backed   -    5,132    - 
Trust preferred securities   -    -    264 
Total  $269,282   $354,131   $313,777 
                
Securities held-to-maturity:               
Government-sponsored mortgage-backed residential  $-   $-   $- 
Trust preferred securities   -    -    24 
Total  $-   $-   $24 

 

The following table provides the scheduled maturities, amortized cost, fair value and weighted average yields for our securities at December 31, 2013.

 

           Weighted 
   Amortized   Fair   Average 
(Dollars in thousands)  Cost   Value   Yield* 
Securities available-for-sale:               
Due in one year or less  $3,060   $3,063    1.40%
Due after one year through five years   46,794    46,698    2.93 
Due after five years through ten years   36,786    36,125    2.25 
Due after ten years   190,652    183,396    2.14 
Total  $277,292   $269,282    2.28 

 

*The weighted average yields are calculated on amortized cost.

 

Deposits

 

We rely primarily on providing excellent customer service and on our long-standing relationships with customers to attract and retain deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits. We attract both short-term and long-term deposits from the general public by offering a wide range of deposit accounts and interest rates. In recent years market conditions have caused us to rely increasingly on short-term certificate accounts and other deposit alternatives that are more responsive to market interest rates. We use forecasts based on interest rate risk simulations to assist management in monitoring our use of certificates of deposit and other deposit products as funding sources and the impact of the use of those products on interest income and net interest margin in various rate environments.

 

Historically, we have utilized certificates of deposit placed by deposit brokers and deposits obtained through the CDARs program to support our asset growth. The CDARS system enables certificates of deposit that would exceed the current $250,000 FDIC coverage limit on deposits in a single financial institution to be redistributed to other financial institutions within the CDARS network in increments under the current coverage limit. However, due to the Bank’s designation as a “troubled institution,” we can no longer accept, renew or roll over brokered deposits (including deposits obtained through the CDARs program) without prior regulatory approval.

 

Total deposits decreased $139.1 million since December 31, 2012. Public funds increased $29.4 million while retail and commercial deposits decreased $168.5 million. We have public funds deposits from school boards, water districts and municipalities within our markets. These deposits are larger than individual retail depositors. However, we do not have any deposit relationships that we believe the loss of which would be significant enough to cause a negative impact on our liquidity position. Brokered deposits and CDARS certificates decreased $30.2 million. Brokered deposits were $27.3 million at December 31, 2013 compared to $56.9 million at December 31, 2012.

 

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The following table shows the amount of our brokered deposits by time remaining until maturity.

 

   (Dollars in  thousands) 
     
2014  $8,591 
2015   3,241 
2016   1,186 
2017   - 
2018   4,609 
2019   9,636 
   $27,263 

 

We are currently a member of Qwickrate, which is a premier non-brokered market place that we use as an additional low cost funding source. Qwickrate deposits totaled $18.2 million at December 31, 2013 and $18.3 million at December 31, 2012. We do not anticipate a negative impact as a result of not being able to renew our $27.3 million of brokered deposits at December 31, 2013, due to additional funding sources such as Qwickrate, decreased loan generation, continued loan pay downs, and our highly liquid and mostly short-term investment portfolio.

 

We have deployed additional resources to try to reduce our cost of funds in this low rate environment. The Consent Order resulted in the Bank being categorized as a "troubled institution" by bank regulators, which limits the interest rate the Bank can pay on interest bearing deposits. Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates .75% above the average rates computed by the FDIC. The Bank has elected not to pursue such a waiver and to adhere to the average rates computed by the FDIC plus the .75% rate cap.

 

The following table breaks down our deposits.

 

   December 31, 
(Dollars in thousands)  2013   2012 
         
Non-interest bearing  $78,480   $75,842 
NOW demand   192,514    155,390 
Savings   90,176    80,645 
Money market   94,367    121,755 
Certificates of deposit   327,950    488,988 
Total  $783,487   $922,620 

 

As of December 31, 2013, certificates of deposits in amounts of $100,000 or more totaled $147.5 million, of which $122.3 million were held by persons residing within our service areas. An additional $25.2 million of certificates of deposits in amounts of $100,000 or more were obtained from deposit brokers.

