10-K 1 tv486302_10k.htm FORM 10-K

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

 

FORM 10-K

(Mark One)

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

  For the fiscal year Ended   December 31, 2017  

 

or

 

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

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 incorporation or organization)   (I.R.S. Employer Identification Number)
     
601 Clinton Street, Defiance, Ohio   43512
(Address of principal executive offices)   (Zip code)

 

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

 

 

 

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

 

Common Stock, Par Value $0.01 Per Share   The NASDAQ Stock Market
(Title of Class)   (Name of each exchange on which registered)

 

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

 

None

(Title of Class)

 

 

 

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

 

Indicate by check mark if registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes ¨ No x

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

 

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

 

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

 

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

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ¨

 

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

 

The aggregate market value of the voting stock held by non-affiliates of the Registrant computed by reference to the average bid and ask price of such stock as of June 30, 2017, was approximately $517.0 million.

 

As of February 23, 2018, there were issued and outstanding 10,182,308 shares of the Registrant’s common stock.

 

Documents Incorporated by Reference

 

Part III of this Form 10-K incorporates by reference certain information from the Registrant’s definitive Proxy Statement for the 2018 Annual Meeting of the Registrant’s shareholders.

 

 

 

 

 

 

First Defiance Financial Corp.

Annual Report on Form 10-K

 

Table of Contents

 

    Page
PART I    
Item 1. Business 3
Item 1A. Risk Factors 24
Item 1B. Unresolved Staff Comments 30
Item 2. Properties 30
Item 3. Legal Proceedings 31
Item 4. Mine Safety Disclosures 31
     
PART II    
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 32
Item 6. Selected Financial Data 34
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation 35
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 55
Item 8. Financial Statements and Supplementary Data 58
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 129
Item 9A. Controls and Procedures 129
Item 9B. Other Information 129
     
PART III    
Item 10. Directors, Executive Officers and Corporate Governance 130
Item 11. Executive Compensation 130
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 130
Item 13.   Certain Relationships and Related Transactions, and Director Independence 131
Item 14. Principal Accounting Fees and Services 131
     
PART IV    
Item 15. Exhibits, Financial Statement Schedules 131
Item 16. 10-K Summary 132
     
SIGNATURES   133

 

 - 2 - 

 

 

PART I

 

Item 1. Business

 

First Defiance Financial Corp. (“First Defiance” or “the Company”) is a unitary thrift holding company that, through its subsidiaries, First Federal Bank of the Midwest (“First Federal” or “the Bank”), First Insurance Group of the Midwest, Inc. (“First Insurance”), and First Defiance Risk Management Inc. (collectively, “the Subsidiaries”), focuses on traditional banking and property, casualty, life and group health insurance products.

 

The Company’s philosophy is to grow and prosper, building long-term relationships based on top quality service, high ethical standards, and safe and sound assets. The Company operates as a locally oriented, community-based financial services organization, augmented by experienced, centralized support in select critical areas. The Company’s local market orientation is reflected in its market area management and local advisory boards, which are comprised of local business persons, professionals and other community representatives that assist area management in responding to local banking needs.

 

The Company’s operating objectives include expansion, diversification within its markets, growth of its fee-based income and growth organically and through acquisitions of financial institutions, branches and financial services businesses. The Company seeks merger or acquisition partners that are culturally similar, have experienced management and possess either significant market area presence or have the potential for improved profitability through financial management, economies of scale and expanded services. The Company regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur. Acquisitions typically involve the payment of premiums over book and market values and, therefore, some dilution of the Company’s tangible book value and net income per common share may occur in any future transaction.

 

Effective February 24, 2017, the Company acquired Commercial Bancshares, Inc. (“Commercial Bancshares”) and its subsidiary, The Commercial Savings Bank (“CSB”), pursuant to an Agreement and Plan of Merger (“merger agreement”), dated August 23, 2016. The acquisition was accomplished by the merger of Commercial Bancshares into First Defiance, immediately followed by the merger of CSB into First Defiance’s banking subsidiary, First Federal. Prior to the consummation of the mergers, CSB operated 7 full-service banking offices in northwest and north central Ohio and 1 commercial loan production office in central Ohio. Commercial Bancshares’ consolidated assets and equity (unaudited) as of February 24, 2017 totaled $348.4 million and $37.5 million, respectively. The Company accounted for the transaction under the acquisition method of accounting which means that the acquired assets and liabilities were recorded at fair value at the date of acquisition.

 

On April 13, 2017, First Defiance and Corporate One Benefits Agency, Inc. (“Corporate One”) jointly announced the acquisition of Corporate One’s business by First Defiance. The total purchase price paid in cash was made up of the following: $6.5 million was paid at closing, $500,000 will be due in July 2018, and approximately $2.3 million will be due at the end of a three-year earn-out based on the compound annual growth rate of net revenue over the performance period of Corporate One, for a total purchase price of $9.3 million. The recorded fair value of the $2.3 million earn-out was $1.8 million at December 31, 2017. As of December 31, 2017, total Company recorded goodwill of $7.9 million, identifiable intangible assets of $756,000 (consisting of customer relationship intangible of $564,000 and a non-compete intangible of $192,000) from the acquisition of Corporate Ones business. Corporate One was a full-service employee benefits consulting organization founded in 1996 with offices located in Archbold, Findlay, Fostoria and Tiffin, Ohio. Corporate One provided consulting services to employers regarding management and modernization of their employee benefit program. It is anticipated that the transaction will enhance employee benefit products offered by First Insurance and expand First Insurance’s presence into adjacent markets in northwest Ohio.

 

 - 3 - 

 

 

At December 31, 2017, the Company had consolidated assets of $3.0 billion, consolidated deposits of $2.4 billion, and consolidated stockholders’ equity of $373.3 million. The Company was incorporated in Ohio in June of 1995. Its principal executive offices are located at 601 Clinton Street, Defiance, Ohio 43512, and its telephone number is (419) 782-5015.

 

First Defiance's website, www.fdef.com, contains a hyperlink under the Investor Relations section to EDGAR, where the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge as soon as reasonably practicable after First Defiance has filed the report with the United State Securities and Exchange Commission (“SEC”).

 

The Subsidiaries

 

The Company’s core business operations are conducted through its subsidiaries:

 

First Federal Bank of the Midwest: First Federal is a federally chartered stock savings bank headquartered in Defiance, Ohio. It conducts operations through thirty-six full-service banking center offices in Allen, Defiance, Fulton, Hancock, Henry, Lucas, Marion, Ottawa, Paulding, Putnam, Seneca, Williams, Wood, and Wyandot counties in northwest and central Ohio, two full-service banking center offices in Allen County in northeast Indiana, five full-service banking center offices in Lenawee County in southeast Michigan and one commercial loan production office in Ann Arbor, Michigan that was opened late in the fourth quarter of 2017.

 

First Federal is primarily engaged in community banking. It attracts deposits from the general public through its offices and website, and uses those and other available sources of funds to originate residential real estate loans, commercial real estate loans, commercial loans, home improvement and home equity loans and consumer loans. In addition, First Federal invests in U.S. Treasury and federal government agency obligations, obligations of the State of Ohio and its political subdivisions, mortgage-backed securities that are issued by federal agencies, including real estate mortgage investment conduits (“REMICs”) and residential collateralized mortgage obligations (“CMOs”), and corporate bonds. First Federal’s deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”). First Federal is a member of the Federal Home Loan Bank (“FHLB”) System.

 

First Insurance Group of the Midwest: First Insurance is a wholly owned subsidiary of First Defiance. First Insurance is an insurance agency that conducts business through offices located in the Archbold, Bowling Green, Bryan, Defiance, Findlay, Fostoria, Lima, Maumee, Oregon, and Tiffin, Ohio areas. The Maumee and Oregon offices were consolidated into a new office in Sylvania, Ohio in January 2018. First Insurance offers property and casualty insurance, life insurance and group health insurance.

 

First Defiance Risk Management: 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. First Defiance Risk Management pools resources with several other similar insurance company subsidiaries of financial institutions to help minimize the risk allocable to each participating insurer.

 

Business Strategy

 

First Defiance’s primary objective is to be a high-performing community banking organization, well regarded in its market areas. First Defiance accomplishes this through emphasis on local decision making and empowering its employees with tools and knowledge to serve its customers’ needs. First Defiance believes in a “Customer First” philosophy that is strengthened by its Mission & Vision and Core Values initiatives. First Defiance also has a tagline of “Better Together” as an indication of its commitment to local, responsive, personalized service. First Defiance believes this strategy results in greater customer loyalty and profitability through core relationships. First Defiance is focused on diversification of revenue sources and increased market penetration in areas where the growth potential exists for a balance between acquisition and organic growth. The primary elements of First Defiance’s business strategy are commercial banking, consumer banking, including the origination and sale of single-family residential loans, enhancement of fee income, wealth management and insurance sales, each united by a strong customer service culture throughout the organization. In the later part of 2017, the Company recognized the need to adapt its organization structure to meet certain future strategic objectives and to continue its past success. The Company believes that fully utilizing the strengths of its leadership team and a structure that supports strategic initiatives will enhance its ability to achieve even more milestones in the future. With that being said, the Company redefined its market areas to support strategies to enhance processes and efficiencies to support overall growth. The new structure includes three metro markets; Toledo, Ohio, Fort Wayne, Indiana, and Columbus, Ohio and two legacy markets; Southern Market Area and Northern Market Area.

 

 - 4 - 

 

 

Commercial and Commercial Real Estate Lending - Commercial and commercial real estate lending have been an ongoing focus and a major component of First Federal’s success. First Federal provides primarily commercial real estate and commercial business loans with an emphasis on owner- occupied commercial real estate and commercial business lending, including a focus on the deposit balances that accompany these relationships. First Federal’s client base tends to be small to middle market customers with annual gross revenues generally between $1 million and $50 million. First Federal’s focus is also on securing multiple guarantors in addition to collateral where possible. These customers require First Federal to have a high degree of knowledge and understanding of their business in order to provide them with solutions to their financial needs. First Federal’s “Customer First” philosophy and culture complements this need of its clients. First Federal believes this personal service model differentiates First Federal from its competitors, particularly the larger regional institutions. First Federal offers a wide variety of products to support commercial clients including remote deposit capture and other cash management services. First Federal also believes that the small business customer is a strong market for First Federal. First Federal participates in many of the Small Business Administration lending programs. Maintaining a diversified portfolio with an emphasis on monitoring industry concentrations and reacting to changes in the credit characteristics of industries is an ongoing focus.

 

Consumer Banking - First Federal offers customers a full range of deposit and investment products including demand, checking, money market, certificates of deposits, Certificate of Deposit Account Registry Service (“CDARS”) and savings accounts. First Federal offers a full range of investment products through the wealth management department and a wide variety of consumer loan products, including residential mortgage loans, home equity loans, and installment loans. First Federal also offers online and mobile banking services.

 

Fee Income Development - Generation of fee income and the diversification of revenue sources are accomplished through the mortgage banking operation, First Insurance and the wealth management department as First Defiance seeks to reduce reliance on retail transaction fee income.

 

Deposit Growth - First Federal’s focus has been to grow core deposits with an emphasis on total relationship banking with both our retail and commercial customers. First Federal’s pricing strategy considers the whole relationship of the customer. First Federal continues to focus on increasing its market share in the communities it serves by providing quality products with extraordinary customer service, business development strategies and branch expansion. First Federal will look to grow its footprint in areas believed to further complement its overall market share and complement its strategy of being a high-performing community bank.

