10-Q 1 v342066_10q.htm FORM 10-Q

  

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

xQuarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the Quarterly Period Ended March 31, 2013

OR

 

¨Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the Transition Period from ___________to__________

 

Commission file number 0-26850

 

First Defiance Financial Corp.

(Exact name of registrant as specified in its charter)

 

Ohio   34-1803915
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification Number)

 

601 Clinton Street, Defiance, Ohio   43512
(Address of principal executive office)   (Zip Code)

 

Registrant's telephone number, including area code: (419) 782-5015

 

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 90 days. Yes x No¨

 

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

 

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

 

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

 

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. Common Stock, $.01 Par Value – 9,773,331 shares outstanding at April 30, 2013.

 

 
 

 

FIRST DEFIANCE FINANCIAL CORP.

 

INDEX

    Page Number
PART I.-FINANCIAL INFORMATION  
     
Item 1. Consolidated Condensed Financial Statements (Unaudited): Consolidated Condensed Statements of Financial Condition – March 31, 2013 and December 31, 2012 2
     
  Consolidated Condensed Statements of Income - Three months ended March 31, 2013 and 2012 4
     
  Consolidated Condensed Statements of Comprehensive Income – Three months ended March 31, 2013 and 2012 5
     
  Consolidated Condensed Statements of Changes in   Stockholders’ Equity – Three months ended March 31, 2013 and 2012 6
     
  Consolidated Condensed Statements of Cash Flows  - Three months ended March 31, 2013 and 2012 7
     
  Notes to Consolidated Condensed Financial Statements 9
     
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 48
Item 3. Quantitative and Qualitative Disclosures about Market Risk 67
     
Item 4. Controls and Procedures 68
     
PART II-OTHER INFORMATION:  
     
 Item 1. Legal Proceedings 69
     
 Item 1A. Risk Factors 69
     
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 69
     
 Item 3. Defaults upon Senior Securities 69
     
Item 4. Mine Safety Disclosures 69
     
 Item 5. Other Information 69
     
 Item 6. Exhibits 69
     
  Signatures 70

 

1
 

 

PART I-FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

FIRST DEFIANCE FINANCIAL CORP.

 

Consolidated Condensed Statements of Financial Condition

(UNAUDITED)

(Amounts in Thousands, except share and per share data)

 

 

 

   March 31,
2013
   December 31,
2012
 
     
Assets          
Cash and cash equivalents:          
Cash and amounts due from depository institutions  $31,342   $45,832 
Federal funds sold   125,000    91,000 
    156,342    136,832 
Securities:          
Available-for-sale, carried at fair value   196,132    194,101 
Held-to-maturity, carried at amortized cost (fair value $499 and $516 at March 31, 2013 and December 31, 2012, respectively)   492    508 
    196,624    194,609 
Loans held for sale   10,761    22,064 
Loans receivable, net of allowance of $26,459 at March 31, 2013 and $26,711 at December 31, 2012, respectively   1,480,549    1,498,546 
Accrued interest receivable   6,025    5,594 
Federal Home Loan Bank stock   19,354    20,655 
Bank owned life insurance   42,061    41,832 
Premises and equipment   39,218    39,663 
Real estate and other assets held for sale   4,313    3,805 
Goodwill   61,525    61,525 
Core deposit and other intangibles   4,402    4,738 
Mortgage servicing rights   8,379    7,833 
Deferred taxes   301    78 
Other assets   9,557    9,174 
Total assets  $2,039,411   $2,046,948 

 

(continued)

 

2
 

 

FIRST DEFIANCE FINANCIAL CORP.

 

Consolidated Condensed Statements of Financial Condition

(UNAUDITED)

(Amounts in Thousands, except share and per share data)

 

 

 

   March 31,
2013
   December 31,
2012
 
     
Liabilities and stockholders’ equity          
Liabilities:          
Deposits  $1,656,348   $1,667,472 
Advances from the Federal Home Loan Bank   12,784    12,796 
Subordinated debentures   36,083    36,083 
Securities sold under repurchase agreements   52,747    51,702 
Advance payments by borrowers   1,366    1,473 
Other liabilities   17,440    19,294 
Total liabilities   1,776,768    1,788,820 
           
Stockholders’ equity:          
Preferred stock, $.01 par value per share: 5,000,000 shares authorized; no shares issued   -    - 
Common stock, $.01 par value per share: 25,000,000 shares authorized; 12,735,313 and 12,739,496  shares issued and 9,766,132 and 9,729,466 shares outstanding, respectively   127    127 
Common stock warrant   878    878 
Additional paid-in capital   135,925    136,046 
Accumulated other comprehensive income, net of tax of $2,050 and $2,301, respectively   3,808    4,274 
Retained earnings   168,563    164,103 
Treasury stock, at cost, 2,969,181 and 3,010,030 shares respectively   (46,658)   (47,300)
Total stockholders’ equity   262,643    258,128 
           
Total liabilities and stockholders’ equity  $2,039,411   $2,046,948 

 

See accompanying notes

 

3
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Income

(UNAUDITED)

(Amounts in Thousands, except share and per share data)

 

   Three Months Ended 
   March 31, 
   2013   2012 
Interest Income          
Loans  $16,796   $18,650 
Investment securities:          
Taxable   678    1,111 
Non-taxable   725    672 
Interest-bearing deposits   58    92 
FHLB stock dividends   219    229 
Total interest income   18,476    20,754 
Interest Expense          
Deposits   1,647    2,369 
FHLB advances and other   90    751 
Subordinated debentures   152    331 
Securities sold under repurchase agreements   60    104 
Total interest expense   1,949    3,555 
Net interest income   16,527    17,199 
Provision for loan losses   425    3,503 
Net interest income after provision for loan losses   16,102    13,696 
Non-interest Income          
Service fees and other charges   2,385    2,671 
Insurance commission income   3,036    2,536 
Mortgage banking income   2,830    2,445 
Gain on sale of non-mortgage loans   15    9 
Gain on sale or call of securities   53    43 
Trust income   163    153 
Income from Bank Owned Life Insurance   229    220 
Other non-interest income   251    342 
Total non-interest income   8,962    8,419 
Non-interest Expense          
Compensation and benefits   8,798    8,465 
Occupancy   1,654    1,788 
FDIC insurance premium   656    669 
State franchise tax   629    514 
Data processing   1,181    1,169 
Amortization of intangibles   336    375 
Other non-interest expense   3,945    3,279 
Total non-interest expense   17,199    16,259 
Income before income taxes   7,865    5,856 
Federal income taxes   2,306    1,703 
Net Income  $5,559   $4,153 
           
Dividends accrued on preferred shares  $-   $(462)
Accretion on preferred shares  $-   $(46)
Net income applicable to common shares  $5,559   $3,645 
           
Earnings per common share (Note 6)          
Basic  $0.57   $0.37 
Diluted  $0.55   $0.37 
Dividends declared per share (Note 5)  $0.10   $0.05 
Average common shares outstanding (Note 6)          
Basic   9,736    9,726 
Diluted   10,105    9,970 

See accompanying notes

 

4
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Comprehensive Income

(UNAUDITED)

(Amounts in Thousands)

  

 

   

   Three Months Ended
March 31,
 
   2013   2012 
   (In thousands) 
Net income  $5,559   $4,153 
           
Other comprehensive income:          
Unrealized losses on securities available for sale   (664)   (49)
Reclassification adjustment for security gains included in net income(1)   (53)   (43)
Income tax benefit   251    32 
Other comprehensive loss   (466)   (60)
           
Comprehensive income  $5,093   $4,093 

 

(1) Amounts are included in gains on sale or call of securities on the Consolidated Condensed Statements of Income. Income tax expense associated with the reclassification adjustments, included in federal income taxes, for the three months ended March 31, 2013 and 2012 was $16 and $13, respectively.

 

5
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Statement of Changes in Stockholders’ Equity

(In Thousands, except number of shares)

 

                   Stock   Accumulated             
           Common   Additional   Acquired   Other           Total 
   Preferred   Common   Stock   Paid-In   by   Comprehensive   Retained   Treasury   Stockholder’s 
   Stock   Stock   Warrant   Capital   ESOP   Income (Loss)   Earnings   Stock   Equity 
                                     
Balance at January 1, 2013  $-   $127   $878   $136,046   $-   $4,274   $164,103   $(47,300)  $258,128 
Net income                                 5,559         5,559 
Other comprehensive loss                            (466)             (466)
Stock option expense                  19                        19 
4,870 shares issued under stock option plan, with no income tax benefit, net of repurchases                  (9)             (81)   142    52 
Restricted share activity under stock incentive Plans, including 31,796 shares issued                  (131)             (45)   500    324 
Common stock dividends declared                                 (973)        (973)
Balance at March 31, 2013  $-   $127   $878   $135,925   $-   $3,808   $168,563   $(46,658)  $262,643 
                                              
Balance at January 1, 2012  $36,641   $127   $878   $135,825   $-   $3,997   $148,010   $(47,351)  $278,127 
Net income                                 4,153         4,153 
Other comprehensive loss                            (60)             (60)
Stock option expense                  34                        34 
150 shares issued under stock option plan, with no income tax benefit                                 (1)   2    1 
Restricted share activity under stock incentive plans                  29                   29    58 
211 shares issued direct purchases                                      4    4 
Preferred stock dividends accrued                                 (462)        (462)
Accretion on preferred shares   46                             (46)        - 
Common stock dividends declared                                 (491)        (491)
Balance at March 31, 2012  $36,687   $127   $878   $135,888   $-   $3,937   $151,163   $(47,316)  $281,364 

 

6
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Cash Flows

(UNAUDITED)

(Amounts in Thousands)

  

 