 

The following table shows at December 31, 2013 the amount of our certificates of deposit of $100,000 or more by time remaining until maturity.

 

   Certificates 
Maturity Period  of Deposit 
   (In Thousands) 
     
Three months or less  $24,090 
Three through six months   12,008 
Six through twelve months   19,585 
Over twelve months   91,866 
Total  $147,549 

 

Advances from Federal Home Loan Bank

 

Deposits are the primary source of funds for our lending and investment activities and for our general business purposes. We can also use advances (borrowings) from the Federal Home Loan Bank (FHLB) to compensate for reductions in deposits or deposit inflows at less than projected levels. At December 31, 2013, outstanding FHLB advances totaled $12.4 million. To decrease our cost of funds and improve interest income, we prepaid two FHLB advances during the third quarter of 2012. We prepaid a $10.0 million convertible fixed rate advance with an interest rate of 3.99% and a scheduled maturity date of 2014. We also prepaid a $5.0 million convertible fixed rate advance with an interest rate of 4.22% and a scheduled date of 2017. In connection with these transactions, we incurred $1.5 million in prepayment penalties. At December 31, 2013, we had sufficient collateral available to borrow approximately $20.2 million in additional advances from the FHLB. Advances from the FHLB are secured by our stock in the FHLB, certain securities, and substantially all of our first mortgage loans on an individual basis.

 

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The FHLB of Cincinnati functions as a central reserve bank providing credit for savings banks and other member financial institutions. As a member, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our home mortgages, other real estate loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided that we meet certain creditworthiness standards. For further information, see Note 10 of the Notes to Consolidated Financial Statements in this Annual Report.

 

The following table provides information about our FHLB advances as of and for the periods ended.

 

   December 31, 
   2013   2012   2011 
   (Dollars in thousands) 
             
Average balance outstanding  $18,960   $22,358   $27,941 
Maximum amount outstanding at any month-end during the period   41,015    27,724    27,816 
Year end balance   12,389    12,596    27,736 
Weighted average interest rate:               
At end of year   3.35%   3.33%   3.71%
During the year   2.84%   4.09%   4.09%

 

Subordinated Debentures

 

Two trust subsidiaries of First Financial Service Corporation have together issued a total of $18 million trust preferred securities. The subsidiaries loaned the sales proceeds from these issuances to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts, which are variable interest entities. Therefore the trusts are not consolidated in our financial statements. Rather, the subordinated debentures we have issued to them are shown as a liability. Our investment in the common stock of the trusts was $310,000.

 

The subordinated debentures are considered as Tier 1 capital or Tier 2 capital for the Corporation under current regulatory guidelines. Capital received from the proceeds of the sale of trust preferred securities cannot constitute more than 25% of the total core capital of the Corporation. The amount of subordinated debentures in excess of the 25% limitation constitutes Tier 2 capital for the Corporation. We have the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years.

 

In 2008, one such trust subsidiary issued $8.0 million in trust preferred securities and loaned the sales proceeds to us, which we used to finance the purchase of our Indiana banking operations. The subordinated debentures we issued to the trust mature on June 24, 2038, can be called at par in whole or in part on or after June 24, 2018, and pay a fixed rate of 8% for thirty years.

 

In 2007, the other trust subsidiary issued 30 year cumulative trust preferred securities totaling $10 million at a 10-year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basis points. These securities mature on March 22, 2037, and can be called at par in whole or in part on or after March 15, 2017.

 

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities. We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the subsidiary trusts will likewise suspend payment of dividends on their trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of December 31, 2013, we have deferred a total of thirteen quarterly payments and these accrued but unpaid interest payments totaled $4.4 million.

 

LIQUIDITY

 

Liquidity refers to our ability to generate adequate amounts of cash to meet financial obligations to our customers and shareholders in order to fund loans, respond to deposit outflows and to cover operating expenses. Maintaining a level of liquid funds through asset/liability management seeks to ensure that these needs are met at a reasonable cost. Liquidity is essential to compensate for fluctuations in the balance sheet and provide funds for growth and normal operating expenditures. Our investment and funds management policy identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The Bank management continually monitors the Bank’s liquidity position with oversight from the Asset Liability Committee.