 

Asset Quality - Maintaining a strong credit culture is of the utmost importance to First Federal. First Federal has maintained a strong credit approval and review process that has allowed the Company to maintain a credit quality standard that balances the return with the risks of industry concentrations and loan types. First Federal is primarily a collateral lender with an emphasis on cash flow performance, while obtaining additional support from personal guarantees and secondary sources of repayment. First Federal has directed its attention to loan types and markets that it knows well and in which it has historically been successful. First Federal strives to have loan relationships that are well diversified in both size and industry, and monitors the overall trends in the portfolio to maintain its industry and loan type concentration targets. First Federal maintains a problem loan remediation process that focuses on detection and resolution. First Federal maintains a strong process of internal control that subjects the loan portfolio to periodic internal reviews as well as independent third-party loan review.

 

 - 5 - 

 

 

Expansion Opportunities - First Defiance believes it is well positioned to take advantage of acquisitions or other business opportunities in its market areas. First Defiance believes it has a track record of successfully accomplishing both acquisitions and de novo branching in its market area. This track record puts the Company in a solid position to enter or expand its business. First Defiance will continue to be disciplined as well as opportunistic in its approach to future acquisitions and de novo branching with a focus on its primary geographic market area, which it knows well, and has been competing in for a long period of time, as well as surrounding market areas.

 

Securities

 

First Defiance’s securities portfolio is managed in accordance with a written policy adopted by the Board of Directors and administered by the Investment Committee. The Chief Financial Officer, Controller, and the Chief Administration Officer can each approve transactions up to $3.0 million. Two of the three officers are required to approve transactions between $3.0 million and $5.0 million. All transactions in excess of $5.0 million must be approved by the Board of Directors.

 

First Defiance’s investment portfolio includes 76 CMO issues totaling $93.9 million, all of which are fully amortizing securities. Management does not believe the risks associated with any of its CMO investments are significantly different from risks associated with other pass-through mortgage-backed securities. First Defiance did not have any off-balance sheet derivative securities at December 31, 2017.

 

Management determines the appropriate classification of debt securities at the time of purchase. Debt securities are classified as held-to-maturity when First Defiance has the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost. Debt securities not classified as held-to-maturity and equity securities are classified as available-for-sale. Available-for-sale securities are stated at fair value.

 

The carrying value of securities at December 31, 2017, by contractual maturity is shown below. Expected maturities will differ from contractual maturities because issuers 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, which are not due at a single maturity date, have been allocated over maturity groupings based on the weighted-average contractual maturities of underlying collateral. The mortgage-backed securities may mature earlier than their weighted-average contractual maturities because of principal prepayments.

 

 - 6 - 

 

 

   Contractually Maturing   Total 
       Weighted       Weighted       Weighted       Weighted         
   Under 1   Average   1 - 5   Average   6-10   Average   Over 10   Average         
   Year   Rate   Years   Rate   Years   Rate   Years   Rate   Amount   Yield 
   (Dollars in Thousands) 
Mortgage-backed securities  $6,334    3.12%  $22,269    3.08%  $17,149    3.02%  $11,817    3.33%  $57,569    3.12%
CMOs   12,751    3.11    43,744    3.10    31,600    3.12    6,250    3.31    94,345    3.12 
U.S. government and federal agency obligations   -    -    519    2.00    -    -    -    -    519    2.00 
Obligations of states and political subdivisions (1)   1,423    4.37    9,425    3.39    36,965    3.76    42,911    3.37    90,724    3.55 
Corporate bonds   -    -    10,017    2.29    2,897    2.58    -    -    12,914    2.36 
Total  $20,508        $85,974        $88,611        $60,978        $256,071      
Unamortized premiums/ (discounts)                                           4,303      
Unrealized gain on securities available for sale and unrecognized gain on held to maturity                                           924      
Total                                          $261,298      

 

(1)Tax exempt yield based on effective tax rate of 35%. Actual coupon rate is approximately equal to the weighted average rate disclosed in the table times 65%.

 

The carrying value of investment securities is as follows:

 

   December 31 
   2017   2016   2015 
   (In Thousands) 
Available-for-sale securities:               
Obligations of U.S. government corporations and agencies  $508   $3,915   $2,994 
Obligations of state and political subdivisions   92,828    88,043    90,389 
CMOs, REMICS and mortgage-backed securities   154,210    146,019    138,074 
Trust preferred stock and preferred stock   1    2    1 
Corporate bonds   13,103    13,013    4,977 
Total  $260,650   $250,992   $236,435 
                
Held-to-maturity securities:               
Mortgage-backed securities  $68   $91   $119 
Obligations of state and political subdivisions   580    93    124 
Total  $648   $184   $243 

 

For additional information regarding First Defiance’s investment portfolio, refer to Note 5 – Investment Securities to the Consolidated Financial Statements.

 

Interest-Bearing Deposits

 

The Company had $55.0 million and $46.0 million in overnight investments at the Federal Reserve at December 31, 2017 and 2016, respectively, which amount is included in interest-bearing deposits. First Defiance had interest-earning deposits in the FHLB of Cincinnati and other financial institutions amounting to $2.0 million and $1.8 million at December 31, 2017 and 2016, respectively.

 

Residential Loan Servicing Activities

 

Servicing mortgage loans for investors involves a contractual right to receive a fee for processing and administering loan payments on mortgage loans that are not owned by the Company and are not included on the Company’s balance sheet. This processing involves collecting monthly mortgage payments on behalf of investors, reporting information to those investors on a monthly basis and maintaining custodial escrow accounts for the payment of principal and interest to investors and property taxes and insurance premiums on behalf of borrowers. At December 31, 2017, First Federal serviced 14,447 loans totaling $1.37 billion. The vast majority of the loans serviced for others are fixed rate conventional mortgage loans. The Company primarily sells its loans to Freddie Mac, Fannie Mae and FHLB. At December 31, 2017, 65.92%, 33.32% and 0.70% of the Company’s sold loans were to Freddie Mac, Fannie Mae and FHLB, respectively.

 

 - 7 - 

 

 

As compensation for its mortgage servicing activities, the Company receives servicing fees, usually approximating 0.25% per annum of the loan balances serviced, plus any late charges collected from delinquent borrowers and other fees incidental to the services provided. In the event of a default by the borrower, the Company receives no servicing fees until the default is cured.

 

The following table sets forth certain information regarding the number and aggregate principal balance of the mortgage loans serviced by the Company, including both fixed and adjustable rate loans, at various interest rates:

 

   December 31 
   2017   2016   2015 
           Percentage           Percentage           Percentage 
   Number   Aggregate   of Aggregate   Number   Aggregate   of Aggregate   Number   Aggregate   of Aggregate 
   of   Principal   Principal   of    Principal   Principal   of   Principal   Principal 
Rate  Loans   Balance   Balance   Loans   Balance   Balance   Loans   Balance   Balance 
   (Dollars in Thousands) 
                                     
Less than 3.00%   2,024   $189,700    13.69%   2,191   $225,328    16.42%   1,836   $188,916    14.06%
3.00% -3.99%   6,598    710,084    51.22    6,279    682,157    49.72    5,606    603,875    44.94 
4.00% -4.99%   3,919    377,821    27.26    3,551    332,023    24.20    3,924    379,917    28.28 
5.00% - 5.99%   1,122    68,423    4.94    1,405    83,775    6.11    1,761    110,616    8.23 
6.00% - 6.99%   626    33,658    2.43    749    41,055    2.99    922    50,937    3.79 
7.00% and over   158    6,382    0.46    175    7,680    0.56    209    9,461    0.70 
Total   14,447   $1,386,068    100.00%   14,350   $1,372,018    100.00%   14,258   $1,343,722    100.00%

 

Loan servicing fees decrease as the principal balance on the outstanding loan decreases and as the remaining time to maturity of the loan shortens.

 

The following table sets forth certain information regarding the remaining maturity of the mortgage loans serviced by the Company as of the dates shown.

 

   December 31 
   2017   2016   2015 
Maturity  Number
of Loans
   % of
Number
 of Loans
   Unpaid
Principal
Amount
   % of
Unpaid
Principal
Amount
   Number
of Loans
   % of
Number
of Loans
   Unpaid
Principal
Amount
   % of
Unpaid
Principal
Amount
   Number
of Loans
   % of
Number
of Loans
   Unpaid
Principal
Amount
   % of
Unpaid
Principal
Amount
 
   (Dollars in Thousands) 
                                                 
1–5 years   444    3.07%  $8,346    0.60%   529    3.69%  $7,432    0.54%   680    4.77%  $10,801    0.80%
6–10 years   2,557    17.70    162,190    11.70    1,784    12.43    102,132    7.44    1,563    10.97    89,364    6.65 
11–15 years   3,012    20.85    278,655    20.10    3,671    25.58    343,750    25.05    3,759    26.36    349,986    26.05 
16–20 years   1,258    8.71    109,300    7.89    1,526    10.63    135,540    9.88    1,635    11.47    144,249    10.74 
21–25 years   2,460    17.03    248,919    17.96    1,846    12.86    169,496    12.35    1,833    12.85    169,889    12.64 
More than 25 years   4,716    32.64    578,658    41.75    4,994    34.81    613,668    44.74    4,788    33.58    579,433    43.12 
Total   14,447    100.00%  $1,386,068    100.00%   14,350    100.00%  $1,372,018    100.00%   14,258    100.00%  $1,343,722    100.00%

 

Lending Activities

 

General A savings bank generally may not make loans to one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable collateral. Real estate is not considered “readily marketable collateral.” Certain types of loans are not subject to these limits. In applying these limits, loans to certain borrowers may be aggregated. Notwithstanding the specified limits, a savings bank may lend to one borrower up to $500,000 “for any purpose.” At December 31, 2017, First Federal’s limit on loans-to-one borrower was $48.8 million and its five largest loans (including available lines of credit) or groups of loans to one borrower, including related entities, were $25.0 million, $24.8 million, $24.4 million, $23.2 million and $22.3 million. All of these loans or groups of loans were performing in accordance with their terms at December 31, 2017.

 

 - 8 - 

 

 

Loan Portfolio Composition The net increase in net loans receivable over the prior year was $407.4 million (including $285.4 million acquired from CSB), $137.8 million and $154.8 million at December 31, 2017, 2016, and 2015, respectively. The loan portfolio contains no foreign loans. The Company’s loan portfolio is concentrated geographically in the northwest and central Ohio, northeast Indiana, and southeast Michigan market areas. Management has identified lending for income generating rental properties as an industry concentration. Total loans for income generating property totaled $838.1 million at December 31, 2017, which represents 34.9% of the Company’s loan portfolio.

 

The following table sets forth the composition of the Company’s loan portfolio by type of loan at the dates indicated.