   Three Months Ended 
   March 31, 
   2013   2012 
Operating Activities          
Net income  $5,559   $4,153 
Items not requiring (providing) cash          
Provision for loan losses   425    3,503 
Depreciation   809    832 
Amortization of mortgage servicing rights, net of impairment recoveries   216    942 
Amortization of core deposit and other intangible assets   336    375 
Net amortization of premiums and discounts on loans and deposits   199    213 
Amortization of premiums and discounts on securities   129    164 
Change in deferred taxes   27    1,064 
Proceeds from the sale of loans held for sale   112,112    109,551 
Originations of loans held for sale   (99,395)   (105,117)
Gain from sale of loans   (2,191)   (2,553)
Loss from sale of property and equipment   1    - 
Gain from sale or call of securities   (53)   (43)
Loss on sale or write-down of real estate and other assets held for sale   17    197 
Stock option expense   19    34 
Restricted stock expense   324    58 
Income from bank owned life insurance   (229)   (220)
Changes in:          
Accrued interest receivable   (431)   (101)
Other assets   (383)   (1,027)
Other liabilities   (1,854)   (34)
Net cash provided by operating activities   15,637    11,991 
           
Investing Activities          
Proceeds from maturities of held-to-maturity securities   16    17 
Proceeds from maturities, calls and pay-downs of available-for-sale securities   13,805    16,376 
Proceeds from sale of real estate and other assets held for sale   785    286 
Proceeds from the sale of available-for-sale securities   1,019    218 
Proceeds from sale of non-mortgage loans   3,629    9 
Purchases of available-for-sale securities   (17,647)   (25,639)
Proceeds from Federal Home Loan stock redemption   1,301    - 
Purchases of premises and equipment, net   (365)   (1,335)
Net decrease in loans receivable   12,447    4,716 
Net cash provided by (used in) investing activities   14,990    (5,352)
           
Financing Activities          
Net (decrease) increase in deposits and advance payments by borrowers   (11,229)   75,048 
Repayment of Federal Home Loan Bank advances   (12)   (11)
Increase (decrease) in securities sold under repurchase agreements   1,045    (5,777)
Proceeds from exercise of stock options   52    1 
Proceeds from treasury stock purchases   -    4 
Cash dividends paid on common stock   (973)   (491)
Cash dividends paid on preferred stock   -    (462)
Net cash provided by (used in) financing activities   (11,117)   68,312 
Increase in cash and cash equivalents   19,510    74,951 
Cash and cash equivalents at beginning of period   136,832    174,931 
Cash and cash equivalents at end of period  $156,342   $249,882 
           
Supplemental cash flow information:          
Interest paid  $1,923   $3,556 
Income taxes paid  $3,100   $- 
Transfers from loans to real estate and other          
assets held for sale  $1,310   $263 
           
Securities traded but not yet settled  $-   $1,212 

 

See accompanying notes.

 

7
 

 

FIRST DEFIANCE FINANCIAL CORP.

Notes to Consolidated Condensed Financial Statements

(Unaudited at March 31, 2013 and 2012)

  

 

 

1.Basis of Presentation

 

First Defiance Financial Corp. (“First Defiance” or the “Company”) is a unitary thrift holding company that conducts business through its subsidiaries, First Federal Bank of the Midwest (“First Federal”), First Insurance Group of the Midwest, Inc. (“First Insurance”), and First Defiance Risk Management Inc. (collectively, the Subsidiaries”). All significant intercompany transactions and balances are eliminated in consolidation.

 

First Federal is primarily engaged in community banking attracting deposits from the general public and using those and other available sources of funds to originate loans primarily in the counties in which its offices are located. First Federal’s traditional banking activities include originating and servicing residential, commercial and consumer loans and providing a broad range of depository, trust and wealth management services. First Insurance is an insurance agency that does business in the Defiance, Archbold, Bryan and Bowling Green, Maumee and Oregon, Ohio areas, offering property and casualty, and group health and life insurance products. First Defiance Risk Management was incorporated on December 20, 2012, as a wholly-owned insurance company subsidiary of the Company to insure the Company and its subsidiaries against certain risks unique to the operations of the Company and for which insurance may not be currently available or economically feasible in today’s insurance marketplace.

 

The consolidated condensed statement of financial condition at December 31, 2012 has been derived from the audited financial statements at that date, which were included in First Defiance’s Annual Report on Form 10-K.

 

The accompanying consolidated condensed financial statements as of March 31, 2013 and for the three month periods ended March 31, 2013 and 2012 have been prepared by First Defiance without audit and do not include information or footnotes necessary for the complete presentation of financial condition, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States. These consolidated condensed financial statements should be read in conjunction with the financial statements and notes thereto included in First Defiance's 2012 Annual Report on Form 10-K for the year ended December 31, 2012. However, in the opinion of management, all adjustments, consisting of only normal recurring items, necessary for the fair presentation of the financial statements have been made. The results for the three month period ended March 31, 2013 are not necessarily indicative of the results that may be expected for the entire year.

 

2.Significant Accounting Policies

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Significant areas where First Defiance uses estimates are the valuation of certain investment securities, the determination of the allowance for loan losses, the valuation of mortgage servicing rights and goodwill, the determination of unrecognized income tax benefits, and the determination of post-retirement benefits.

 

8
 

 

Earnings Per Common Share

 

Basic earnings per common share is computed by dividing net income applicable to common shares (net income less dividend requirements for preferred stock and accretion of preferred stock discount) by the weighted average number of shares of common stock outstanding during the period. All outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends are considered participating securities for the calculation. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options, warrants, restricted stock awards or units and stock grants.

 

Newly Effective Accounting Standards

 

In February 2013, the FASB issued ASU 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The standard requires that companies present in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line items affected by the reclassification. The new requirements are effective for public companies in the fiscal years, and interim periods within those years, beginning after December 15, 2012. The Company adopted this standard on January 1, 2013. The effect of adopting this standard increased the Company’s disclosure surrounding reclassification items out of accumulated other comprehensive income.

 

9
 

 

3.Fair Value

 

FASB ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

 

FASB ASC Topic 820 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on the best information available. In that regard, FASB ASC Topic 820 established a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

·Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

 

·Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by a correlation or other means.

 

·Level 3: Unobservable inputs for determining fair value of assets and liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

 

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

 

10
 

 

Available for sale securities - Securities classified as available for sale are generally reported at fair value utilizing Level 2 inputs where the Company obtains fair value measurements from an independent pricing service that uses matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows and the bonds’ terms and conditions, among other things. Securities in Level 1 include federal agency preferred stock securities. Securities in Level 2 include U.S. Government agencies, mortgage-backed securities, corporate bonds and municipal securities. The Company classifies its pooled trust preferred collateralized debt obligations as Level 3. The portfolio consists of collateralized debt obligations backed by pools of trust preferred securities issued by financial institutions and insurance companies. Based on the lack of observable market data, the Company estimated fair values based on the observable data available and reasonable unobservable market data. The Company estimated fair value based on a discounted cash flow model which used appropriately adjusted discount rates reflecting credit and liquidity risks. The Company used an independent third party which is described further in Note 7.

 

Impaired loans - Fair values for impaired collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure.  Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach.  The cost method bases value in the cost to replace the current property.  Value of market comparison approach evaluates the sales price of similar properties in the same market area.  The income approach considers net operating income generated by the property and an investors required return.  Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available.  Comparable sales adjustments are based on known sales prices of similar type and similar use properties and duration of time that the property has been on the market to sell.  Such adjustments made in the appraisal process are typically significant and result in a Level 3 classification of the inputs for determining fair value.

 

Real Estate held for sale - Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, established a new cost basis. These assets are then reviewed monthly by members of the asset review committee for valuation changes and are accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which may utilize a single valuation approach or a combination of approaches including cost, comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments may be significant and typically result in a Level 3 classification of the inputs for determining fair value.

 

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company.  Once received, a member of the Company’s asset quality or collections department reviews the assumptions and approaches utilized in the appraisal.  Appraisal values are discounted between a range of 0% to 20% to account for other factors that may impact the value of collateral. In determining the value of impaired collateral dependent loans and other real estate owned, significant unobservable inputs may be used which include:  physical condition of comparable properties sold, net operating income generated by the property and investor rates of return.

 

11
 

 

Mortgage servicing rights – On a quarterly basis, mortgage servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level based on a model that calculates the present value of estimated future net servicing income. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and are validated against available market data (Level 2).

 

Mortgage banking derivative - The fair value of mortgage banking derivatives are evaluated monthly based on derivative valuation models using quoted prices for similar assets adjusted for specific attributes of the commitments and other observable market data at the valuation date (Level 2).

  

The following table summarizes the financial assets measured at fair value on a recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

 

Assets and Liabilities Measured on a Recurring Basis

 

 

March 31, 2013

 

 

Level 1

Inputs

  

 

Level 2

Inputs

  

 

Level 3

Inputs

  

 

Total Fair

Value

 
   (In Thousands) 
Available for sale securities:                    
                     
Obligations of U.S. government  corporations and agencies  $-   $7,045   $-   $7,045 
U.S. treasury bonds        1,001         1,001 
Mortgage-backed - residential   -    38,922    -    38,922 
Collateralized mortgage obligations   -    57,163    -    57,163 
Trust preferred stock   -    -    1,651    1,651 
Preferred stock   251    -    -    251 
Corporate bonds   -    8,971    -    8,971 
Obligations of state and political subdivisions   -    81,128    -    81,128 
Mortgage banking derivative - asset   -    918    -    918 
Mortgage banking derivative - liability   -    (223)   -    (223)

 

12
 

 

December 31, 2012  Level 1
Inputs
   Level 2
Inputs
   Level 3
Inputs
   Total Fair
Value
 
   (In Thousands) 
Available for sale securities:                    
                     
Obligations of U.S. Government  corporations and agencies  $-   $11,069   $-   $11,069 
U.S. treasury bonds   -    1,002    -    1,002 
Mortgage-backed – residential   -    31,461    -    31,461 
Collateralized mortgage obligations   -    57,466    -    57,466 
Trust preferred stock   -    -    1,474    1,474 
Preferred stock   134    -    -    134 
Corporate bonds   -    8,884    -    8,884 
Obligations of state and political subdivisions   -    82,611    - -    82,611 
Mortgage banking derivative - asset   -    950    -    950 
Mortgage banking derivative - liability   -    (94)   -    (94)

  

The table below presents a reconciliation and income classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2013 and March 31, 2012:

  