 

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Our banking centers provide access to retail deposit markets. If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources. In addition to maintaining a stable core deposit base, we maintain adequate liquidity primarily through the use of investment securities. Traditionally, we have also borrowed from the FHLB to supplement our funding requirements. At December 31, 2013, we had sufficient collateral available to borrow approximately $20.2 million in additional advances from the FHLB. We believe that we have adequate funding sources through unpledged investment securities, repayments of loan principal, investment securities paydowns and maturities and potential asset sales to meet our foreseeable liquidity requirements.

 

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the Corporation include dividends from the Bank, borrowings and access to the capital markets.

 

The primary source of funding for the Corporation has been dividends and returns of investment from the Bank. Kentucky banking laws limit the amount of dividends that the Bank can pay to the Corporation without prior approval of the KDFI. Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods. Our Consent Order requires us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation.

 

The Corporation has also entered into a formal agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends on our common or preferred stock. We will not be able to pay cash dividends on our common stock in the future until we first pay all unpaid dividends on our Senior Preferred Shares and all deferred distributions on our trust preferred securities. We may not redeem shares or obtain additional borrowings without prior approval. Because of these limitations, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to the Corporation. During 2013, the Bank did not declare or pay any dividends to the Corporation. Cash held by the Corporation at December 31, 2013 was $147,000 compared to cash of $333,000 at December 31, 2012.

 

CAPITAL

 

Stockholders’ equity decreased $11.6 million during 2013, primarily due to an increase in unrealized losses on securities available-for-sale during the period. Our average stockholders’ equity to average assets ratio decreased to 4.15% at December 31, 2013 compared to 4.42% at the end of 2012.

 

On January 9, 2009, we sold $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the U.S. Treasury (“Treasury”) under the terms of its Capital Purchase Program. The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares paid cumulative dividends at a rate of 5% per year for the first five years and reset to a rate of 9% per year on January 9, 2014.

 

Under the terms of our CPP stock purchase agreement, we also issued Treasury a warrant to purchase an amount of our common stock equal to 15% of the aggregate amount of the Senior Preferred Shares, or $3 million. The warrant entitles Treasury to purchase 215,983 common shares at a purchase price of $13.89 per share. The initial exercise price for the warrant and the number of shares subject to the warrant were determined by reference to the market price of our common stock calculated on a 20-day trailing average as of December 8, 2008, the date Treasury approved our application. The warrant has a term of 10 years and is potentially dilutive to earnings per share.

 

Effective with the fourth quarter of 2010, we suspended payment of regular quarterly cash dividends on our Senior Preferred Shares. The dividends are cumulative and will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes.

 

On April 29, 2013, Treasury sold our Senior Preferred Shares to six funds in an auction.  Following the sale, the full $20 million stated value of our Senior Preferred Shares remains outstanding and our obligation to pay deferred and future dividends, currently at an annual rate of 9%, continues until our Senior Preferred Shares are fully retired.

 

During 2013, we did not purchase any shares of our common stock. Like our agreement with the Federal Reserve, the terms of our Senior Preferred Shares do not allow us to repurchase shares of our common stock without prior written consent until the Senior Preferred Shares are fully retired.

 

Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.

 

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The following table shows the ratios of Tier 1 capital, total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of December 31, 2013.

 

   Capital Adequacy Ratios as of     
   December 31, 2013     
   Regulatory   Ratio Required         
Risk-Based Capital Ratios  Minimums   by Consent Order   The Bank   The Corporation 
Tier 1 capital   4.00%   N/A    12.23%   10.28%
Total risk-based capital   8.00%   12.00%   13.48%   12.13%
Tier 1 leverage ratio   4.00%   9.00%   7.96%   6.68%

 

In its 2012 Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. At December 31, 2013, the Bank’s Tier 1 capital ratio was 7.96% and the total risk-based capital ratio was 13.48% compared to 6.53% and 12.21% at December 31, 2012. We are continuing our efforts to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank.

 

The terms of the 2012 Consent Order and the actions we have taken to attain the capital ratios and meet the other requirements of the Order are described in greater detail in Item 1 Business--Regulatory Matters.