 

   December 31 
   2017   2016   2015   2014   2013 
   Amount   %   Amount   %   Amount   %   Amount   %   Amount   % 
   (Dollars in Thousands) 
Real estate:                                                  
1-4 family residential  $274,862    11.1%  $207,550    10.2%  $205,330    11.0%  $206,437    12.2%  $195,752    12.2%
Multi-family  residential   248,092    10.1    196,983    9.7    167,558    9.0    156,530    9.3    148,952    9.2 
Commercial real estate   987,129    40.0    843,579    41.5    780,870    41.8    683,958    40.6    670,666    41.6 
Construction   265,476    10.8    182,886    9.0    163,877    8.7    112,385    6.7    86,058    5.3 
Total real estate loans   1,775,559    72.0    1,430,998    70.4    1,317,635    70.5    1,159,310    68.8    1,101,428    68.3 
                                                   
Other:                                                  
                                                   
Commercial   526,142    21.3    469,055    23.0    419,349    22.4    399,730    23.7    388,236    24.1 
Home equity and improvement   135,457    5.5    118,429    5.8    116,962    6.2    111,813    6.6    106,930    6.6 
Consumer finance   29,109    1.2    16,680    0.8    16,281    0.9    15,466    0.9    16,902    1.0 
    690,708    28.0    604,164    29.6    552,592    29.5    527,009    31.2    512,068    31.7 
Total loans   2,466,267    100.0%   2,035,162    100.0%   1,870,227    100.0%   1,686,319    100.0%   1,613,496    100.0%
Less:                                                  
Undisbursed loan funds   115,972         93,355         66,902         38,653         32,290      
Net deferred loan origination fees   1,582         1,320         1,108         880         758      
Allowance for loan losses   26,683         25,884         25,382         24,766         24,950      
Net loans  $2,322,030        $1,914,603        $1,776,835        $1,622,020        $1,555,498      

 

In addition to the loans reported above, First Defiance had $10.4 million, $9.6 million, $5.5 million, $4.5 million, and $9.1 million in loans classified as held for sale at December 31, 2017, 2016, 2015, 2014 and 2013, respectively. The fair value of such loans, which are all single-family residential mortgage loans, approximated their carrying value for all years presented.

 

Contractual Principal, Repayments and Interest Rates The following table sets forth certain information at December 31, 2017, regarding the dollar amount of gross loans maturing in First Defiance’s portfolio, based on the contractual terms to maturity. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less.

 

   Years After December 31, 2017 
  

Due Less
than 1

  

 

Due 1-2

  

 

Due 3-5  

 Due 5-10

  

 

Due 10-15

  

 

Due 15+

  

 

Total

 
   (In Thousands) 
Real estate  $502,526   $203,035   $769,909   $146,336   $65,905   $87,848   $1,775,559 
Other loans:                                   
Commercial   361,561    59,542    96,673    8,243    123    -    526,142 
Home equity and improvement   121,475    3,108    7,768    1,678    840    588    135,457 
Consumer finance   13,710    6,176    8,216    970    37    -    29,109 
Total  $999,272   $271,861   $882,566   $157,227   $66,905   $88,436   $2,466,267 

 

 - 9 - 

 

 

The schedule above does not reflect the actual life of the Company’s loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which give First Defiance the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid.

 

The following table sets forth the dollar amount of gross loans due after one year from December 31, 2017, which has fixed interest rates or which have floating or adjustable interest rates.

 

       Floating or     
   Fixed   Adjustable     
   Rates   Rates   Total 
   (In Thousands) 
             
Real estate  $475,443   $797,590   $1,273,033 
Commercial   120,148    44,433    164,581 
Other   27,893    1,488    29,381 
   $623,484   $843,511   $1,466,995 

 

Originations, Purchases and Sales of Loans The lending activities of First Federal are subject to the written, non-discriminatory underwriting standards and loan origination procedures established by the Board of Directors and management. Loan originations are obtained from a variety of sources, including referrals from existing customers, real estate brokers, developers and builders, newspaper, internet and radio advertising and walk-in customers.

 

First Federal’s loan approval process for all types of loans is intended to assess the borrower’s ability to repay the loan, the viability of the loan and the adequacy of the value of the collateral that will secure the loan.

 

A commercial loan application is first reviewed by a commercial lender and underwritten by a commercial credit analyst. The commercial lender may approve credits within their lending limit, and another loan officer with limits sufficient to cover the exposure must approve credits exceeding an individual’s lending limit. All credits which exceed $250,000 in aggregate exposure must be presented for review or approval to the Senior Loan Committee comprised of senior lending personnel. Credits which exceed $5,000,000 in aggregate exposure must be presented for approval to the Executive Loan Committee.

 

Residential mortgage applications are accepted by retail lenders or branch managers, who utilize an automated underwriting system to review the loan request. First Federal also receives mortgage applications via an online residential mortgage origination system. A final approval of all residential mortgage applications is made by a member of a centralized underwriting staff within their designated lending limits. Loan requests in excess or outside an individual underwriter’s limit are approved by the Senior Loan Committee and, if necessary, by the Executive Loan Committee.

 

Retail lenders and branch managers are authorized to originate and approve direct consumer loan requests that are within policy guidelines and within the lender’s approved lending limit. Loans in excess of the lender’s approved lending limit may be approved by retail lending managers up to their approved lending limit. Loans in excess of the retail lending manager’s authorized lending limit or outside of policy must be approved by the Senior Loan Committee and, if necessary, by the Executive Loan Committee.

 

First Federal offers adjustable-rate loans in order to decrease the vulnerability of its operations to changes in interest rates. The demand for adjustable-rate loans in First Federal’s primary market area has been a function of several factors, including customer preference, the level of interest rates, the expectations of changes in the level of interest rates and the difference between the interest rates offered for fixed-rate loans and adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate residential loans that can be originated at any time is largely determined by the demand for each in a competitive environment.

 

 - 10 - 

 

 

Adjustable-rate loans represented 9.9% of First Federal’s total originations of one-to-four family residential mortgage loans in 2017 compared to 10.8% and 10.3% during 2016 and 2015, respectively.

 

Adjustable-rate loans decrease the risks associated with changes in interest rates, but involve other risks, primarily because as interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, thereby increasing the potential for default. At the same time, the marketability of the underlying property may be adversely affected by higher interest rates.

 

The following table shows total loans originated, loan reductions, and the net increase in First Federal’s total loans and loans held for sale during the periods indicated:

 

   Years Ended December 31 
   2017   2016   2015 
   (In Thousands) 
Loan originations:               
1-4 family residential  $240,921   $294,307   $241,658 
Multi-family residential   74,342    59,957    44,352 
Commercial real estate   181,289    166,437    241,969 
Construction   205,088    138,553    116,224 
Commercial   219,588    389,037    465,543 
Home equity and improvement   68,856    56,816    54,676 
Consumer finance   15,185    10,426    10,235 
Total loans originated   1,005,269    1,115,533    1,174,657 
Loans acquired in acquisitions:   285,448    -    - 
Loans purchased:   11,476    822    - 
Loan reductions:               
Loan pay-offs   350,971    232,302    265,311 
Loans sold   231,073    282,589    231,067 
Periodic principal repayments   288,215    432,445    493,383 
    870,259    947,336    989,761 
Net increase in total loans and loans held for sale  $431,934   $169,019   $184,896 

 

Asset Quality

 

First Defiance’s credit policy establishes guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to ensure sound credit decisions. First Defiance’s credit policies and review procedures are meant to minimize the risk and uncertainties inherent in lending. In following the policies and procedures, management must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur because of changing economic conditions.

 

Delinquent Loans The following table sets forth information concerning delinquent loans at December 31, 2017, in dollar amount and as a percentage of First Defiance’s total loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts that are past due.

 

 - 11 - 

 

 

   30 to 59 Days   60 to 89 Days   90 Days and Over   Total 
   Amount   Percentage   Amount   Percentage   Amount   Percentage   Amount   Percentage 
   (Dollars in Thousands) 
                                 
1-4 family residential real estate  $1,305    0.05%  $1,031    0.04%  $1,463    0.06%  $3,799    0.15%
Multi-  family residential   418    0.02    -    0.00    -    0.00    418    0.02 
Commercial real estate   616    0.02    277    0.01    1,964    0.07    2,857    0.10 
Construction   -    0.00    -    0.00    -    0.00    -    0.00 
Commercial   179    0.01    1,248    0.05    1,393    0.06    2,820    0.12 
Home equity and improvement   2,465    0.10    428    0.02    206    0.01    3,099    0.13 
Consumer finance   292    0.01    79    0.00    2    0.00    373    0.01 
Total  $5,275    0.21%  $3,063    0.12%  $5,028    0.20%  $13,366    0.53%

 

Overall, the level of delinquencies at December 31, 2017, increased from the levels at December 31, 2016, when First Defiance reported that 0.32% of its outstanding loans were at least 30 days delinquent. The level of total loans 90 or more days delinquent has increased to 0.20% at December 31, 2017, from 0.17% at December 31, 2016. The level of total loans 60-89 days delinquent increased to 0.12% at December 31, 2017, from 0.07% at December 31, 2016. The level of loans that were 30 to 59 days past due increased to 0.21% at December 31, 2017, from 0.08% at December 31, 2016. Management has assessed the collectability of all loans that are 90 days or more delinquent as part of its procedures in establishing the allowance for loan losses.

 

Nonperforming Assets All loans are reviewed on a regular basis and are placed on non-accrual status when, in the opinion of management, the collectability of additional interest is not expected. Generally, First Defiance places all loans more than 90 days past due on non-accrual status. First Defiance also places loans on non-accrual status when the loan is paying as agreed but the Company believes the financial condition of the borrower is such that this classification is warranted. When a loan is placed on non-accrual status, total unpaid interest accrued to date is reversed. Subsequent payments are generally applied to the outstanding principal balance but may be recorded as interest income, depending on the assessment of the ultimate collectability of the loan. First Defiance considers that a loan is impaired when, based on current information and events, it is probable that it will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan agreement. First Defiance measures impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral, if collateral dependent. If the estimated recoverability of the impaired loan is less than the recorded investment, First Defiance will recognize impairment by allocating a portion of the allowance for loan losses on cash flow dependent loans and by charging off the deficiency on collateral dependent loans.

 

Loans originated by First Federal having principal balances of $56.3 million, $27.4 million and $41.9 million were considered impaired as of December 31, 2017, 2016 and 2015, respectively. The increase in impaired loans from 2016 to 2017 is due to an increase in two loan relationships totaling $11.0 million that became impaired during 2017 as well as $10.4 million of newly impaired loans from the CSB acquisition due to new financial information received. These amounts of impaired loans exclude large groups of small-balance homogeneous loans that are collectively evaluated for impairment such as residential mortgage, consumer installment and credit card loans, except for those classified as troubled debt restructurings. There was $1.4 million of interest received and recorded in income during 2017 related to impaired loans. There was $1.7 million and $1.3 million recorded in 2016 and 2015, respectively. Unrecorded interest income based on the loan’s contractual terms on these impaired loans and all non-performing loans in 2017, 2016 and 2015 was $1.1 million, $1.2 million, and $1.5 million, respectively. The average recorded investment in impaired loans during 2017, 2016 and 2015 (excluding loans accounted for under FASB ASC Topic 310 Subtopic 30) was $47.1 million, $32.8 million and $51.8 million, respectively. The total allowance for loan losses related to these loans was $0.8 million, $0.8 million, and $0.4 million at December 31, 2017, 2016 and 2015, respectively.

 

 - 12 - 

 

 

Real estate acquired by foreclosure is classified as real estate owned until such time as it is sold. First Defiance also repossesses other assets securing loans, consisting primarily of automobiles. When such property is acquired it is recorded at fair value less cost to sell. Costs relating to development and improvement of property are capitalized, whereas costs relating to holding the property are expensed. Valuations are periodically performed by management and a write-down of the value is recorded with a corresponding charge to operations if it is determined that the carrying value of property exceeds its estimated net realizable value. During 2017, First Defiance recognized $20,000 of expense related to write-downs in value of real estate acquired by foreclosure. The balance of real estate owned at December 31, 2017 was $1.5 million.