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(In Thousands)
Beginning balance, January 1, 2013  $1,474 
Total gains or losses (realized/unrealized)     
Included in earnings (unrealized)   - 
Included in other comprehensive income (presented gross of taxes)   177 
Amortization   - 
Sales   - 
Transfers in and/or out of Level 3   - 
Ending balance, March 31, 2013  $1,651 

 

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(In Thousands)
Beginning balance, January 1, 2012  $1,342 
Total gains or losses (realized/unrealized)     
Included in earnings (unrealized)   - 
Included in other comprehensive income (presented gross of taxes)   35 
Amortization   - 
Sales   - 
Transfers in and/or out of Level 3   - 
Ending balance, March 31, 2012  $1,377 

 

13
 

 

The following table summarizes the financial assets measured at fair value on a non-recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

 

Assets and Liabilities Measured on a Non-Recurring Basis

 

March 31, 2013  Level 1 Inputs   Level 2 Inputs   Level 3 Inputs   Total Fair
Value
 
   (In Thousands) 
Impaired loans                
Residential Loans  $-   $-   $459   $459 
Commercial Loans   -    -    1,317    1,317 
Home Equity Loans   -    -    164    164 
Multi Family Loans   -    -    390    390 
CRE loans   -    -    12,653    12,653 
Total Impaired loans   -    -    14,983    14,983 
Mortgage servicing rights   -    3,609    -    3,609 
Real estate held for sale                    
Residential Loans   -    -    -    - 
CRE loans   -    -    -    - 
Total Real Estate held for sale   -    -    -    - 

 

December 31, 2012  Level 1 Inputs   Level 2 Inputs   Level 3 Inputs   Total Fair
Value
 
   (In Thousands) 
Impaired loans                    
Residential Loans  $-   $-   $599   $599 
Commercial Loans   -    -    771    771 
Home Equity Loans   -    -    168    168 
Multi Family Loans   -    -    407    407 
CRE loans   -    -    12,126    12,126 
Total Impaired loans   -    -    14,071    14,071 
Mortgage servicing rights   -    7,833    -    7,833 
Real estate held for sale                    
Residential Loans   -    -    61    61 
CRE loans   -    -    385    385 
Total Real Estate held for sale   -    -    446    446 

 

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of March 31, 2013, the significant unobservable inputs used in the fair value measurements were as follows:

 

   Fair
Value
   Valuation Technique  Unobservable Inputs  Range of
Inputs
 
   (Dollars in Thousands) 
               
Trust preferred stock  $1,651   Discounted cash flow  Constant prepayment rate   2-40%
           Expected asset default   0-30%
           Expected recoveries   10-15%
Impaired Loans- Applies to all loan classes  $14,983   Appraisals  Discounts for collection issues and changes in market conditions   0-10%

 

14
 

 

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of December 31, 2012, the significant unobservable inputs used in the fair value measurements were as follows:

 

   Fair
Value
   Valuation Technique  Unobservable Inputs  Range of
Inputs
 
   (Dollars in Thousands) 
               
Trust preferred stock  $1,474   Discounted cash flow   Constant prepayment rate         2-40 %
           Expected asset default        0-30%
           Expected recoveries       10-15%
Impaired Loans- Applies to all loan classes  $14,071   Appraisals   Discounts for collection issues and changes in market conditions    0-10%
Real estate held for sale – Applies to all classes  $446   Appraisals   Discounts for changes in market conditions     0-20%

  

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a fair value of $15.0 million, with no valuation allowance at March 31, 2013. A provision expense of $621,000 for the three months ended March 31, 2013 was included in earnings.

 

Mortgage servicing rights which are carried at the lower of cost or fair value had a fair value of $3.6 million at March 31, 2013, with a valuation allowance of $1.8 million. A recovery of $473,000 for the three months ended March 31, 2013 was included in earnings.

 

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a fair value of $14.1 million with a valuation allowance of $0 at December 31, 2012. Provision expense of $4.8 million for the three months ended March 31, 2012 was included in earnings.

 

Mortgage servicing rights which are carried at the lower of cost or fair value had a fair value of $7.8 million at December 31, 2012 resulting in a valuation allowance of $2.3 million. A charge of $79,000 for the three months ended March 31, 2012 was included in earnings.

 

Real estate held for sale is determined using Level 3 inputs which include appraisals and are adjusted for estimated costs to sell. The change in fair value of real estate held for sale was $137,000 for the three months ended March 31, 2012 which was recorded directly as an adjustment to current earnings through non-interest expense.

 

In accordance with FASB ASC Topic 825, the Fair Value Measurements tables are a comparative condensed consolidated statement of financial condition based on carrying amount and estimated fair values of financial instruments as of March 31, 2013 and December 31, 2012. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of First Defiance.

 

15
 

 

Much of the information used to arrive at “fair value” is highly subjective and judgmental in nature and therefore the results may not be precise. Subjective factors include, among other things, estimated cash flows, risk characteristics and interest rates, all of which are subject to change. With the exception of investment securities, the Company’s financial instruments are not readily marketable and market prices do not exist. Since negotiated prices for the instruments, which are not readily marketable depend greatly on the motivation of the buyer and seller, the amounts that will actually be realized or paid per settlement or maturity of these instruments could be significantly different.

 

The carrying amount of cash and cash equivalents, term notes payable and advance payments by borrowers for taxes and insurance, as a result of their short-term nature, is considered to be equal to fair value and are classified as Level 1.

 

It was not practicable to determine the fair value of Federal Home Loan Bank (“FHLB”) stock due to restrictions placed on its transferability.

 

The fair value of loans that reprice within 90 days is equal to their carrying amount. For other loans, the estimated fair value is calculated based on discounted cash flow analysis, using interest rates currently being offered for loans with similar terms, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost of fair value as previously described. The allowance for loan losses is considered to be a reasonable adjustment for credit risk. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price. The fair value of loans held for sale is estimated based on binding contracts and quotes from third party investors resulting in a Level 2 classification.

 

The fair value of accrued interest receivable is equal to the carrying amounts resulting in a Level 2 or Level 3 classification which is consistent with its underlying value.

 

The fair value of non-interest bearing deposits are considered equal to the amount payable on demand at the reporting date (i.e. carrying value) and are classified as Level 1. The fair value of savings, NOW and certain money market accounts are equal to their carrying amounts and are a Level 2 classification. Fair values of fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

 

The fair values of securities sold under repurchase agreements are equal to their carrying amounts resulting in a Level 2 classification. The carrying value of subordinated debentures and deposits with fixed maturities is estimated based discounted cash flow analyses based on interest rates currently being offered on instruments with similar characteristics and maturities resulting in a Level 3 classification.

 

FHLB advances with maturities greater than 90 days are valued based on discounted cash flow analysis, using interest rates currently being quoted for similar characteristics and maturities resulting in a Level 2 classification. The cost or value of any call or put options is based on the estimated cost to settle the option at March 31, 2013.

 

16
 

 

       Fair Value Measurements at March 31, 2013 
   Carrying
Value
   Total   Level 1   Level 2   Level 3 
Financial Assets:                         
Cash and cash equivalents  $156,342   $156,342   $156,342   $-   $- 
Investment securities   196,624    196,631    251    194,729    1,651 
Federal Home Loan Bank Stock   19,354    N/A    N/A    N/A    N/A 
Loans, net, including loans held for sale   1,491,310    1,509,279    -    11,042    1,498,237 
Accrued interest receivable   6,025    6,025    -    1,194    4,831 
                          
Financial Liabilities:                         
Deposits  $1,656,348   $1,659,700   $291,765   $1,367,935   $- 
Advances from Federal Home Loan Bank   12,784    13,403    -    13,403    - 
Securities sold under repurchase agreements   52,747    52,747    -    52,747    - 
Subordinated debentures   36,083    35,292    -    -    35,292 

 

       Fair Value Measurements at December 31, 2012
(In Thousands)
 
   Carrying
Value
   Total   Level 1   Level 2   Level 3 
Financial Assets:                         
Cash and cash equivalents  $136,832   $136,832   $136,832   $-   $- 
Investment securities   194,609    194,617    134    193,009    1,474 
Federal Home Loan Bank Stock   20,655    N/A    N/A    N/A    N/A 
Loans, net, including loans held for sale   1,520,610    1,543,438    -    22,577    1,520,861 
Accrued interest receivable   5,594    5,594    -    757    4,837 
                          
Financial Liabilities:                         
Deposits  $1,667,472   $1,671,713   $315,132   $1,356,581   $- 
Advances from Federal Home Loan Bank   12,796    13,466    -    13,466    - 
Securities sold under repurchase agreements   51,702    51,702    -    51,702    - 
Subordinated debentures   36,083    35,766    -    -    35,766 

 

4.Stock Compensation Plans

 

First Defiance has established equity based compensation plans for its directors and employees. On March 15, 2010, the Board adopted, and the shareholders approved at the 2010 Annual Shareholders Meeting, the First Defiance Financial Corp. 2010 Equity Incentive Plan (the “2010 Equity Plan”). The 2010 Equity Plan replaces all existing plans. All awards currently outstanding under prior plans will remain in effect in accordance with their respective terms. Any new awards will be made under the 2010 Equity Plan. The 2010 Equity Plan allows for issuance of up to 350,000 common shares through the award of options, stock grants, restricted stock units (“RSU”), stock appreciation rights or other stock-based awards.

 

17
 

 

As of March 31, 2013, 291,400 options had been granted and remain outstanding at option prices based on the market value of the underlying shares on the date the options were granted. Options granted under all plans vest 20% per year except for the 2009 grant to the Company’s executive officers, which vested 40% in 2011 and then 20% annually. All options expire ten years from the date of grant. Vested options of retirees expire on the earlier of the scheduled expiration date or three months after the retirement date.

 

In August 2011, the Company approved a 2011 Short-Term (“STIP”) and a 2011 Long-Term (“LTIP”) Equity Incentive Plan for selected members of management. The Plans became effective January 1, 2011 and provide for cash and/or equity benefits if certain performance targets are achieved. Awards issued under these Plans will reduce the amount of awards available to be issued under the 2010 Equity Plan.