 

OFF BALANCE SHEET ARRANGEMENTS

 

Our off balance sheet arrangements consist of commitments to make loans, unused borrower lines of credit, and standby letters of credit, which are disclosed in Note 20 to the consolidated financial statements.

 

AGGREGATE CONTRACTUAL OBLIGATIONS

 

           Greater than   Greater than     
       Less than   one year to   3 years to   More than 
December 31, 2013  Total   one year   3 years   5 years   5 years 
   (Dollars in thousands) 
Aggregate Contractual Obligations:                         
Time deposits  $327,949   $158,041   $97,775   $29,282   $42,851 
FHLB borrowings   12,389    222    850    10,819    498 
Subordinated debentures   18,000    -    -    -    18,000 
Lease commitments   8,367    615    1,204    938    5,610 

 

FHLB borrowings represent the amounts that are due to the FHLB of Cincinnati. These amounts have fixed maturity dates.  One of these borrowings, although fixed, is subject to conversion provisions at the option of the FHLB. The FHLB has the right to convert this advance to a variable rate or we can prepay the advance at no penalty. There is a substantial penalty if we prepay the advance before the FHLB exercises its right. We do not believe the convertible fixed rate advance will be converted in the near term.

 

The subordinated debentures, which mature June 24, 2038 and March 22, 2037, are redeemable before the maturity date at our option on or after June 24, 2018 and March 15, 2017 at their principal amount plus accrued interest. The subordinated debentures are also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The interest rate on the subordinated debentures is at a 30 year fixed rate of 8.00% and a 10 year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 1.60%.

 

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities. Together, the junior subordinated notes had an outstanding principal amount of $18 million. We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, our subsidiary trusts will likewise suspend payment of dividends on the trust preferred securities they issued. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.

 

Lease commitments represent the total future minimum lease payments under non-cancelable operating leases.

 

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IMPACT OF INFLATION & CHANGING PRICES

 

The consolidated financial statements and related financial data presented in this filing have been prepared in accordance with U.S. generally accepted accounting principles, which require the measurement of financial position and operating results in historical dollars without considering changes in the relative purchasing power of money over time due to inflation.

 

The primary impact of inflation on our operations is reflected in increasing operating costs. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates have a more significant impact on our performance than the effects of general levels of inflation and changes in prices. Periods of high inflation are often accompanied by relatively higher interest rates, and periods of low inflation are accompanied by relatively lower interest rates. As market interest rates rise or fall in relation to the rates earned on our loans and investments, the value of these assets decreases or increases respectively.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Asset /Liability Management and Market Risk

 

To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”). Comprised of senior management representatives, the ALCO has the responsibility for approving and ensuring compliance with asset/liability management policies. Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates. The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies. Management considers interest rate risk to be our most significant market risk.

 

We utilize an earnings simulation model to analyze net interest income sensitivity. We then evaluate potential changes in market interest rates and their subsequent effects on net interest income. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. We also incorporate assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

 

Our interest sensitivity profile was asset sensitive at December 31, 2013 and December 31, 2012. Given a sustained 100 basis point increase in interest rates, our base net interest income would increase by an estimated 3.89% at December 31, 2013 compared to an increase of 9.21% at December 31, 2012.

 

We did not run a model simulation for declining interest rates as of December 31, 2013 and December 31, 2012, because the Federal Open Market Committee effectively lowered the Fed Funds Target Rate between 0.00% to 0.25% in December 2008 and therefore, no further short-term rate reductions can occur.

 

Our interest sensitivity at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities, their relative pricing schedules, market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.

 

We use various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking. As demonstrated by the December 31, 2013 and December 31, 2012 sensitivity tables, our balance sheet has an asset sensitive position. This means that our earning assets, which consist of loans and investment securities, will change in price at a faster rate than our deposits and borrowings. Therefore, if short term interest rates increase, our net interest income will increase. Likewise, if short term interest rates decrease, our net interest income will decrease.

 

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Our sensitivity to interest rate changes is presented based on data as of December 31, 2013 and 2012.