 

As of December 31, 2017, First Defiance’s total non-performing loans amounted to $30.7 million or 1.31% of total loans (net of undisbursed loan funds and deferred fees and costs), compared to $14.3 million or 0.74% of total loans, at December 31, 2016. Non-performing loans are loans which are more than 90 days past due or on nonaccrual. The nonperforming loan balance for 2017 includes $25.5 million of loans that were originated by First Federal and also considered impaired, compared to $11.3 million for 2016.

 

The following table sets forth the amounts and categories of First Defiance’s non-performing assets (excluding impaired loans not considered non-performing) and troubled debt restructurings at the dates indicated.

 

   December 31 
   2017   2016   2015   2014   2013 
   (Dollars in Thousands) 
Nonperforming loans:                         
1-4 family residential real estate  $3,037   $2,928   $2,610   $3,332   $3,273 
Multi-family residential real estate   128    2,639    2,419    2,539    581 
Commercial real estate   18,091    6,953    7,429    12,635    15,253 
Commercial   8,841    1,007    3,078    4,993    8,327 
Home equity and improvement   590    730    689    619    413 
Consumer finance   28    91    36    12    - 
Total nonperforming loans   30,715    14,348    16,261    24,130    27,847 
                          
Real estate owned   1,532    455    1,321    6,181    5,859 
Total repossessed assets   1,532    455    1,321    6,181    5,859 
                          
Total nonperforming assets  $32,247   $14,803   $17,582   $30,311   $33,706 
                          
Restructured loans, accruing  $13,770   $10,544   $11,178   $24,686   $27,630 
                          
Total nonperforming assets as a  percentage of total assets   1.08%   0.60%   0.77%   1.39%   1.58%
Total nonperforming loans as a percentage of total loans*   1.31%   0.74%   0.90%   1.47%   1.76%
Total nonperforming assets as a percentage of total loans plus REO*   1.37%   0.76%   0.97%   1.83%   2.12%
Allowance for loan losses as a percent  of total nonperforming assets   82.75%   174.86%   144.36%   81.71%   74.02%

 

* Total loans are net of undisbursed loan funds and deferred fees and costs.

 

Allowance for Loan Losses First Defiance maintains an allowance for loan losses to absorb probable incurred credit losses in the loan portfolio. The allowance for loan loss is made up of two components. The first is a general reserve, which is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolio based on quantitative and qualitative factors.

 

 - 13 - 

 

 

The second component of the allowance for loan loss is the specific reserve in which the Company sets aside reserves based on the analysis of individual credits. In evaluating the adequacy of its allowance each quarter, management grades all loans in the commercial portfolio. See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations – Allowance for Loan Losses” for further discussion on management’s evaluation of the allowance for loan losses.

 

Loans are charged against the allowance when such loans meet the Company’s established policy on loan charge-offs and the allowance itself is adjusted quarterly by recording a provision for loan losses. As such, actual losses and losses provided for should be approximately the same if the overall quality, composition and size of the portfolio remained static along with a static loan environment. To the extent that the portfolio grows at a rapid rate or overall quality or the loan environment deteriorates, the provision generally will exceed charge-offs. However, in certain circumstances net charge-offs may exceed the provision for loan losses when management determines that loans previously provided for in the allowance for loan losses are uncollectible and should be charged off or as overall credit or the loan environment improves. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowances may be necessary, and net earnings could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations.

 

At December 31, 2017, First Defiance’s allowance for loan losses totaled $26.7 million compared to $25.9 million at December 31, 2016. The following table sets forth the activity in First Defiance’s allowance for loan losses during the periods indicated.

 

   Years Ended December 31 
   2017   2016   2015   2014   2013 
   (Dollars in Thousands) 
                     
Allowance at beginning of year  $25,884   $25,382   $24,766   $24,950   $26,711 
Provision for credit losses   2,949    283    136    1,117    1,824 
Charge-offs:                         
1-4 family residential real estate   (279)   (350)   (282)   (426)   (643)
Commercial real estate and multi-family   (429)   (92)   (468)   (1,018)   (2,475)
Commercial   (2,301)   (615)   (68)   (2,982)   (1,230)
Consumer finance   (139)   (94)   (53)   (41)   (94)
Home equity and improvement   (301)   (268)   (350)   (392)   (757)
Total charge-offs   (3,449)   (1,419)   (1,221)   (4,859)   (5,199)
Recoveries   1,299    1,638    1,701    3,558    1,614 
Net (charge-offs) recoveries   (2,150)   219    480    (1,301)   (3,585)
Ending allowance  $26,683   $25,884   $25,382   $24,766   $24,950 
                          
Allowance for loan losses to total non-  performing loans at end of year   86.87%   180.40%   156.09%   102.64%   89.60%
Allowance for loan losses to total loans at end of year*   1.14%   1.33%   1.41%   1.50%   1.58%
Net charge-offs (recoveries) for the year to average loans   0.10%   -0.01%   -0.03%   0.08%   0.23%

 

* Total loans are net of undisbursed loan funds and deferred fees and costs.

 

The provision for credit losses increased significantly in 2017 from previous years due to growth of the loan portfolio as well as an increase in net charge offs. The decrease in the allowance for loan loss as a percentage of total loans at December 31, 2017 vs December 31, 2016 is primarily attributable to the CSB acquisition. The CSB loans acquired were recorded at fair value with purchase accounting adjustments discounting the loan balance instead of an allowance for loan losses. For the CSB loans acquired, the discount recorded totaled $3.9 million, or 1.9% of acquired CSB loans at December 31, 2017. Management feels that the level of the allowance for loan losses at December 31, 2017, is sufficient to cover the estimated losses incurred but not yet recognized in the loan portfolio.

 

 - 14 - 

 

 

The following table sets forth information concerning the allocation of First Defiance’s allowance for loan losses by loan categories at the dates indicated. For information about the percent of total loans in each category to total loans, see “Lending Activities-Loan Portfolio Composition” Below.

 

   December 31 
   2017   2016   2015   2014   2013 
       Percent of       Percent of       Percent of       Percent of       Percent of 
       total loans       total loans       total loans       total loans       total loans 
   Amount   by category   Amount   by category   Amount   by category   Amount   by category   Amount   by category 
   (Dollars in Thousands) 
1-4 family residential  $2,532    11.1%  $2,627    10.2%  $3,212    11.0%  $2,494    12.2%  $2,847    12.2%
Multi-family residential real estate   2,702    10.1    2,228    9.7    2,151    9.0    2,453    9.3    2,508    9.2 
Commercial real estate   10,354    40.0    10,625    41.5    11,772    41.8    11,268    40.6    12,000    41.6 
Construction   647    10.8    450    9.0    517    8.7    221    6.7    134    5.3 
Commercial loans   7,965    21.3    7,361    23.0    5,192    22.4    6,509    23.7    5,678    24.1 
Home equity and improvement loans   2,255    5.5    2,386    5.8    2,270    6.2    1,704    6.6    1,635    6.6 
Consumer loans   228    1.2    207    0.8    171    0.9    117    0.9    148    1.0 
   $26,683    100.0%  $25,884    100.0%  $25,382    100.0%  $24,766    100.0%  $24,950    100.0%

 

Sources of Funds

 

General Deposits are the primary source of First Defiance’s funds for lending and other investment purposes. In addition to deposits, First Defiance derives funds from loan principal repayments. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings from the FHLB may be used on a short-term basis to compensate for reductions in the availability of funds from other sources. They may also be used on a longer-term basis for general business purposes. During 2007, First Defiance issued $15.0 million of trust preferred securities through an unconsolidated affiliated trust. Proceeds from the offering were used for general corporate purposes including funding of dividends and stock buybacks as well as bolstering regulatory capital at the First Federal level. First Defiance also issued $20.0 million of similar trust preferred securities in 2005.

 

Deposits First Defiance’s deposits are attracted principally from within First Defiance’s primary market area through the offering of a broad selection of deposit instruments, including checking accounts, money market accounts, savings accounts, and term certificate accounts. Deposit account terms vary, with the principal differences being the minimum balance required, the time periods the funds must remain on deposit, and the interest rate.

 

To supplement its funding needs, First Defiance also has the ability to utilize the national market for certificates of deposit. First Defiance has used these deposits in the past and could in the future if necessary.

 

Average balances and average rates paid on deposits are as follows:

 

   Years Ended December 31 
   2017   2016   2015 
   Amount   Rate   Amount   Rate   Amount   Rate 
   (Dollars in Thousands) 
                         
Non-interest-bearing demand deposits  $528,926    -   $441,731    -   $388,257    - 
Interest bearing demand deposits   955,248    0.18%   798,266    0.17%   742,856    0.16%
Savings deposits   284,814    0.04    235,137    0.04    215,253    0.04 
Time deposits   530,414    1.33    430,487    1.12    441,510    0.92 
Totals  $2,299,402    0.38%  $1,905,621    0.33%  $1,787,876    0.30%

 

The following table sets forth the maturities of First Defiance’s retail certificates of deposit having principal amounts $250,000 or greater at December 31, 2017 (In Thousands):

 

 - 15 - 

 

 

Retail certificates of deposit maturing in quarter ending:     
March 31, 2018  $4,813 
June 30, 2018   9,358 
September 30, 2018   8,172 
December 31, 2018   3,428 
After December 31, 2018   28,072 
Total retail certificates of deposit with balances $250,000 or greater  $53,843 

 

The following table details the deposit accrued interest payable as of December 31:

 

   2017   2016 
   (In Thousands) 
         
Interest bearing demand deposits and money market accounts  $29   $23 
Certificates of deposit   68    19 
   $97   $42 

 

For additional information regarding First Defiance’s deposits see Note 11 to the Consolidated Financial Statements.

 

Borrowings First Defiance may obtain advances from the FHLB of Cincinnati by pledging certain of its residential mortgage loans, commercial real estate loans, multi-family loans, home equity loans and investment securities provided certain standards related to creditworthiness have been met. Such advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities.

 

The following table sets forth certain information as to First Defiance’s FHLB advances and other borrowings at the dates indicated.

 

   Years Ended December 31 
   2017   2016   2015 
   (Dollars in Thousands) 
Long-term:               
FHLB advances  $84,279   $103,943   $59,902 
Weighted average interest rate   1.55%   1.42%   1.62%
                
Short-term:               
Securities sold under agreement to repurchase  $26,019   $31,816   $57,188 
Weighted average interest rate   0.20%   0.22%   0.27%

 

The following table sets forth the maximum month-end balance and average balance of First Defiance’s long-term FHLB advances and other borrowings during the periods indicated.

 

   Years Ended December 31 
   2017   2016   2015 
   (Dollars in Thousands) 
Long-term:               
FHLB advances:               
Maximum balance  $105,214   $103,943   $59,902 
Average balance   102,115    84,944    38,185 
Weighted average interest rate   1.44%   1.42%   1.62%

 

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The following table sets forth the maximum month-end balance and average balance of First Defiance’s short-term FHLB advances and other borrowings during the periods indicated.