 

In March 2012, the Company approved a 2012 STIP and a 2012 LTIP for selected members of management. The Plans are effective January 1, 2012 and provide for cash and/or equity benefits if certain performance targets are achieved. Awards issued under these Plans reduce the amount of awards available to be issued under the 2010 Equity Plan.

 

Cash and/or equity benefits under the 2011 STIP and LTIP and 2012 STIP were paid out to the selected members of management in the first quarter of 2013 based on the achievement of certain performance targets. One member of management was not paid until April 2013.

 

In March 2013, the Company approved a 2013 STIP and a 2013 LTIP for selected members of management.

 

Under the 2013 STIP the participants may earn up to 25% to 45% of their salary for potential payout based on the achievement of certain corporate performance targets during the calendar year. The final amount of benefits under the 2013 STIP will be determined as of December 31, 2013 and will be paid out in cash in the first quarter of 2014. The participants are required to be employed on the day of payout in order to receive such payment.

 

Under the 2013 LTIP the participants may earn up to 25% to 45% of their salary for potential payout in the form of equity awards based on the achievement of certain corporate performance targets over a three year period. The Company granted 86,065 RSU’s to the participants in this Plan effective January 1, 2013, which represents the maximum target award. The amount of benefit under the 2013 LTIP will be determined individually at the 12 month period ending December 31, 2013, the 24 month period ending December 31, 2014 and the 36 month period ending December 31, 2015. The awards’ vesting will be as follows: 16.7% of the target award after the end of the performance period ending December 31, 2013, 27.8% of the target award at the end of the performance period ending December 31, 2014 and 55.5% of the target award at the end of the performance period ending December 31, 2015. The benefits earned under the 2013 LTIP Plan will be paid out in equity in the first quarter following the close of the applicable performance period. The participants are required to be employed on the day of payout in order to receive such payment.

 

18
 

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes model. Expected volatilities are based on historical volatilities of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. There were no options granted during the three months ended March 31, 2013 or 2012.

 

Following is activity under the plans during the three months ended March 31, 2013:

 

Stock options 

 

 

Options

Outstanding

  

 

 

Weighted

Average

Exercise Price

   Weighted
Average
Remaining
Contractual
Term (in years)
  

 

Aggregate

Intrinsic
Value

(in 000’s)

 
Options outstanding, January 1, 2013   312,350   $20.33           
Forfeited or cancelled   7,400    20.19           
Exercised   13,550    18.80           
Granted   -    -           
Options outstanding, March 31, 2013   291,400   $20.42    3.90   $1,335 
Vested or expected to vest at March 31, 2013   291,400   $20.42    3.90   $1,335 
Exercisable at March 31, 2013   250,910   $21.72    3.59   $892 

 

As of March 31, 2013, there was $35,000 of total unrecognized compensation costs related to unvested stock options granted under the Company’s equity plans. The cost is expected to be recognized over a weighted-average period of 1.3 years.

 

At March 31, 2013, 106,061 RSU’s were outstanding. Compensation expense is recognized over the performance period based on the achievements of targets as established with the plan documents. Total accrued expense of $273,000 was recorded during the three months ended March 31, 2013 and approximately $262,000 is included within other liabilities at March 31, 2013 related to the STIPs and LTIPs.

 

   Restricted Stock Units   Stock Grants 
       Weighted-Average       Weighted-Average 
       Grant Date       Grant Date 
Unvested Shares  Shares   Fair Value   Shares   Fair Value 
                 
Unvested at January 1, 2013   38,871   $14.74    11,260   $13.28 
Granted   91,187    19.42    20,639    15.77 
Vested   (20,639)   15.77    (31,899)   14.89 
Forfeited   (3,358)   11.97    -    - 
Unvested at March 31, 2013   106,061   $18.66    -   $- 

 

The maximum amount of compensation expense that may be recorded for the 2013 STIP and the 2012 and 2013 LTIPs at March 31, 2013 is approximately $2.5 million. However, the estimated expense expected to be recorded as of March 31, 2013 based on the performance measures in the plans, is $2.0 million of which $1.6 million is unrecognized at March 31, 2013 and will be recognized over the remaining performance periods.

 

19
 

 

5.Dividends on Common Stock

 

First Defiance declared and paid a $0.10 per common stock dividend in the first quarter of 2013 and declared and paid a $0.05 per common stock dividend in the first quarter of 2012.

 

6.Earnings Per Common Share

 

The following table sets forth the computation of basic and diluted earnings per common share (in thousands except per share data):

 

   Three months ended
March 31,
 
   2013   2012 
Numerator for basic and diluted earnings per common share – Net income applicable to common shares  $5,559   $3,645 
Denominator:          
Denominator for basic earnings per common share – weighted average common shares   9,736    9,726 
Effect of warrants   295    208 
Effect of employee stock options   74    36 
           
Denominator for diluted earnings per common share share   10,105    9,970 
Basic earnings per common share  $0.57   $0.37 
Diluted earnings per common share  $0.55   $0.37 

 

There were 144,350 shares under option granted to employees excluded from the diluted earnings per common share calculation as they were anti-dilutive for the three months ended March 31, 2013. Shares under option of 256,643 were excluded from the diluted earnings per common share calculations as they were anti-dilutive for the three months ended March 31, 2012.

 

20
 

 

7.Investment Securities

 

The following is a summary of available-for-sale and held-to-maturity securities:

 

  

 

Amortized

Cost

   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
  

 

 

Fair Value

 
At March 31, 2013  (In Thousands) 
Available-for-Sale Securities:                    
Obligations of U.S. government corporations and agencies  $7,000   $45   $-   $7,045 
U.S. treasury bonds   1,000    1    -    1,001 
Mortgage-backed securities – residential   37,642    1,284    (4)   38,922 
Collateralized mortgage obligations   55,809    1,374    (20)   57,163 
Trust preferred securities and preferred stock   3,600    216    (1,914)   1,902 
Corporate bonds   8,772    200    (1)   8,971 
Obligations of state and political subdivisions   75,563    5,617    (52)   81,128 
Totals  $189,386   $8,737   $(1,991)  $196,132 
                     
Held-to-Maturity Securities*:                    
FHLMC certificates  $65   $-   $(1)  $64 
FNMA certificates   153    5    -    158 
GNMA certificates   57    3    -    60 
Obligations of state and political subdivisions   217    -    -    217 
Totals  $492   $8   $(1)  $499 

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
   (In Thousands) 
At December 31, 2012                
Available-for-sale                    
Obligations of U.S. government corporations and agencies  $11,000   $69   $-   $11,069 
U.S. treasury bonds   1,000    2    -    1,002 
Mortgage-backed securities - residential   30,020    1,441    -    31,461 
Collateralized mortgage obligations   55,962    1,504    -    57,466 
Trust preferred stock and preferred stock   3,600    99    (2,091)   1,608 
Corporate bonds   8,717    167    -    8,884 
Obligations of state and political subdivisions   76,339    6,277    (5)   82,611 
Total Available-for-Sale  $186,638   $9,559   $(2,096)  $194,101 
                     
Held-to-Maturity*:                    
FHLMC certificates  $69   $-   $(1)  $68 
FNMA certificates   162    6    -    168 
GNMA certificates   60    3    -    63 
Obligations of states and political subdivisions   217    -    -    217 
Total Held-to-Maturity  $508   $9   $(1)  $516 

 

*FHLMC, FNMA, and GNMA certificates are residential mortgage-backed securities.

 

21
 

 

The amortized cost and fair value of the investment securities portfolio at March 31, 2013 are shown below by contractual maturity. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. For purposes of the maturity table, mortgage-backed securities (“MBS”), collateralized mortgage obligations (“CMO”) and REMICs, which are not due at a single maturity date, have not been allocated over the maturity groupings. These securities may mature earlier than their weighted-average contractual maturities because of principal prepayments.

 

   Available-for-Sale   Held-to-Maturity 
   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value 
   (In Thousands) 
Due in one year or less  $3,255   $3,275   $-   $- 
Due after one year through five years   10,052    10,324    217    217 
Due after five years through ten years   34,479    36,826    -    - 
Due after ten years   48,149    49,622    -    - 
MBS/CMO   93,451    96,087    275    282 
   $189,386   $196,134   $492   $499 

 

Investment securities with a carrying amount of $124.1 million at March 31, 2013 were pledged as collateral on public deposits, securities sold under repurchase agreements, Federal Reserve discount window and FHLB advances.

 

As of March 31, 2013, the Company’s investment portfolio consisted of 335 securities, 20 of which were in an unrealized loss position.

 

The following tables summarize First Defiance’s securities that were in an unrealized loss position at March 31, 2013 and December 31, 2012:

 

   Duration of Unrealized Loss Position     
   Less than 12 Months   12 Months or Longer   Total 
       Gross       Gross         
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loses 
   (In Thousands) 
At March 31, 2013                              
Available-for-sale securities:                              
Mortgage-backed securities - residential  $2,057   $(4)  $-   $-   $2,057   $(4)
Collateralized mortgage obligations   1,961    (20)   -    -    1,961    (20)
Obligations of state and political subdivisions   2,902    (52)   -    -    2,902    (52)
Corporate bonds   999    (1)   -    -    999    (1)
Trust preferred stock and preferred stock   -    -    1,651    (1,914)   1,651    (1,914)
Held-to-maturity securities:                              
Mortgage-backed securities - residential   -    -    35    (1)   35    (1)
Total temporarily impaired securities  $7,919   $(77)  $1,686   $(1,915)  $9,605   $(1,992)

  

22
 

  

   Duration of Unrealized Loss Position     
   Less than 12 Months   12 Months or Longer   Total 
       Gross       Gross         
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loses 
   (In Thousands) 
At December 31, 2012                              
Available-for-sale securities:                              
Mortgage-backed securities - residential  $1   $-   $-   $-   $1   $- 
Obligations of state and political subdivisions   949    (5)   -    -    949    (5)
Trust preferred stock and preferred stock   -    -    1,474    (2,091)   1,474    (2,091)
Total temporarily impaired securities  $950   $(5)  $1,474   $(2,091)  $2,424   $(2,096)

 

With the exception of Trust Preferred Securities, the above securities all have fixed interest rates, and all securities have defined maturities. Their fair value is sensitive to movements in market interest rates. First Defiance has the ability and intent to hold these investments for a time necessary to recover the amortized cost without impacting its liquidity position and it is not more than likely that the Company will be required to sell the investments before anticipated recovery.