 

       December 31, 2013
Increase in Rates
 
       100   200 
(Dollars in thousands)  Base   Basis Points   Basis Points 
             
Projected interest income  $27,800   $31,688   $35,783 
Projected interest expense   5,364    8,378    11,392 
                
Net interest income  $22,436   $23,310   $24,391 
Change from base       $874   $1,955 
% Change from base        3.89%   8.71%

 

       December 31, 2012
Increase in Rates
 
       100   200 
(Dollars in thousands)  Base   Basis Points   Basis Points 
             
Projected interest income  $34,262   $38,129   $41,653 
Projected interest expense   9,458    11,044    12,631 
                
Net interest income  $24,804   $27,085   $29,022 
Change from base       $2,281   $4,218 
% Change from base        9.21%   17.01%

 

The increase in projected interest expense from base at December 31, 2013 is related to our $20 million stated value of Senior Preferred Shares. Our obligation to pay deferred and future dividends on our Senior Preferred Shares increases from an annual rate of 5% at December 31, 2013 to 9% in January 2014 and continues until they are retired.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

FIRST FINANCIAL SERVICE CORPORATION

 

Table of Contents

 

Audited Consolidated Financial Statements:

 

·Report on Management’s Assessment of Internal Control Over Financial Reporting
·Report of Independent Registered Public Accounting Firm
·Consolidated Balance Sheets
·Consolidated Statements of Operations
·Consolidated Statements of Comprehensive Income (Loss)
·Consolidated Statements of Changes in Stockholders’ Equity
·Consolidated Statements of Cash Flows
·Notes to Consolidated Financial Statements

 

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Management’s Report on Internal Control Over Financial Reporting

 

First Financial Service Corporation is responsible for the preparation, integrity, and fair presentation of the consolidated financial statements included in this annual report. We, as management of First Financial Service Corporation, are responsible for establishing and maintaining effective internal control over financial reporting that is designed to produce reliable financial statements in conformity with U. S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the system of internal control over financial reporting as of December 31, 2013, in relation to criteria for effective internal control over financial reporting as described in "Internal Control - Integrated Framework," issued by the 1992 Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management concludes that, as of December 31, 2013, its system of internal control over financial reporting is effective based on those criteria. This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.

 

Date: March 28, 2014 By: Gregory S. Schreacke   
    President
    Principal Executive Officer
     
Date: March 28, 2014 By: Frank Perez
    Chief Financial Officer
    Principal Financial Officer &
    Principal Accounting Officer

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and Stockholders

First Financial Service Corporation

Elizabethtown, Kentucky

 

We have audited the accompanying consolidated balance sheets of First Financial Service Corporation as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income (loss), changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2013. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles.

 

Both the Company and its bank subsidiary, First Federal Savings Bank, are under regulatory enforcement orders issued by their primary regulators. First Federal Savings Bank is not in compliance with its regulatory enforcement order which requires, among other things, increased minimum regulatory capital ratios. First Federal Savings Bank’s continued non-compliance with its regulatory enforcement order may result in additional adverse regulatory action.

 

 
   
  Crowe Horwath LLP

 

Louisville, Kentucky

March 28, 2014

 

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FIRST FINANCIAL SERVICE CORPORATION

Consolidated Balance Sheets

 

   December 31, 
(Dollars in thousands, except per share data)  2013   2012 
         
ASSETS:          
Cash and due from banks  $13,476   $12,598 
Interest bearing deposits   52,512    50,505 
Total cash and cash equivalents   65,988    63,103 
           
Securities available-for-sale   269,282    354,131 
Loans held for sale   470    3,887 
           
Loans, net of unearned fees   466,862    524,835 
Allowance for loan losses   (9,576)   (17,265)
Net loans   457,286    507,570 
           
Federal Home Loan Bank stock   4,430    4,805 
Cash surrender value of life insurance   10,428    10,060 
Premises and equipment, net   23,773    27,048 
Real estate owned:          
Acquired through foreclosure, net of valuation allowance of $581 (2013) and $500 (2012)   11,657    22,286 
Bank lots   1,469    - 
Other repossessed assets   37    34 
Accrued interest receivable   2,224    2,690 
Accrued income taxes   2,907    2,928 
Low-income housing investments   6,965    7,061 
Other assets   1,701    1,459 
           
TOTAL ASSETS  $858,617   $1,007,062