 

   Years Ended December 31 
   2017   2016   2015 
   (Dollars in Thousands) 
Short-term:               
FHLB advances:               
Maximum balance  $-   $30,000   $- 
Average balance   44    861    41 
Weighted average interest rate   0.80%   0.39%   0.18%
Securities sold under agreement to repurchase:               
Maximum balance  $26,019   $57,984   $60,272 
Average balance   23,337    52,821    54,632 
Weighted average interest rate   0.23%   0.26%   0.28%

 

First Defiance borrows funds under a variety of programs at the FHLB. As of December 31, 2017, there was $84.3 million outstanding under various long-term FHLB advance programs. First Defiance utilizes short-term advances from the FHLB to meet cash flow needs and for short-term investment purposes. At December 31, 2017 and 2016, no outstanding balances existed under First Defiance’s short-term Cash Management Advance Line of Credit or REPO line of credit. The total available under the Cash Management Advance Line is $15.0 million. Additionally, First Defiance has $100.0 million available under a REPO line of credit. Amounts are generally borrowed under these lines on an overnight basis. First Federal’s total borrowing capacity at the FHLB is limited by various collateral requirements. Eligible collateral includes mortgage loans, home equity loans, non-mortgage loans, cash, and investment securities. At December 31, 2017, other than amounts available on the REPO and Cash Management line, First Federal had additional borrowing capacity with the FHLB of $567.4 million as a result of these collateral requirements.

 

As a member of the FHLB of Cincinnati, First Federal must maintain a minimum investment in the capital stock of that FHLB in an amount defined in the FHLB’s regulations. First Federal is permitted to own stock in excess of the minimum requirement and was in compliance with the minimum requirement with an investment in stock of the FHLB of Cincinnati of $16.0 million at December 31, 2017, and $13.8 million at December 31, 2016. First Federal holds stock of the FHLB of Indianapolis of $5,000 at December 31, 2017, and December 31, 2016.

 

Each FHLB is required to establish standards of community investment or service that its members must maintain for continued access to long-term advances from the FHLB. The standards take into account a member’s performance under the Community Reinvestment Act and its record of lending to first-time homebuyers.

 

For additional information regarding First Defiance’s FHLB advances and other debt see Notes 12 and 14 to the Consolidated Financial Statements.

 

Subordinated Debentures - In March 2007, the Company sponsored an affiliated trust, First Defiance Statutory Trust II (“Trust Affiliate II”) that issued $15.0 million of Guaranteed Capital Trust Securities (“Trust Preferred Securities”). In connection with the transaction, the Company issued $15.5 million of Junior Subordinated Deferrable Interest Debentures (“Subordinated Debentures”) to Trust Affiliate II. Trust Affiliate II 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 Subordinated Debentures held by Trust Affiliate II are the sole assets of the trust. Distributions on the Trust Preferred Securities issued by Trust Affiliate II are payable quarterly at a variable rate equal to the three-month LIBOR rate plus 1.5%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate II was 3.09% and 2.46% as of December 31, 2017 and 2016 respectively.

 

 - 17 - 

 

 

The Trust Preferred Securities are subject to mandatory redemption, in whole or in part, upon repayment of the Subordinated Debentures. The Company entered into an agreement that fully and unconditionally guarantees the Trust Preferred Securities subject to the terms of the guarantee. The Trust Preferred Securities and Subordinated Debentures mature on June 15, 2037, but can be redeemed at the Company’s option at any time now.

 

In October 2005, the Company formed an affiliated trust, First Defiance Statutory Trust I (“Trust Affiliate I”) that issued $20.0 million of Trust Preferred Securities. In connection with the 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 Subordinated Debentures held by Trust Affiliate I are the sole assets of the trust. 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%, or 2.97% and 2.34% as of December 31, 2017 and 2016 respectively.

 

The Trust Preferred Securities issued by Trust Affiliate I are subject to mandatory redemption, in whole or in part, upon repayment of the Subordinated Debentures. The Company entered into an agreement that fully and unconditionally guarantees the Trust Preferred Securities subject to the terms of the guarantee. The Trust Preferred Securities and Subordinated Debentures mature on December 15, 2035, but can be redeemed by the Company at any time now.

 

Employees

 

First Defiance had 674 employees at December 31, 2017. None of these employees are represented by a collective bargaining agent, and First Defiance believes that it maintains good relationships with its personnel.

 

Competition

 

Competition in originating commercial real estate and commercial loans comes mainly from commercial banks with banking center offices in the Company’s market area. Competition for the origination of mortgage loans arises mainly from savings associations, commercial banks, and mortgage companies. The distinction among market participants is based on a combination of price, the quality of customer service and name recognition. The Company competes for loans by offering competitive interest rates and product types and by seeking to provide a higher level of personal service to borrowers than is furnished by competitors. First Federal has a significant market share of the lending markets in which it conducts operations, except for central Ohio.

 

Management believes that First Federal’s most direct competition for deposits comes from local financial institutions. The distinction among market participants is based on price and the quality of customer service and name recognition. First Federal’s cost of funds fluctuates with general market interest rates. During certain interest rate environments, additional significant competition for deposits may be expected from corporate and governmental debt securities, as well as from money market mutual funds. First Federal competes for conventional deposits by emphasizing quality of service, extensive product lines and competitive pricing.

 

Regulation

 

General – First Defiance is subject to regulation examination and oversight by the Federal Reserve Board (“Federal Reserve”). First Federal is subject to regulation, examination and oversight by the Office of the Comptroller of the Currency (“OCC”). Because the FDIC insures First Federal’s deposits, First Federal is also subject to examination and regulation by the FDIC. In addition, First Federal is subject to regulations of the Consumer Financial Protection Bureau (the “CFPB”) which was established by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and has broad powers to adopt and enforce consumer protection regulations. First Defiance and First Federal must file periodic reports with the Federal Reserve and the OCC and examinations are conducted periodically by the Federal Reserve, the OCC and the FDIC to determine whether First Defiance and First Federal are in compliance with various regulatory requirements and are operating in a safe and sound manner.

 

 - 18 - 

 

 

First Defiance is also subject to various Ohio laws which restrict takeover bids, tender offers and control-share acquisitions involving public companies which have significant ties to Ohio.

 

Holding Company Regulation - First Defiance is a unitary thrift holding company and is subject to the Federal Reserve regulations, examination, supervision and reporting requirements. Federal law generally prohibits a thrift holding company from controlling any other savings association or thrift holding company, without prior approval of the Federal Reserve, or from acquiring or retaining more than 5% of the voting shares of a savings association or holding company thereof, which is not a subsidiary.

 

Regulatory Capital Requirements and Prompt Corrective Action – The federal banking regulators have adopted risk-based capital guidelines for financial institutions and their holding companies, designed to absorb losses. The guidelines provide a systematic analytical framework, which makes regulatory capital requirements sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures expressly into account in evaluating capital adequacy and minimizes disincentives to holding liquid, low-risk assets. Capital levels as measured by these standards are also used to categorize financial institutions for purposes of certain prompt corrective action regulatory provisions.

 

In July 2013, the United States banking regulators issued final new capital rules applicable to smaller banking organizations which also implement certain provisions of the Dodd-Frank Act. The new minimum capital requirements became effective on January 1, 2015, whereas a new capital conservation buffer and deductions from common equity capital phase in from January 1, 2016, through January 1, 2019, and most deductions from common equity tier 1 capital are being phased in from January 1, 2015, through January 1, 2019.

 

The rules include (a) a minimum common equity tier 1 (“CET1”) capital ratio of 4.5%, (b) a minimum Tier 1 capital ratio of 6.0%, (c) a minimum total capital ratio of 8.0%, and (d) a minimum leverage ratio of 4%.

 

Common equity for the common equity tier 1 capital ratio includes common stock (plus related surplus) and retained earnings, plus limited amounts of minority interests in the form of common stock, less the majority of certain regulatory deductions.

 

Tier 1 capital includes common equity as defined for the common equity tier 1 capital ratio, plus certain non-cumulative preferred stock and related surplus, cumulative preferred stock and related surplus and trust preferred securities that have been grandfathered (but which are not permitted going forward), and limited amounts of minority interests in the form of additional Tier 1 capital instruments, less certain deductions.

 

Tier 2 capital, which can be included in the total capital ratio, includes certain capital instruments (such as subordinated debt) and limited amounts of the allowance for loan and lease losses, subject to new eligibility criteria, less applicable deductions.

 

The deductions from common equity tier 1 capital include goodwill and other intangibles, certain deferred tax assets, mortgage-servicing assets above certain levels, gains on sale in connection with a securitization, investments in a banking organization’s own capital instruments and investments in the capital of unconsolidated financial institutions (above certain levels).

 

Under the guidelines, capital is compared to the relative risk related to the balance sheet. To derive the risk included in the balance sheet, one of several risk weights is applied to different balance sheet and off-balance sheet assets, primarily based on the relative credit risk of the counterparty. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

 - 19 - 

 

 

The rules also place restrictions on the payment of capital distributions, including dividends, and certain discretionary bonus payments to executive officers if the company does not hold a capital conservation buffer of greater than 2.5% composed of common equity tier 1 capital above its minimum risk-based capital requirements, or if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter. The capital conservation buffer phases in through January 1, 2019 and is currently 1.875%.

 

The federal banking agencies have established a system of “prompt corrective action” to resolve certain problems of undercapitalized banks. This system is based on five capital level categories for insured depository institutions: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." The federal banking agencies may (or in some cases must) take certain supervisory actions depending upon a bank's capital level. For example, the banking agencies must appoint a receiver or conservator for a bank within 90 days after it becomes "critically undercapitalized" unless the bank's primary regulator determines, with the concurrence of the FDIC, that other action would better achieve regulatory purposes. Banking operations otherwise may be significantly affected depending on a bank's capital category. For example, a bank that is not "well capitalized" generally is prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market, and the holding company of any undercapitalized depository institution must guarantee, in part, specific aspects of the bank's capital plan for the plan to be acceptable.

 

Effective January 1, 2015, in order to be "well-capitalized," a financial institution must have a common equity tier 1 capital ratio of 6.5%, a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital of at least 8% and a leverage ratio of at least 5%, and the institution must not be subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. As of December 31, 2017, First Federal met the ratio requirements in effect at that date to be deemed "well-capitalized." See Note 17 of the Notes to the Consolidated Financial Statements which is incorporated herein by reference.

 

The following table sets forth the amounts and percentage levels of regulatory capital of First Defiance and First Federal, the minimum amounts required for each of First Defiance and First Federal, and the amounts required for First Federal to be deemed well capitalized under the prompt corrective action system, all as of December 21, 2017. (Dollars in Thousands):

 

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   Actual   Minimum Required for
Adequately Capitalized
   Minimum Required to be Well
Capitalized for Prompt
Corrective Action
 
   Amount   Ratio   Amount   Ratio(1)   Amount   Ratio 
                         
CET1 Capital (to Risk-Weighted Assets) (2)
Consolidated  $274,832    10.43%  $118,596    4.5%   N/A    N/A 
First Federal  $298,571    11.33%  $118,534    4.5%  $171,216    6.5%
                               
Tier 1 Capital (2)                              
Consolidated  $309,832    10.80%  $114,773    4.0%   N/A    N/A 
First Federal  $298,571    10.43%  $114,539    4.0%  $143,173    5.0%
 
Tier 1 Capital (to Risk Weighted Assets) (2)
Consolidated  $309,832    11.76%  $158,128    6.0%   N/A    N/A 
First Federal  $298,571    11.33%  $158,046    6.0%  $220,728    8.0%
                               
Total Capital (to Risk Weighted Assets) (2)
Consolidated  $336,515    12.77%  $210,838    8.0%   N/A    N/A 
First Federal  $332,254    12.35%  $210,728    8.0%  $263,410    10.0%

 

(1)Excludes capital conservation buffer of 1.25% as of December 31, 2017.
(2)Core capital is computed as a percentage of adjusted total assets of $2.87 billion for consolidated and $2.86 billion for the Bank. Risk-based capital is computed as a percentage of total risk-weighted assets of $2.64 billion for consolidated and $2.63 billion for the Bank.