 

Realized gains from the sales of investment securities totaled $53,000 ($37,000 after tax) in the first quarter of 2013 while there were realized gains of $43,000 ($28,000 after tax) in the first quarter of 2012.

 

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least quarterly, and more frequently when economic or market conditions warrant such an evaluation. The investment portfolio is evaluated for OTTI by segregating the portfolio into two general segments. Investment securities classified as available-for-sale or held-to-maturity are generally evaluated for OTTI under FASB ASC Topic 320. Certain collateralized debt obligations (“CDOs”) are evaluated for OTTI under FASB ASC Topic 325, Investment – Other.

 

When OTTI occurs under either model, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected compared to the book value of the security and is recognized in earnings. The amount of OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

 

In the first quarter of 2013 and 2012, management determined there was no OTTI.

 

23
 

 

The Company held eight CDOs at March 31, 2013. Four of those CDOs were written down in full prior to January 1, 2010. The remaining four CDOs have a total amortized cost of $3.6 million at March 31, 2013. Of these, two, with a total amortized cost of $1.6 million, were identified as OTTI in prior periods. The final two CDOs, with a total amortized cost of $2.0 million, continue to pay principal and interest payments in accordance with the contractual terms of the securities and no credit loss impairment has been identified in management’s analysis. Therefore, these two CDO investments have not been deemed by management to be OTTI.

 

Given the conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, the Company’s CDOs will be classified within Level 3 of the fair value hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

 

As required under FASB ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.

 

The Company’s CDO valuations were supported by analysis prepared by an independent third party. Their approach to determining fair value involved several steps: 1) detailed credit and structural evaluation of each piece of collateral in the CDO; 2) collateral performance projections for each piece of collateral in the CDO (default, recovery and prepayment/amortization probabilities) and 3) discounted cash flow modeling.

 

Trust Preferred CDOs Discount Rate Methodology

 

First Defiance uses market-based yield indicators as a baseline for determining appropriate discount rates, and then adjusts the resulting discount rates on the basis of its credit and structural analysis of specific CDO instruments. The primary focus is on the returns a fixed income investor would require in order to allocate capital on a risk adjusted basis. There is currently no active market for trust preferred CDOs, however, First Defiance looks principally to market yields for stand-alone trust preferred securities issued by banks, thrifts and insurance companies for which there is an active and liquid market. The next step is to make a series of adjustments to reflect the differences that nevertheless exist between these products (both credit and structural) and, most importantly, to reflect idiosyncratic credit performance differences (both actual and projected) between these products and the underlying collateral in the specific CDOs. Importantly, as part of the analysis described above, First Defiance considers the fact that structured instruments frequently exhibit leverage not present in stand-alone instruments, and make adjustments as necessary to reflect this additional risk.

 

Fundamental to this evaluation is an assessment of the likelihood of CDO coverage test failures that would have the effect of diverting cash flow away from the relevant CDO bond for some period of time. Generally speaking, the Company adjusts indicative credit spreads upwards in the case of CDOs that have relatively weaker collateral and/or less cushion with respect to overcollateralization and interest coverage test ratios and downwards if the reverse is true. This aspect of the Company’s discount rate methodology is important because there is frequently a great difference in the risks present in CDO instruments that are otherwise very similar (i.e. CDOs with the same basic type of collateral, the same manager, the same vintage, etc., may exhibit vastly different performance characteristics). With respect to this last point, First Defiance notes that given today’s credit environment, characterized by high default and deferral rates, it is typically the case that deal-specific credit performance (determined on the basis of the credit characteristics of remaining collateral) is the best indicator of what a willing market participant would pay for an instrument.

 

24
 

 

The Company uses the same methodology for all of its CDOs and believes its valuation methodology is appropriate for all of its CDOs in accordance with FASB ASC Topic 320 as well as other related guidance. Beginning with the first quarter of 2013, the Company made the decision to only obtain the third party analysis twice a year, June and December, as a result of the stabilization in its current CDO portfolio. Management still obtains the fair value and cash flow value on a quarterly basis and prepares its internal other-than-temporary impairment analysis.

  

The default and recovery probabilities for each piece of collateral were formed based on the evaluation of the collateral credit and a review of historical industry default data and current/near-term operating conditions. For collateral that has already deferred, the Company assumed a recovery of 10% of par for banks, thrifts or other depository institutions and 15% for insurance companies. Although there is a possibility that the deferring collateral will become current at some point in the future, First Defiance has conservatively assumed that it will continue to defer and gradually will default.

 

The following table details the six securities with other-than-temporary impairment, their lowest credit rating at March 31, 2013 and the related credit losses recognized in earnings for the three month period ended March 31, 2013 (In Thousands):

 

   TPREF
Funding II
   Alesco
VIII
   Preferred
Term
Security
XXVII
   Trapeza
CDO I
   Alesco
Preferred
Funding
VIII
   Alesco
Preferred
Funding
IX
     
   Rated
Caa3
   Rated Ca   Rated C   Rated
Ca
   Not Rated   Not Rated   Total 
Cumulative OTTI related to credit loss at January 1, 2013  $323   $1,000   $78   $857   $453   $465   $3,176 
Addition – Qtr 1   -    -    -    -    -    -    - 
Cumulative OTTI related to credit loss at March 31, 2013  $323   $1,000   $78   $857   $453   $465   $3,176 

 

The amount of OTTI recognized in accumulated other comprehensive income (“AOCI”) was $717,000 for the above securities at March 31, 2013. There was $749,000 recognized in AOCI at December 31, 2012.

 

The following table provides additional information related to the four CDO investments for which a balance remains as of March 31, 2013 (dollars in thousands):

 

25
 

 

CDO  Class   Amortized
Cost
   Fair
Value
   Unrealized
Loss
   OTTI
Losses
2013
   Lowest
Rating
   Current
Number of
Banks and
Insurance
Companies
   Actual
Deferrals
and
Defaults as
a % of
Current
Collateral
   Expected
Deferrals
and
Defaults as
a % of
Remaining
Performing
Collateral
   Excess
Sub-
ordination
as a % of
Current
Performing
Collateral
 
TPREF Funding II   B    673    223    450    -    Caa3    15    43.47%   17.92%   -% 
I-Preferred Term Sec I   B-1    1,000    631    369    -    CCC    15    7.96%   23.00%   25.62%
Dekania II CDO   C-1    990    548    442    -    CCC    32    -%    13.69%   29.62%
Preferred Term Sec XXVII   C-1    902    249    653    -    C    32    27.09%   22.29%   6.23%
Total       $3,565   $1,651   $1,914   $-                          

 

The Company’s assumed average lifetime default rate declined from 27.9% at the end of the fourth quarter 2012 to a rate of 26.7% at the end of the first quarter 2013.

 

There were no changes in the accumulated credit losses recognized in earnings for debt securities during the periods ended March 31, 2013 and 2012.

 

The proceeds from the sales and calls of securities and the associated gains are listed below:

 

   Three Months Ended
March 31,
 
   2013   2012 
   (In thousands) 
Proceeds  $1,019   $218 
Gross realized gains   53    43 
Gross realized losses   -    - 

 

26
 

  

8.Loans

 

Loans receivable consist of the following (in thousands):

 

   March 31,   December 31, 
   2013   2012 
Real Estate:          
Secured by 1-4 family residential  $197,675   $200,826 
Secured by multi-family residential   125,526    122,275 
Secured by commercial real estate   676,572    675,110 
Construction   33,398    37,788 
    1,033,171    1,035,999 
Other Loans:          
Commercial   365,551    383,817 
Home equity and improvement   106,524    108,718 
Consumer Finance   15,549    15,936 
    487,624    508,471 
Total loans   1,520,795    1,544,470 
Deduct:          
Undisbursed loan funds   (13,084)   (18,478)
Net deferred loan origination fees and costs   (703)   (735)
Allowance for loan loss   (26,459)   (26,711)
Totals  $1,480,549   $1,498,546 

 

Loan segments have been identified by evaluating the portfolio based on collateral and credit risk characteristics.

 

The following table discloses allowance for loan loss activity for the quarter ended

March 31, 2013 and 2012 by portfolio segment and impairment method ($ in thousands):

 

Quarter Ended March 31,
2013
  1-4 Family
Residential
Real Estate
   Construction   Multi- Family
Residential
Real Estate
   Commercial
Real Estate
   Commercial   Home Equity
and
Improvement
   Consumer   Total 
Beginning Allowance  $3,506   $75   $2,197   $12,702   $6,325   $1,759   $147   $26,711 
Charge-Offs   (206)   0    0    (266)   (205)   (272)   (46)   (995)
Recoveries   99    0    0    101    76    23    19    318 
Provisions   34    (8)   213    830    (892)   213    35    425 
Ending Allowance  $3,433   $67   $2,410   $13,367   $5,304   $1,723   $155   $26,459 

 

Quarter Ended March 31,
2012
  1-4 Family
Residential
Real Estate
   Construction   Multi- Family
Residential
Real Estate
   Commercial
Real Estate
   Commercial   Home Equity
and
Improvement
   Consumer   Total 
Beginning Specific Allocations  $4,095   $63   $2,850   $17,640   $6,576   $1,856   $174   $33,254 
Charge-Offs   (738)   -    (238)   (4,258)   (2,666)   (211)   (41)   (8,152)
Recoveries   55    -    -    108    30    21    14    228 
Provisions   (39)   10    219    2,710    753    (181)   31    3,503 
Ending Allowance  $3,373   $73   $2,831   $16,200   $4,693   $1,485   $178   $28,833 

 

28
 

 

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of March 31, 2013:

 

(In Thousands)

 