 

In September 2017, the Federal Reserve Board, along with other bank regulatory agencies, proposed amendments to its capital requirements to simplify various aspects of the capital rules and thereby reduce regulatory burden for “non-advanced approaches” banking organizations. The Bank is a non-advanced approach bank because it has total consolidated assets of less than $250 billion and balance sheet foreign exposures of less than the maximum amount for a non-advanced approach bank. Because the amendments were proposed with a request for comments and have not been finalized, we do not yet know what effect the final rules will have on the Bank’s capital calculations. In November 2017, the federal banking agencies extended, for such non-advanced approaches banks, the existing capital requirements for certain items that were scheduled to change effective January 1, 2018, in light of the simplification amendments being considered.

 

Dividends - Dividends paid by First Federal to First Defiance are subject to various regulatory restrictions. First Federal paid $13.0 million in dividends to First Defiance in 2017 and $22.0 million in 2016. Generally, First Federal may not pay dividends to First Defiance in excess of its net profits (as defined by statute) for the last two fiscal years, plus any year-to-date net profits without the approval of the OCC. First Insurance paid $1.8 million in dividends to First Defiance in 2017 and $1.2 million in dividends in 2016. First Defiance Risk Management paid $1.0 million in dividends to First Defiance in each of 2017 and 2016.

 

First Defiance’s ability to pay dividends to its shareholders is primarily dependent on its receipt of dividends from the Subsidiaries. The Federal Reserve expects First Defiance to serve as a source of strength for First Federal and may require First Defiance to retain capital for further investment in First Federal, rather than pay dividends to First Defiance shareholders. Payment of dividends by First Defiance or First Federal may be restricted at any time at the discretion of its applicable regulatory authorities if they deem such dividends to constitute an unsafe or unsound practice. These provisions could have the effect of limiting First Defiance's ability to pay dividends on its common shares.

 

Transactions with Insiders and Affiliates - Loans to executive officers, directors and principal shareholders and their related interests must conform to the lending limits. Most loans to directors, executive officers and principal shareholders must be approved in advance by a majority of the “disinterested” members of board of directors of the association with any “interested” director not participating. All loans to directors, executive officers and principal shareholders must be made on terms substantially the same as offered in comparable transactions with the general public or as offered to all employees in a company-wide benefit program. Loans to executive officers are subject to additional restrictions. In addition, all related party transactions must be approved by the Company’s audit committee pursuant to NASDAQ Rule 5630, including loans made by financial institutions in the ordinary course of business. All transactions between savings associations and their affiliates must comply with Sections 23A and 23B of the Federal Reserve Act (“FRA”) and the Federal Reserve’s Regulation W. An affiliate of a savings association is any company or entity that controls, is controlled by, or is under common control with the savings association. First Defiance, First Defiance Risk Management and First Insurance are affiliates of First Federal.

 

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Deposit Insurance - The FDIC maintains the DIF, which insures the deposit accounts of First Federal to the maximum amount provided by law. The general insurance limit is $250,000 per separately insured depositor. This insurance is backed by the full faith and credit of the United States government.

 

The FDIC assesses deposit insurance premiums on each insured institution quarterly based on risk characteristics of the institution. The FDIC may also impose a special assessment in an emergency situation.

 

Pursuant to the Dodd-Frank Act, the FDIC has established 2.0% as the designated reserve ratio (DRR), which is the ratio of the DIF to insured deposits of the total industry. In March 2016, the FDIC adopted final rules designed to meet the statutory minimum DRR of 1.35% by September 30, 2020, the deadline imposed by the Dodd-Frank Act. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets of less than $10 billion of the increase in the statutory minimum DRR to 1.35% from the former statutory minimum of 1.15%. The FDIC’s rules reduced assessment rates on all banks but imposed a surcharge on banks with assets of $10 billion or more until the DRR reaches 1.35% and provide assessment credits to banks with assets of less than $10 billion for the portion of their assessments that contribute to the increase of the DRR to 1.35%. The rules also changed the method to determine risk-based assessment rates for established banks with less than $10 billion in assets to better ensure that banks taking on greater risks pay more for deposit insurance than less risky banks.

 

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation, a mixed-ownership government corporation established to recapitalize a predecessor to the DIF. These assessments will continue until the Financing Corporation bonds mature in 2019.

 

As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, federally-insured institutions. It also may prohibit any federally-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the Deposit Insurance Fund. The FDIC also has the authority to take enforcement actions against insured institutions. Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged or is engaging in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or written agreement entered into with the FDIC.

 

Consumer Protection Laws and Regulations - Banks are subject to regular examination to ensure compliance with federal statutes and regulations applicable to their business, including consumer protection statutes and implementing regulations. Potential penalties under these laws include, but are not limited to, fines. The Dodd-Frank Act established the CFPB, which has extensive regulatory and enforcement powers over consumer financial products and services. The CFPB has adopted numerous rules with respect to consumer protection laws, amending some existing regulations and adopting new ones, and has commenced enforcement actions. The following are just some of the consumer protection laws applicable to First Federal:

 

Community Reinvestment Act of 1977: imposes a continuing and affirmative obligation to fulfill the credit needs of its entire community, including low- and moderate-income neighborhoods.

 

Equal Credit Opportunity Act: prohibits discrimination in any credit transaction on the basis of any of various criteria.

 

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Truth in Lending Act: requires that credit terms are disclosed in a manner that permits a consumer to understand and compare credit terms more readily and knowledgeably.

 

Fair Housing Act: makes it unlawful for a lender to discriminate in its housing-related lending activities against any person on the basis of any of certain criteria.

 

Home Mortgage Disclosure Act: requires financial institutions to collect data that enables regulatory agencies to determine whether the financial institutions are serving the housing credit needs of the communities in which they are located.

 

Real Estate Settlement Procedures Act: requires that lenders provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibits abusive practices that increase borrowers’ costs.

 

Privacy provisions of the Gramm-Leach-Bliley Act: requires financial institutions to establish policies and procedures to restrict the sharing of non-public customer data with non-affiliated parties and to protect customer information from unauthorized access.

 

The banking regulators also use their authority under the Federal Trade Commission Act to take supervisory or enforcement action with respect to unfair or deceptive acts or practices by banks that may not necessarily fall within the scope of specific banking or consumer finance law.

 

Community Reinvestment Act - Under the Community Reinvestment Act (“CRA”), every FDIC-insured institution is obligated, consistent with safe and sound banking practices, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA requires the appropriate federal banking regulator, in connection with the examination of an insured institution, to assess the institution’s record of meeting the credit needs of its community and to consider this record in its evaluation of certain applications to banking regulators, such as an application for approval of a merger or the establishment of a branch. An unsatisfactory rating may be used as the basis for the denial of an application to acquire another financial institution or open a new branch. As of its last examination, First Federal received a CRA rating of “satisfactory.”

 

Executive and Incentive Compensation - In June 2010, the Federal Reserve Board, the OCC and the FDIC issued joint interagency guidance on incentive compensation policies (the Joint Guidance) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. This principles-based guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should: (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks; (ii) be compatible with effective internal controls and risk management; and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. The Joint Guidance made incentive compensation part of the regulatory agencies’ examination process, with the findings of the supervisory initiatives included in reports of examination and enforcement actions possible.

 

In May 2016, the federal bank regulatory agencies approved a joint notice of proposed rules (the Proposed Joint Rules) designed to prohibit incentive-based compensation arrangements that encourage inappropriate risks at financial institutions. The Proposed Joint Rules would apply to covered financial institutions with total assets of $1 billion or more. For all covered institutions, including Level 3 institutions like us, the proposed rule would:

 

prohibit incentive-based compensation arrangements that are “excessive” or “could lead to material financial loss;”

 

require incentive based compensation that is consistent with a balance of risk and reward, effective management and control of risk, and effective governance; and

 

 - 23 - 

 

 

require board oversight, recordkeeping and disclosure to the appropriate regulatory agency.

 

Further, as stock exchanges impose additional listing requirements under the Dodd-Frank Act, public companies will be required to implement “clawback” procedures for incentive compensation payments and to disclose the details of the procedures, which allow recovery of incentive compensation that was paid on the basis of erroneous financial information necessitating a restatement due to material noncompliance with financial reporting requirements. This clawback policy is intended to apply to compensation paid within a three-year look-back window of the restatement and would cover all executives who received incentive awards.

 

Patriot Act - In response to the terrorist events of September 11, 2001, the Uniting and Strengthening of America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the Patriot Act) was signed into law in October 2001. The Patriot Act gives the United States government powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and broadened anti-money laundering requirements. Title III of the Patriot Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions. Among other requirements, Title III and related regulations require regulated financial institutions to establish a program specifying procedures for obtaining identifying information from customers seeking to open new accounts and establish enhanced due diligence policies, procedures and controls designed to detect and report suspicious activity. First Federal has established policies and procedures that it considers to be in compliance with the requirements of the Patriot Act.

 

Volcker Rule – The Volcker Rule under the Dodd-Frank Act prohibits banks and their affiliates from engaging in proprietary trading and investing in and sponsoring hedge funds and private equity funds. The Volcker Rule, which became effective in July 2015, does not significantly impact the operations of First Defiance or its subsidiaries, as the Company does not engage in the businesses prohibited by the Volcker Rule.

 

Item 1A. Risk Factors

 

The risks listed below present risks that could have a material impact on the Company’s financial condition, results of operations, or business. The risks and uncertainties described below are the not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations.

 

Economic and financial market conditions may adversely affect First Defiance’s operations and financial condition.

 

First Defiance’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services First Defiance offers, is highly dependent upon the business environment in the markets where the Company operates, mainly in the State of Ohio and in the Great Lake Region. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters; or a combination of these or other factors. Conditions such as inflation, recession, unemployment, changes in interest rates, fiscal and monetary policy and other factors beyond First Defiance’s control may adversely affect its deposit levels and composition, demand for loans, the ability of its borrowers to repay their loans and the value of the collateral securing the loans it makes. Because First Defiance has a significant amount of real estate loans, decreases in real estate values could adversely affect the value of property used as collateral and First Defiance’s ability to sell the collateral upon foreclosure.

 

 - 24 - 

 

 

First Defiance’s loan portfolio includes a concentration of commercial real estate loans and commercial loans, which involve risks specific to real estate value and the successful operations of these businesses.

 

At December 31, 2017, First Federal’s portfolio of commercial real estate loans totaled $1.2 billion, or approximately 50.1% of total loans. First Federal’s commercial real estate loans typically have higher principal amounts than residential real estate loans, and many of our commercial real estate borrowers have more than one loan outstanding. As a result, an adverse development on one loan can expose First Defiance to greater risk of loss on other loans. Additionally, repayment of the loans is generally dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic conditions and events outside of the control of the borrower or lender could negatively impact the future cash flow and market values of the affected properties.