   1-4 Family       Multi- Family                     
   Residential       Residential   Commercial       Home Equity         
   Real Estate   Construction   Real Estate   Real Estate   Commercial   & Improvement   Consumer   Total 
Allowance for loan losses:                                        
                                         
Ending allowance balance attributable to loans:                                        
                                         
Individually evaluated for impairment  $279   $-   $-   $1,092   $58   $24   $-   $1,453 
                                         
Collectively evaluated for impairment   3,154    67    2,410    12,259    5,245    1,699    155    24,989 
                                         
Acquired with deteriorated credit quality   -    -    -    16    1    -    -    17 
                                         
Total ending allowance balance  $3,433   $67   $2,410   $13,367   $5,304   $1,723   $155   $26,459 
                                         
Loans:                                        
                                         
Loans individually evaluated for impairment  $11,336   $-   $1,264   $44,730   $8,194   $2,888   $82   $68,494 
                                         
Loans collectively evaluated for impairment   186,785    20,308    125,597    632,167    358,402    104,116    15,464    1,442,839 
                                         
Loans acquired with deteriorated credit quality   34    -    -    432    30    -    -    496 
                                         
Total ending loans balance  $198,155   $20,308   $126,861   $677,329   $366,626   $107,004   $15,546   $1,511,829 

 

29
 

 

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2012:

 

(In Thousands)

 

   1-4 Family       Multi- Family                     
   Residential       Residential   Commercial       Home Equity         
   Real Estate   Construction   Real Estate   Real Estate   Commercial   & Improvement   Consumer   Total 
Allowance for loan losses:                                        
                                         
Ending allowance balance attributable to loans:                                        
                                         
Individually evaluated for impairment  $281   $-   $-   $1,070   $138   $2   $-   $1,491 
                                         
Collectively evaluated for impairment   3,225    75    2,197    11,632    6,187    1,757    147    25,220 
                                         
Acquired with deteriorated credit quality   -    -    -    -    -    -    -    - 
                                         
Total ending allowance balance  $3,506   $75   $2,197   $12,702   $6,325   $1,759   $147   $26,711 
                                         
Loans:                                        
                                         
Loans individually evaluated for impairment  $11,930   $45   $1,626   $46,053   $8,830   $2,678   $124   $71,286 
                                         
Loans collectively evaluated for impairment   189,348    19,251    120,829    630,534    376,007    106,516    15,815    1,458,300 
                                         
Loans acquired with deteriorated credit quality   36    -    -    436    32    -    -    504 
                                         
Total ending loans balance  $201,314   $19,296   $122,455   $677,023   $384,869   $109,194   $15,939   $1,530,090 

 

30
 

 

The following table presents the average balance, interest income recognized and cash basis income recognized on impaired loans by class of loans. (In Thousands)

 

   Three Months Ended March 31, 2013 
   Average
Balance
   Interest
Income
Recognized
   Cash Basis
Income
Recognized
 
Residential Owner Occupied  $6,947   $88   $86 
Residential Non Owner Occupied   4,669    35    35 
Total Residential Real Estate   11,616    123    121 
Construction   22    -    - 
Multi-Family   1,444    7    7 
CRE Owner Occupied   14,701    62    58 
CRE Non Owner Occupied   24,318    203    193 
Agriculture Land   926    9    7 
Other CRE   5,369    1    1 
Total Commercial Real Estate   45,314    275    259 
Commercial Working Capital   1,487    4    5 
Commercial Other   6,981    23    22 
Total Commercial   8,468    27    27 
Consumer   104    2    2 
Home Equity and Home Improvement   2,772    34    32 
Total Impaired Loans  $69,740   $468   $448 

 

31
 

 

   Three Months Ended March 31, 2012 
   Average
Balance
   Interest
Income
Recognized
   Cash Basis
Income
Recognized
 
Residential Owner Occupied  $1,931   $13   $12 
Residential Non Owner Occupied   2,728    23    23 
Total Residential Real Estate   4,659    36    35 
Construction   80    -    - 
Multi-Family   2,288    16    16 
CRE Owner Occupied   9,476    13    12 
CRE Non Owner Occupied   15,580    91    71 
Agriculture Land   1,441    14    14 
Other CRE   8,044    1    1 
Total Commercial Real Estate   34,541    119    98 
Commercial Working Capital   2,210    3    3 
Commercial Other   4,786    5    5 
Total Commercial   6,996    8    8 
Consumer   -    -    - 
Home Equity and Home Improvement   38    1    1 
Total Impaired Loans  $48,602   $180   $158 

 

32
 

 

The following table presents loans individually evaluated for impairment by class of loans as of March 31, 2013: (In Thousands)

 

   Unpaid
Principal
Balance*
   Recorded
Investment
   Allowance
for Loan
Losses
Allocated
 
With no allowance recorded:               
Residential Owner Occupied  $5,153   $5,103   $- 
Residential Non Owner Occupied   3,942    3,206    - 
Total Residential Real Estate   9,095    8,309    - 
Construction   -    -    - 
Multi-Family Residential Real Estate   1,413    1,264    - 
CRE Owner Occupied   12,200    9,849    - 
CRE Non Owner Occupied   10,717    7,707    - 
Agriculture Land   1,039    1,082    - 
Other CRE   9,224    5,664    - 
Total Commercial Real Estate   33,180    24,302    - 
Commercial Working Capital   964    662    - 
Commercial Other   5,781    5,723    - 
Total Commercial   6,745    6,385    - 
Consumer   79    79    - 
Home Equity and Home Improvement   2,626    2,492    - 
Total loans with no allowance recorded  $53,138   $42,831   $- 
                
With an allowance recorded:               
Residential Owner Occupied  $1,753   $1,760   $256 
Residential Non Owner Occupied   1,265    1,267    23 
Total Residential Real Estate   3,018    3,027    279 
Construction   -    -    - 
Multi-Family Residential Real Estate   -    -    - 
CRE Owner Occupied   5,676    5,055    240 
CRE Non Owner Occupied   15,135    15,201    847 
Agriculture Land   111    114    3 
Other CRE   86    58    2 
Total Commercial Real Estate   21,008    20,428    1,092 
Commercial Working Capital   -    -    - 
Commercial Other   1,805    1,809    58 
Total Commercial   1,805    1,809    58 
Consumer   3    3    - 
Home Equity and Home Improvement   395    396    24 
Total loans with an allowance recorded  $26,229   $25,663   $1,453 

 

*Unpaid principal balance includes partial charge-offs.

 

Impaired loans have been recognized in conformity with FASB ASC Topic 310.

 

33
 

 

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2012: (In Thousands)

 

   Unpaid
Principal
Balance*
   Recorded
Investment
   Allowance
for Loan
Losses
Allocated
 
With no allowance recorded:               
Residential Owner Occupied  $5,427   $5,357   $- 
Residential Non Owner Occupied   4,211    3,420    - 
Total Residential Real Estate   9,638    8,777    - 
Construction   300    45    - 
Multi-Family Residential Real Estate   1,775    1,626    - 
CRE Owner Occupied   12,314    9,782    - 
CRE Non Owner Occupied   11,054    9,105    - 
Agriculture Land   1,176    993    - 
Other CRE   8,741    5,527    - 
Total Commercial Real Estate   33,285    25,407    - 
Commercial Working Capital   1,565    1,565    - 
Commercial Other   6,367    5,338    - 
Total Commercial   7,932    6,903    - 
Consumer   125    124    - 
Home Equity and Home Improvement   2,777    2,642    - 
Total loans with no allowance recorded  $55,832   $45,524   $- 
                
With an allowance recorded:               
Residential Owner Occupied  $1,697   $1,701   $257 
Residential Non Owner Occupied   1,449    1,452    24 
Total Residential Real Estate   3,146    3,153    281 
Construction   -    -    - 
Multi-Family Residential Real Estate   -    -    - 
CRE Owner Occupied   5,735    5,118    245 
CRE Non Owner Occupied   15,301    15,357    820 
Agriculture Land   111    112    3 
Other CRE   88    59    2 
Total Commercial Real Estate   21,235    20,646    1,070 
Commercial Working Capital   300    301    10 
Commercial Other   1,623    1,626    128 
Total Commercial   1,923    1,927    138 
Consumer   -    -    - 
Home Equity and Home Improvement   36    36    2 
Total loans with an allowance recorded  $26,340   $25,762   $1,491 

 

*Unpaid principal balance includes partial charge-offs.

 

34
 

 

The following table presents the aggregate amounts of non-performing assets, comprised of non-performing loans and real estate owned on the dates indicated:

 

   March 31,
2013
   December 31,
2012
 
   (in thousands) 
Non-accrual loans  $35,283   $32,570 
Loans over 90 days past due and still accruing   -    - 
Total non-performing loans   35,283    32,570 
Real estate and other assets held for sale   4,313    3,805 
Total non-performing assets  $39,596   $36,375 

 

The following table presents the aging of the recorded investment in past due and non accrual loans as of March 31, 2013 by class of loans: (In Thousands)

 

   Current   30-59 days   60-89 days   90+ days   Total
Past Due
   Total Non
Accrual
 
Residential Owner Occupied  $122,921   $1,418   $83   $1,420   $2,921   $1,594 
Residential Non Owner Occupied   70,247    865    524    677    2,066    2,566 
                               
Total Residential Real Estate   193,168    2,283    607    2,097    4,987    4,160 
                               
Construction   20,308    -    -    -    -    - 
Multi-Family   126,813    -    -    48    48    1,189 
                               
CRE Owner Occupied   319,908    2,779    365    3,483    6,627    10,402 
CRE Non Owner Occupied   232,445    225    423    2,723    3,371    7,583 
Agriculture Land   73,371    109    28    82    219    770 
Other Commercial Real Estate   37,111    -    -    4,277    4,277    4,930 
                               
Total Commercial Real Estate   662,835    3,113    816    10,565    14,494    23,685 
                               
Commercial Working Capital   151,607    10    -    762    772    1,121 
Commercial Other   209,562    246    1,187    3,252    4,685    5,037 
                               
Total Commercial   361,169    256    1,187    4,014    5,457    6,158 
                               
Consumer   15,425    117    4    -    121    - 
Home Equity/Home Improvement   106,035    325    560    84    969    84 
                               
Total Loans  $1,485,753   $6,094   $3,174   $16,808   $26,076   $35,276 

 

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The following table presents the aging of the recorded investment in past due and non accrual loans as of December 31, 2012 by class of loans: (In Thousands)

 

   Current   30-59 days   60-89 days   90+ days   Total
Past Due
   Total Non
Accrual
 
Residential Owner Occupied  $125,362   $1,238   $604   $945   $2,787   $1,125 
Residential Non Owner Occupied   71,777    413    126    849    1,388    2,473 
                               
Total Residential Real Estate   197,139    1,651    730    1,794    4,175    3,598 
                               
Construction   19,296    -    -    -    -    - 
Multi-Family   122,455    -    -    -    -    1,178 
                               
CRE Owner Occupied   321,071    1,248    382    1,622    3,252    9,652 
CRE Non Owner Occupied   235,592    134    1,321    2,480    3,935    6,674 
Agriculture Land   72,092    84    31    -    115    813 
Other Commercial Real Estate   36,510    21    875    3,560    4,456    4,761 
                               
Total Commercial Real Estate   665,265    1,487    2,609    7,662    11,758    21,900 
                               
Commercial Working Capital   161,110    -    155    1,204    1,359    1,528 
Commercial Other   218,477    584    1,201    2,138    3,923    4,136 
                               
Total Commercial   379,587    584    1,356    3,342    5,282    5,664 
                               
Consumer   15,702    229    8    -    237    - 
Home Equity/Home Improvement   106,458    2,294    225    217    2,736    217 
                               
Total Loans  $1,505,902   $6,245   $4,928   $13,015   $24,188   $32,557 

 

Troubled Debt Restructurings

 

As of March 31, 2013 and December 31, 2012, the Company has a recorded investment in troubled debt restructurings (“TDRs”) of $34.0 million and $35.5 million, respectively. The Company has allocated $1.1 million of specific reserves to those loans at each of March 31, 2013 and December 31, 2012, and has committed to lend additional amounts totaling up to $35,000 and $41,000 at March 31, 2013 and December 31, 2012, respectively.

 

The Company offers various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted. Each TDR is uniquely designed to meet the specific needs of the borrower. Commercial and industrial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral or an additional guarantor is often requested when granting a concession. Commercial mortgage loans modified in a TDR often involve temporary interest-only payments, re-amortization of remaining debt in order to lower payments, and sometimes reducing the interest rate lower than the current market rate. Residential mortgage loans modified in a TDR are comprised of loans where monthly payments are lowered, either through interest rate reductions or principal only payments for a period of time, to accommodate the borrowers’ financial needs, interest is capitalized into principal, or the term and amortization are extended. Home equity modifications are made infrequently and usually involve providing an interest rate that is lower than the borrower would be able to obtain due to credit issues. All retail loans where the borrower is in bankruptcy are classified as TDRs regardless of whether or not a concession is made.

 

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Of the loans modified in a TDR, $6.0 million are on non-accrual status and partial charge-offs have in some cases been taken against the outstanding balance. Loans modified as a TDR may have the financial effect of increasing the allowance associated with the loan. If the loan is determined to be collateral dependent, the estimated fair value of the collateral, less any selling costs is used to determine if there is a need for a specific allowance or charge-off. If the loan is determined to be cash flow dependent, the allowance is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate.

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the three month period ending March 31, 2013 and March 31, 2012:

 

   Loans Modified as a TDR for the Three
Months Ended March 31, 2013
($ in thousands)
 
Troubled Debt Restructurings  Number of Loans   Recorded
Investment (as of
period end)
 
Residential Owner Occupied  4   $367 
Residential Non Owner Occupied  1    198 
CRE Owner Occupied  1    29 
CRE Non Owner Occupied  0    - 
Agriculture Land  1    219 
Other CRE  0    0 
Commercial / Industrial  1    14 
Home Equity / Improvement  8    492 
Consumer  2    4 
Total  18   $1,323 

 

The loans described above increased the ALLL by $19,000 in the three month period ending March 31, 2013.

 

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   Loans Modified as a TDR for the Three
Months Ended March 31, 2012
($ in thousands)
 
Troubled Debt Restructurings  Number of Loans   Recorded
Investment (as of
period end)
 
Residential Owner Occupied  2   $148 
Residential Non Owner Occupied  1    83 
CRE Owner Occupied  2    951 
CRE Non Owner Occupied  0    - 
Agriculture Land  1    339 
Other CRE  0    - 
Commercial / Industrial  0    - 
Home Equity / Improvement  0    - 
Consumer  0    - 
Total  6   $1,521 

 

The loans described above decreased the ALLL by $15,000, after charge-offs of $700,000, in the three month period ending March 31, 2012.

 

The following table presents loans by class modified as TDRs for which there was a payment default within twelve months following the modification during the quarter ending March 31, 2013:

 

   Three Months Ended March 31, 2013 
Troubled Debt Restructurings
That Subsequently Defaulted:
  Number of
Loans
   Recorded
Investment
(as of Period
End)
 
Residential Owner Occupied  4   $312 
Residential Non Owner Occupied  1    198 
CRE Owner Occupied  2    858 
CRE Non Owner Occupied  -    - 
Agriculture Land  -    - 
Other CRE  -    - 
Commercial / Industrial  2    744 
Home Equity / Improvement  4    53 
Consumer  -    - 
Total  13   $2,165 

 

The TDRs that subsequently defaulted described above decreased the allowance for loan losses by $1,000 for the period ended March 31, 2013, after $0 charge-offs.

 

There were no loans that defaulted within the three months ended March 31, 2012 which had been modified within one year of the default date. A default for the purposes of this disclosure is a TDR loan in which the borrower is 90 days or more past due.

 

The terms of certain other loans were modified during the period ending March 31, 2013 that did not meet the definition of a TDR. The modification of these loans involved a modification of the terms of a loan to borrowers who were not experiencing financial difficulties. A total of 42 loans were modified under this definition during the three month period ended March 31, 2013.

 

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In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed on the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification.

 

Credit Quality Indicators

 

Loans are categorized into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Loans are analyzed individually by classifying the loans as to credit risk. This analysis includes all non-homogeneous loans, such as commercial and commercial real estate loans and certain homogenous mortgage, home equity and consumer loans. This analysis is performed on a quarterly basis. First Defiance uses the following definitions for risk ratings:

 

Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

 

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

 

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

 

Not Graded. Loans classified as not graded are generally smaller balance residential real estate, home equity and consumer installment loans which are originated primarily by using an automated underwriting system. These loans are monitored based on their delinquency status and are evaluated individually only if they are seriously delinquent.

 

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of March 31, 2013, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows: (In Thousands)

 

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Category  Pass   Special
Mention
   Substandard   Doubtful   Not
Graded
   Total 
                         
Residential Owner Occupied  $4,043   $42   $3,861   $90   $117,805   $125,841 
Residential Non Owner Occupied   54,810    3,658    7,009    -    6,837    72,314 
                               
Total Residential Real Estate   58,853    3,700    10,870    90    124,642    198,155 
                               
Construction   12,844    129    -    -    7,335    20,308 
Multi-Family   122,566    751    2,538    -    1,006    126,861 
                               
CRE Owner Occupied   297,600    10,464    18,360    -    110    326,534 
CRE Non Owner Occupied   202,862    11,351    21,454    -    149    235,816 
Agriculture Land   71,412    606    1,573    -    -    73,591 
Other Commercial Real Estate   31,137    2,067    7,324    -    860    41,388 
                               
Total Commercial Real Estate   603,011    24,488    48,711    -    1,119    677,329 
                               
Commercial Working Capital   146,445    4,131    1,803    -    -    152,379 
Commercial Other   202,218    4,830    7,199    -    -    214,247 
                               
Total Commercial   348,663    8,961    9,002    -    -    366,626 
                               
Consumer   -    -    90    -    15,456    15,546 
Home Equity/Home Improvement   -    -    835    24    106,145    107,004 
                               
Total Loans  $1,145,937   $38,029   $72,046   $114   $255,703   $1,511,829 

 

40
 

 

As of December 31, 2012, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows: (In Thousands)

 

Category  Pass   Special
Mention
   Substandard   Doubtful   Not
Graded
   Total 
                         
Residential Owner Occupied  $4,221   $75   $3,617   $234   $120,002   $128,149 
Residential Non Owner Occupied   55,771    2,453    8,248    -    6,693    73,165 
                               
Total Residential Real Estate   59,992    2,528    11,865    234    126,695    201,314 
                               
Construction   11,360    -    45    -    7,891    19,296 
Multi-Family   118,121    910    2,404    -    1,020    122,455 
                               
CRE Owner Occupied   292,765    10,440    18,740    -    2,378    324,323 
CRE Non Owner Occupied   207,745    9,077    22,615    -    90    239,527 
Agriculture Land   69,924    769    1,514    -    -    72,207 
Other Commercial Real Estate   31,875    891    7,222    -    978    40,966 
                               
Total Commercial Real Estate   602,309    21,177    50,091    -    3,446    677,023 
                               
Commercial Working Capital   156,433    3,587    2,449    -    -    162,469 
Commercial Other   208,783    5,204    8,413    -    -    222,400 
                               
Total Commercial   365,216    8,791    10,862    -    -    384,869 
                               
Consumer   -    -    70    -    15,869    15,939 
Home Equity/Home Improvement   -    -    668    64    108,462    109,194 
                               
Total Loans  $1,156,998   $33,406   $76,005   $298   $263,383   $1,530,090 

 

Beginning with the first quarter of 2013 allowance analysis, management decided to return to using a twelve quarter look-back period, from using an eight quarter look-back period that has been used since December 31, 2010, for calculating the historical loss ratio. Management is not certain that the relatively low levels of charge-offs incurred in recent quarters are sustainable given the low levels of economic growth in its markets and believes the longer look-back period better captures loan portfolio risks at this time.