 

At December 31, 2017, First Federal’s portfolio of commercial loans totaled $526.1 million, or approximately 21.3% of total loans. Commercial loans generally expose First Defiance to a greater risk of nonpayment and loss than commercial real estate or residential real estate loans since repayment of such loans often depends on the successful operations and income stream of the borrowers. First Federal’s commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower such as accounts receivable, inventory, machinery or real estate. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The collateral securing other loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists.

 

First Defiance targets its business lending towards small and medium-sized businesses, many of which have fewer financial resources than larger companies and may be more susceptible to economic downturns. If general economic conditions negatively impact these businesses, First Defiance’s results of operations and financial condition may be adversely affected.

 

Increases to the allowance for loan losses may cause First Defiance’s earnings to decrease.

 

First Federal makes a number of assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of loans. In determining the amount of the allowance for loan losses, First Federal relies on loan quality reviews, past loss experience, and an evaluation of economic conditions, among other factors. If its assumptions prove to be incorrect, First Federal’s allowance for loan losses may not be sufficient to cover actual losses, resulting in additions to the allowance. In addition, bank regulators periodically review First Federal’s allowance and may require First Federal to increase its allowance. Material additions to the allowance and any loan losses that exceed First Federal’s reserves would materially adversely affect First Defiance’s results of operations and financial condition.

 

Changes in interest rates can adversely affect First Defiance’s profitability.

 

First Defiance’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities, and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond First Defiance’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Open Market Committee. Changes in monetary policy, including changes in interest rates, could influence not only the interest First Defiance receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) First Defiance’s ability to originate loans and obtain deposits, (ii) the fair value of First Defiance’s financial assets and liabilities, and (iii) the average duration of certain assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, First Defiance’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. Any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on First Defiance’s results of operations and financial condition.

 

 - 25 - 

 

 

First Federal originates a significant amount of residential mortgage loans that it sells in the secondary market. The origination of residential mortgage loans is highly dependent on the local real estate market and the current interest rates. Increasing interest rates tend to reduce the origination of loans for sale and consequently fee income, which First Defiance reports as mortgage banking income. Conversely, decreasing interest rates have the effect of causing clients to refinance mortgage loans faster than anticipated. This causes the value of mortgage servicing rights on the loans sold to be lower than originally anticipated. If this happens, First Defiance may be required to write down the value of its mortgage servicing rights faster than anticipated, which will increase expense and lower earnings. Accelerated repayments on loans and mortgage backed securities could result in the reinvestment of funds at lower rates than the loans or securities were paying.

 

Laws and regulations may affect First Defiance’s results of operations.

 

The earnings of financial institutions are affected by the regulations and policies of various regulatory authorities, including the Federal Reserve, the OCC, the FDIC and the CFPB. The Federal Reserve has extensive supervisory authority over the Company, affecting a comprehensive range of matters relating to ownership and control of First Defiance’s shares, First Defiance’s acquisition of other companies and businesses, permissible activities for the Company to engage in, maintenance of adequate capital levels and other aspects of operations. These supervisory and regulatory powers are intended primarily for the protection of First Defiance’s depositors and borrowers and the deposit insurance fund, rather than First Defiance’s shareholders.

 

Comprehensive revisions to the regulatory capital framework were finalized by the Federal Reserve, the OCC, and the FDIC in 2013. The revised regulations change what qualifies as regulatory capital, raises minimum requirements, and introduces the concept of additional capital buffers. The need to maintain more and higher quality capital as well as greater liquidity going forward could limit our business activities, including lending, and our ability to expand, either organically or through acquisitions. In addition, the new liquidity standards could require us to increase our holdings of highly liquid short-term investments, thereby reducing our ability to invest in longer-term assets even if more desirable from a balance sheet management perspective.

 

The laws and regulations applicable to the banking industry could change at any time. The potential exists for new laws and regulations, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations. Increased regulation could increase First Defiance’s cost of compliance and reduce its income to the extent that they limit the manner in which First Defiance may conduct business, including its ability to offer new products, charge fees for specific products and services, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads.

 

First Defiance’s ability to meet cash flow needs on a timely basis at a reasonable cost may adversely affect net income.

 

First Defiance’s principal sources of liquidity are local deposits and wholesale funding sources such as FHLB advances, Federal Funds purchased, securities sold under repurchase agreements, and brokered or other out-of-market certificate of deposit purchases. Also, First Defiance maintains a portfolio of securities that can be used as a secondary source of liquidity. First Defiance’s access to funding sources in amounts adequate to finance or capitalize its activities or on terms that are acceptable could be impaired by factors that affect First Defiance directly or the financial services industry or economy in general, such as further disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry.

 

 - 26 - 

 

 

Other possible sources of liquidity include the sale or securitization of loans, the issuance of additional collateralized borrowings beyond those currently utilized with the FHLB, the issuance of debt securities and the issuance of preferred or common securities in public or private transactions, or borrowings from a commercial bank. First Defiance does not currently have any borrowings from a commercial bank, but it has used them in the past.

 

Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, pay dividends to First Defiance’s shareholders, or fulfill obligations such as repaying First Defiance’s borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, results of operations and financial condition.

 

Competition affects First Defiance’s earnings.

 

First Defiance’s continued profitability depends on its ability to continue to effectively compete to originate loans and attract and retain deposits. Competition for both loans and deposits is intense in the financial services industry. The Company competes in its market area by offering superior service and competitive rates and products. The type of institutions First Defiance competes with include large regional commercial banks, smaller community banks, savings institutions, mortgage banking firms, credit unions, finance companies, brokerage firms, insurance agencies and mutual funds. As a result of their size and ability to achieve economies of scale, certain of First Defiance’s competitors can offer a broader range of products and services than the Company can offer. To stay competitive in its market area, First Defiance may need to adjust the interest rates on its products to match rates of its competition, which could have a negative impact on net interest margin.

 

The increasing complexity of First Defiance’s operations presents varied risks that could affect its earnings and financial condition.

 

First Defiance processes a large volume of transactions on a daily basis and is exposed to numerous types of risks related to internal processes, people and systems. These risks include, but are not limited to, the risk of fraud by persons inside or outside the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, breaches of data security and our internal control system and compliance with a complex array of consumer and safety and soundness regulations. First Defiance could also experience additional loss as a result of potential legal actions that could arise as a result of operational deficiencies or as a result of noncompliance with applicable laws and regulations.

 

First Defiance has established and maintains a system of internal controls that provides management with information on a timely basis and allows for the monitoring of compliance with operational standards. These systems have been designed to manage operational risks at an appropriate, cost effective level. Procedures exist that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. Losses from operational risks may still occur, however, including losses from the effects of operational errors.

 

Unauthorized disclosure of sensitive or confidential client or customer information or confidential trade secrets, whether through a breach of the Company’s computer systems or otherwise, could severely harm its business.

 

Potential misuse of funds or information by First Defiance’s employees or by third parties could result in damage to First Defiance’s customers for which First Defiance could be held liable, subject First Defiance to regulatory sanctions and otherwise adversely affect First Defiance’s financial condition and results of operations.

 

 - 27 - 

 

 

First Defiance’s employees handle a significant amount of funds, as well as financial and personal information. First Defiance also depends upon third-party vendors who have access to funds and personal information about customers. Cybersecurity breaches of other companies, such as the breach of the systems of a credit bureau, may result in criminals using personal information obtained from such other source to impersonate a customer of First Defiance and obtain funds from customer accounts. Further, First Defiance may be affected by data breaches at retailers and other third parties who participate in data interchanges with First Defiance’s customers that involve the theft of customer credit and debit card data, which may include the theft of debit card PIN numbers and commercial card information used to make purchases at such retailers and other third parties. Such data breaches could result in First Defiance incurring significant expenses to reissue debit cards and cover losses, which could result in a material adverse effect on First Defiance’s results of operations.

 

Although First Defiance has implemented systems to minimize the risk of fraudulent taking or misuse of funds or information, there can be no assurance that such systems will be adequate or that a taking or misuse of funds or information by employees, by third parties who have authorized access to funds or information, or by third parties who are able to access funds or information without authorization will never occur. First Defiance could be held liable for such an event and could also be subject to regulatory sanctions. First Defiance could also incur the expense of developing additional controls and investing in additional equipment or contracts to prevent future such occurrences. Although First Defiance has insurance to cover such potential losses, First Defiance cannot provide assurance that such insurance will be adequate to meet any liability, and insurance premiums may rise substantially if First Defiance suffers such an event. In addition, any loss of trust or confidence placed in First Defiance by our clients could result in a loss of business, which could adversely affect our financial condition and results of operations, or result in a loss of investor confidence, hurting First Defiance’s stock price and ability to acquire capital in the future. First Defiance could also lose revenue by the wrongful appropriation of confidential information about its business operations by competitors who use the information to compete with First Defiance.

 

First Defiance could suffer a material adverse impact from interruptions in the effective operation of, or security breaches affecting, First Defiance’s computer systems.

 

First Defiance relies heavily on its own information systems and those of vendors to conduct our business and to process, record, and monitor transactions. Risks to the system could result from a variety of factors, including the potential for bad acts on the part of hackers, criminals, employees and others. As one example, some banks have experienced denial of service attacks in which individuals or organizations flood the bank’s website with extraordinarily high volumes of traffic, with the goal and effect of disrupting the ability of the bank to process transactions. Other businesses have been victims of a ransomware attack in which a business becomes unable to access its own information and is presented with a demand to pay a ransom in order to once again have access to its information. First Defiance is also at risk for the impact of natural disasters, terrorism and international hostilities on its systems or for the effects of outages or other failures involving power or communications systems operated by others. These risks also arise from the same types of threats to businesses with which First Defiance deals.

 

Potential adverse consequences of attacks on First Defiance’s computer systems or other threats include damage to First Defiance’s reputation, loss of customer business, costs of incentives to customers or business partners in order to maintain their relationships, loss of investor confidence and a reduction in First Defiance’s stock price, litigation, increased regulatory scrutiny and potential enforcement actions, repairs of system damage, increased investments in cybersecurity (such as obtaining additional technology, making organizational changes, deploying additional personnel, training personnel and engaging consultants), and increased insurance premiums, all of which could result in financial loss and material adverse effects on First Defiance’s results of operations and financial condition.

 

If First Defiance forecloses on collateral property resulting in First Defiance’s ownership of the underlying real estate, First Defiance may be subject to the increased costs associated with the ownership of real property, resulting in reduced income.

 

A significant portion of First Defiance’s loan portfolio is secured by real property. During the ordinary course of business, First Defiance may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, First Defiance may be liable for remediation costs, as well as for personal injury and property damage.

 

 - 28 - 

 

 

In addition, when First Defiance forecloses on real property, the amount First Defiance realizes after a default is dependent upon factors outside of First Defiance’s control, including, but not limited to, economic conditions, neighborhood real estate values, interest rates, real estate taxes, operating expenses of the mortgaged properties, zoning laws, governmental rules, regulations and fiscal policies, and acts of God. Certain expenditures associated with the ownership of real estate, principally real estate taxes and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the rental income earned from such property, and First Defiance may have to sell the property at a loss. The foregoing expenditures could adversely affect First Defiance’s financial condition and results of operations.

 

First Defiance’s business strategy includes planned growth, with a focus on strategic acquisitions. First Defiance’s financial condition and results of operations could be negatively affected if First Defiance fails to grow or fails to manage its growth effectively.