 

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9.Mortgage Banking

 

Net revenues from the sales and servicing of mortgage loans consisted of the following:

 

   Three Months Ended
 March 31,
 
   2013   2012 
   (in thousands) 
Gain from sale of mortgage loans  $2,176   $2,544 
Mortgage loans servicing revenue (expense):          
Mortgage loans servicing revenue   870    844 
Amortization of mortgage servicing rights   (689)   (864)
Mortgage servicing rights valuation adjustments   473    (79)
    654    (99)
           
Net revenue from sale and servicing of mortgage loans  $2,830   $2,445 

 

The unpaid principal balance of residential mortgage loans serviced for third parties was $1.4 billion at March 31, 2013 and $1.3 billion at December 31, 2012.

 

Activity for capitalized mortgage servicing rights and the related valuation allowance follows for the three months ended March 31, 2013 and 2012:

 

   March 31, 
2013
   March 31,
2012
 
   (in thousands) 
Mortgage servicing assets:          
Balance at beginning of period  $10,121   $10,219 
Loans sold, servicing retained   762    749 
Amortization   (689)   (864)
Carrying value before valuation allowance at end of period   10,194    10,106 
           
Valuation allowance:          
Balance at beginning of period   (2,288)   (1,529)
Impairment (expense) recovery   473    (79)
Balance at end of period   (1,815)   (1,608)
Net carrying value of MSRs at end of period  $8,379   $8,498 
Fair value of MSRs at end of period  $8,436   $8,498 

 

Amortization of mortgage servicing rights is computed based on payments and payoffs of the related mortgage loans serviced. Estimates of future amortization expense are not easily estimable.

 

Included in the first quarter of 2013 is an accrual for estimated secondary market buy-back losses of $581,000 compared to no losses accrued for the same period in 2012. These losses were accrued and expensed as of March 31, 2013 based on an estimated exposure to repurchase requests resulting from notifications received from Fannie Mae’s post-foreclosure review process during the first quarter of 2013.

 

42
 

 

10.Deposits

 

A summary of deposit balances is as follows (in thousands):

 

   March 31,
2013
   December 31,
2012
 
Non-interest-bearing checking accounts  $291,765   $315,132 
Interest-bearing checking and money market accounts   681,061    664,857 
Savings accounts   177,336    166,945 
Retail certificates of deposit less than $100,000   330,870    342,472 
Retail certificates of deposit greater than $100,000   173,379    176,029 
Brokered or national certificates of deposit   1,937    2,037 
   $1,656,348   $1,667,472 

 

11.Borrowings

 

First Defiance’s debt, FHLB advances and junior subordinated debentures owed to unconsolidated subsidiary trusts are comprised of the following:

 

   March 31,
2013
   December 31,
2012
 
   (in thousands) 
FHLB Advances:          
Putable advances  $12,000   $12,000 
Amortizable mortgage advances   784    796 
Total  $12,784   $12,796 
           
Junior subordinated debentures owed to unconsolidated subsidiary trusts  $36,083   $36,083 

 

The putable advances can be put back to the Company at the option of the FHLB on a quarterly basis. $12.0 million of the putable advances with a weighted average rate of 2.72% were not yet callable by the FHLB at March 31, 2013. The call dates for these advances range from April 15, 2013 to June 12, 2013 and the maturity dates range from January 14, 2015 to March 12, 2018. Putable advances are callable at the option of the FHLB on a quarterly basis.

 

In March 2007, the Company sponsored an affiliated trust, First Defiance Statutory Trust II (Trust Affiliate II) that issued $15 million of Guaranteed Capital Trust Securities (Trust Preferred Securities). In connection with this transaction, the Company issued $15.5 million of Junior Subordinated Deferrable Interest Debentures (Subordinated Debentures) to Trust Affiliate II. The Company formed Trust Affiliate II for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Subordinated Debentures held by Trust Affiliate II are the sole assets of that trust. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the Trust Preferred Securities issued by Trust Affiliate II are payable quarterly at a fixed rate equal to 6.441% for the first five years and a floating interest rate based on three-month LIBOR plus 1.5%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate II was 1.78% as of March 31, 2013 and 1.89% as of December 31, 2012.

 

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The Company also sponsored an affiliated trust, First Defiance Statutory Trust I (Trust Affiliate I), that issued $20 million of Trust Preferred Securities in 2005. In connection with this transaction, the Company issued $20.6 million of Subordinated Debentures to Trust Affiliate I. Trust Affiliate I was formed for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Junior Debentures held by Trust Affiliate I are the sole assets of the trust. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the Trust Preferred Securities issued by Trust Affiliate I are payable quarterly at a variable rate equal to the three-month LIBOR rate plus 1.38%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate I was 1.66% and 1.77% on March 31, 2013 and December 31, 2012 respectively.

 

The Trust Preferred Securities issued by Trust Affiliates I and II are subject to mandatory redemption, in whole or part, upon repayment of the Subordinated Debentures. The Company has entered into agreements that fully and unconditionally guarantee the Trust Preferred Securities subject to the terms of the guarantees. The Trust Preferred Securities and Subordinated Debentures issued by Trust Affiliate I mature on December 15, 2035 but may be redeemed by the issuer at par after October 28, 2010. The Trust Preferred Securities issued by Trust Affiliate II mature on June 15, 2037, but may be redeemed at the Company’s option at any time on or after June 15, 2012, or at any time upon certain events.

 

Interest on both issues of trust preferred securities may be deferred for a period of up to five years at the option of the issuer.

 

12.Commitments, Guarantees and Contingent Liabilities

 

Loan commitments are made to accommodate the financial needs of First Federal’s customers; however, there are no long-term, fixed-rate loan commitments that result in market risk. Standby letters of credit commit the Company to make payments on behalf of customers when certain specified future events occur. They primarily are issued to facilitate customers’ trade transactions.

 

Both arrangements have credit risk, essentially the same as that involved in extending loans to customers, and are subject to the Company’s normal credit policies. Collateral (e.g., securities, receivables, inventory and equipment) is obtained based on Management’s credit assessment of the customer.

 

The Company’s maximum obligation to extend credit for loan commitments (unfunded loans and unused lines of credit) and standby letters of credit outstanding as of the periods stated below were as follows (in thousands):

 

44
 

 

   March 31, 2013   December 31, 2012 
   Fixed Rate   Variable Rate   Fixed Rate   Variable Rate 
Commitments to make loans  $53,174   $74,184   $50,205   $48,035 
Unused lines of credit   23,236    238,257    21,975    228,269 
Standby letters of credit   -    21,388    -    18,166 
Total  $76,410   $333,829   $72,180   $294,470 

 

Commitments to make loans are generally made for periods of 60 days or less.

In addition to the above commitments, First Defiance had commitments to sell $37.8 million and $53.6 million of loans to Freddie Mac, Fannie Mae, Federal Home Loan Bank of Cincinnati or BB&T Mortgage at March 31, 2013 and December 31, 2012, respectively.

 

13.Income Taxes

 

The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax in the state of Indiana. The Company is no longer subject to examination by taxing authorities for years before 2008. The Company currently operates primarily in the states of Ohio and Michigan, which tax financial institutions based on their equity rather than their income.

 

14.Derivative Financial Instruments

 

Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated in hedge relationships. First Federal had approximately $30.2 million and $34.0 million of interest rate lock commitments at March 31, 2013 and December 31, 2012, respectively. There were $37.8 million and $53.6 million of forward commitments for the future delivery of residential mortgage loans at March 31, 2013 and December 31, 2012, respectively.

 

The fair value of these mortgage banking derivatives are reflected by a derivative asset. The table below provides data about the carrying values of these derivative instruments:

 

   March 31, 2013   December 31, 2012 
   Assets   (Liabilities)       Assets   (Liabilities)     
           Derivative          Derivative 
   Carrying   Carrying   Net Carrying   Carrying   Carrying   Net Carrying 
   Value   Value   Value   Value   Value   Value 
   (In Thousands) 
Derivatives not designated as hedging instruments                              
Mortgage Banking Derivatives  $918   $(223)  $695   $950   $(94)  $856 

 

The table below provides data about the amount of gains and losses recognized in income on derivative instruments not designated as hedging instruments:

 

45
 

 

   Three Months Ended
March 31,
 
   2013   2012 
   (In Thousands) 
Derivatives not designated as hedging instruments        
           
Mortgage Banking Derivatives – Gain (Loss)  $(161)  $273 

 

The above amounts are included in mortgage banking income with gain on sale of mortgage loans.

 

Note 15 - Other Comprehensive Income (Loss)

 

The before and after tax amounts allocated to each component of other comprehensive income (loss) are presented in the table below. Reclassification adjustments related to securities available for sale are included in gains on sale or call of securities in the accompanying consolidated condensed statements of income.

 

   Before Tax
Amount
   Tax Expense
(Benefit)
   Net of Tax
Amount
 
Three months ended March 31, 2013:            
Securities available for sale and transferred securities:               
Change in net unrealized gain/loss during the period  $(664)  $(235)  $(429)
Reclassification adjustment for net gains included in net income   (53)   (16)   (37)
Total other comprehensive loss  $(717)  $(251)  $(466)
                
Three months ended March 31, 2012:               
Securities available for sale and transferred securities:               
Change in net unrealized gain/loss during the period  $(49)  $(19)  $(30)
Reclassification adjustment for net gains included in net income   (43)   (13)   (30)
Total other comprehensive loss  $(92)  $(32)  $(60)

 

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Activity in accumulated other comprehensive income (loss), net of tax, was as follows:

 

         Accumulated 
   Securities   Post-   Other 
   Available   retirement   Comprehensive 
   For Sale   Benefit   Income 
Balance January 1, 2013  $4,851   $(577)  $4,274 
Other comprehensive loss before reclassifications   (429)   -    (429)
Amounts reclassified from accumulated other comprehensive loss   (37)   -    (37)
                
Net other comprehensive loss during period   (466)   -    (466)
                
Balance March 31, 2013  $4,385   $(577)  $3,808 
                
Balance January 1, 2012  $4,704   $(707)  $3,997 
Other comprehensive loss before reclassifications   (30)   -    (30)
Amounts reclassified from accumulated other comprehensive loss   (30)   -    (30)