 

First Defiance’s ability to grow successfully will depend on a variety of factors, including the continued availability of desirable business opportunities, its ability to integrate mergers and other acquisitions and manage growth and First Defiance’s ability to raise capital. There can be no assurance that growth opportunities will be available.

 

First Defiance may acquire other financial institutions or parts of institutions in the future, open new branches, and consider new lines of business and new products or services. Expansions of its business would involve a number of expenses and risks, including:

 

·the time and costs associated with identifying and evaluating potential acquisitions or expansions into new markets;

 

·the potential inaccuracy of estimates and judgments used to evaluate the business and risks with respect to target institutions;

 

·the time and costs of hiring local management and opening new offices;

 

·the delay between commencing making acquisitions or engaging in new activities and the generation of profits from the expansion;

 

·First Defiance’s ability to finance an expansion and the possible dilution to existing shareholders;

 

·the diversion of management’s attention to the expansion;

 

·management’s lack of familiarity with new market areas;

 

·the integration of new products and services and new personnel into First Defiance’s existing business;

 

·the incurrence and possible impairment of goodwill associated with an acquisition and effects on First Defiance’s results of operations; and

 

·the risk of loss of key employees and customers.

 

If First Defiance’s growth involves the acquisition of companies through mergers or other acquisitions, the success of such acquisitions will depend on, among other things, First Defiance’s ability to combine the businesses in a manner that permits growth opportunities and cost efficiencies, and does not cause inconsistencies in standards, controls, procedures and policies that adversely affect the ability of First Defiance to maintain relationships with customers and employees or to achieve the anticipated benefits of the acquisitions.

 

Failure to manage First Defiance’s growth effectively could have a material adverse effect on its business, future prospects, financial condition or results of operations and could adversely affect First Defiance’s ability to successfully implement its business strategy.

 

 - 29 - 

 

 

First Defiance’s ability to pay dividends is subject to regulatory limitations which, to the extent First Defiance requires such dividends in the future, may affect its ability to pay dividends or repurchase its stock.

 

As a savings and loan holding company, First Defiance is a separate legal entity from First Federal and does not have significant operations of its own. Dividends from First Federal provide a significant source of capital for First Defiance. The availability of dividends from First Federal is limited by various statutes and regulations. The federal banking regulators require that insured financial institutions and their holding companies should generally only pay dividends out of current operating earnings. It is possible, depending upon the financial condition of First Federal and other factors, that the OCC, as First Federal’s primary regulator, could assert that the payment of dividends or other payments by First Federal are an unsafe or unsound practice. In the event First Federal is unable to pay dividends to First Defiance, First Defiance may not be able to pay its obligations as they become due, repurchase its stock, or pay dividends on its common stock. Consequently, the potential inability to receive dividends from First Defiance could adversely affect First Defiance’s business, financial condition, results of operations or prospects.

 

Failure to integrate or adopt new technology may undermine First Defiance’s ability to meet customer demands, leading to adverse effects on First Defiance’s financial condition and results of operations.

 

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. First Defiance’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies it is operations. First Defiance may not be able to effectively implement or have the resources to implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could adversely affect First Defiance’s business, financial condition, or results of operations.

 

Item 1B.Unresolved Staff Comments

 

None.

 

Item 2.Properties

 

At December 31, 2017, First Federal conducted its business from its main office at 601 Clinton Street, Defiance, Ohio, and forty-two other full-service banking centers in northwest and central Ohio, northeast Indiana and southeast Michigan as well as a loan production office in southeast Michigan. First Insurance conducted its business from nine offices in northwest Ohio.

 

In January 2017, First Federal opened a branch located at 1707 Cherry St., Toledo, Ohio. This office is leased.

 

In February 2017, First Federal acquired seven branches in the Commercial Savings Bank acquisition: 118 S. Sandusky Ave., Upper Sandusky, Ohio; 112 E. Liberty St., Arlington, Ohio; 128 S. Vance St., Carey, Ohio; 1660 Tiffin Ave., Findlay, Ohio; 17480 Cherokee St., Harpster, Ohio; 279 Jamesway Dr., Marion, Ohio; 195 Barks Rd. West, Marion, Ohio. These offices are owned. The branch located at 1660 Tiffin Ave., Findlay, Ohio was closed on June 30, 2017.

 

In April 2017, First Insurance acquired four insurance offices in the Corporate One acquisition: 107 Ditto St., Suite 400, Archbold, Ohio; 101 W. Sandusky St., Suite 306, Findlay, Ohio; 1650 N. Countyline St., Suite 200, Fostoria, Ohio and 643 Miami St., Suite 5, Tiffin, Ohio. These offices are leased.

 

 - 30 - 

 

 

In November 2017, First Defiance entered into a lease agreement for the office located at 5520 Monroe St., Sylvania, Ohio. This office opened as a branch for First Federal and an insurance office for First Insurance in January 2018. Two First Insurance offices moved into this location: 1755 Indian Wood Cir., Maumee, Ohio and 4350 Navarre Ave., Oregon, Ohio. These leases were terminated in January 2018.

 

In December 2017, First Federal entered into a lease agreement for the office located at 1995 Highland Dr., Ann Arbor, Michigan. This office opened in December as a loan production office.

 

First Defiance maintains its headquarters in the main office of First Federal at 601 Clinton Street, Defiance, Ohio. Back-office operation departments, including information technology, loan processing and underwriting, deposit processing, accounting and risk management are headquartered in an operations center located at 25600 Elliott Rd., Defiance, Ohio.

 

The following table sets forth certain information with respect to the offices and other properties of the Company at December 31, 2017. See Note 9 to the Consolidated Financial Statements.

 

   Leased/  Net Book Value     
Description/address  Owned  of Property   Deposits 
      (In Thousands) 
First Federal             
Main Office             
601 Clinton St., Defiance, OH  Owned  $3,120   $223,102 
Operations Center             
25600 Elliott Rd., Defiance, OH  Owned   4,641    N/A 
Branch Offices, First Federal             
204 E. High St., Bryan, OH  Owned   531    161,290 
211 S. Fulton St., Wauseon, OH  Owned   315    80,641 
625 Scott St., Napoleon, OH  Owned   828    80,346 
1050 E. Main St., Montpelier, OH  Owned   229    47,772 
1800 Scott St., Napoleon, OH  Owned   1,078    35,850 
1177 N. Clinton St., Defiance, OH  Owned, Land Lease Leased   682    43,910 
905 N. Williams St., Paulding, OH  Owned   623    85,825 
201 E. High St., Hicksville, OH  Owned   269    35,894 
3900 N. Main St., Findlay, OH  Owned   772    60,326 
1694 N. Countyline St., Fostoria, OH  Owned   536    68,386 
1226 W. Wooster St., Bowling Green, OH  Owned   843    123,336 
301 S. Main St., Findlay, OH  Owned   728    104,224 
405 E. Main St., Ottawa, OH  Owned   265    96,342 
124 E. Main St., McComb, OH  Owned   151    20,127 
7591 Patriot Dr., Findlay, OH  Owned   1,000    47,873 
417 W. Dussel Dr., Maumee, OH  Owned, Land Lease   665    84,692 
230 E. Second St., Delphos, OH  Owned   819    104,705 
105 S. Greenlawn Ave., Elida, OH  Owned   289    42,760 
2600 Allentown Rd., Lima, OH  Owned   906    48,769 
22020 W. State Rt. 51, Genoa, OH  Owned   705    37,096 
3426 Navarre Ave., Oregon, OH  Owned   777    41,017 
1077 Louisiana Ave., Perrysburg, OH  Owned   498    44,634 
2565 Shawnee Rd., Lima, OH  Owned   1,202    37,592 
1595 W. Dupont Rd., Fort Wayne, IN  Leased   -    25,008 
135 S. Main St., Glandorf, OH  Leased   -    16,970 
300 N. Main St., Adrian, MI  Owned   583    83,999 
1701 W. Maumee St., Adrian, MI  Owned   184    48,827 
211 W. Main St., Morenci, MI  Owned   157    34,582 
539 S. Meridian Hwy., Hudson, MI  Owned   473    49,149 
1449 W. Chicago Blvd., Tecumseh, MI  Owned   1,355    65,506 
1200 N. Main St., Bowling Green OH  Owned   1,529    10,903 
9909 Illinois Rd, Fort Wayne, IN  Owned   1,895    47,819 
4501 Cemetery Rd, Hilliard, OH  Owned   947    6,558 
2920 W. Central Ave., Toledo, OH  Owned   161    1,288 
118 S. Sandusky Ave., Upper Sandusky, OH  Owned   1,144    121,402 
112 E. Liberty St., Arlington, OH  Owned   85    21,849 
128 S. Vance St., Carey, OH  Owned   171    54,650 
17480 Cherokee St., Harpster, OH  Owned   136    12,517 
279 Jamesway Dr., Marion, OH  Owned   705    33,678 
195 Barks Rd. West, Marion, OH  Owned   633    43,745 
1707 Cherry St., Toledo, OH  Owned   72    2,447 
1995 Highland Dr., Suite A, Ann Arbor, MI  Leased   -    - 
5520 Monroe St., Sylvania, OH  Leased   -    250 
              
First Insurance Group             
511 Fifth St., Defiance, OH  Leased   436    N/A 
209 W. Poe Rd., Bowling Green, OH  Leased   -    N/A 
204 E. High St., Bryan, OH  Leased   -    N/A 
1755 Indian Wood Cir., Maumee, OH  Leased   -    N/A 
4350 Navarre Ave., Oregon, OH  Leased   -    N/A 
2600 Allentown Rd., Lima, OH  Leased   -    N/A 
107 Ditto St., Suite 400, Archbold, OH  Leased   -    N/A 
101 W. Sandusky St., Suite 306, Findlay, OH  Leased   -    N/A 
1650 N. Countyline St., Suite 200, Fostoria, OH  Leased   -    N/A 
643 Miami St., Suite 5, Tiffin, OH  Leased   -    N/A 
5520 Monroe St., Suite A, Sylvania, OH  Leased   -    N/A 
      $33,138   $2,437,656 

 

Item 3.Legal Proceedings

 

First Defiance is involved in routine legal proceedings that are incidental to and occur in the ordinary course of business which, in the aggregate, are believed by management to be immaterial to the financial condition of First Defiance.

 

Item 4.Mine Safety Disclosures

 

Not applicable.

 

 - 31 - 

 

 

PART II

 

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

 

The Company’s common shares trade on The NASDAQ Global Select Market under the symbol “FDEF.” As of February 23, 2018, the Company had approximately 2,407 shareholders of record.

 

The Company’s ability to pay dividends to its shareholders is subject to regulatory limitations due to the Company’s dependence on First Federal as a source of capital for the payment of the dividends. The Federal Reserve expects First Defiance to serve as a source of strength for First Federal and may require First Defiance to retain capital for further investment in First Federal, rather than pay dividends to First Defiance shareholders. If federal banking regulators deem the payment of dividends to be an unsafe or unsound banking practice, the regulators, within their discretion, may restrict the Company’s payment of dividends to its shareholders. The table below shows the reported high and low sales prices of the common shares and cash dividends declared per common share during the periods indicated in 2017 and 2016.

 

   Year Ending 
   December 31, 2017   December 31, 2016 
   High   Low   Dividend   High   Low   Dividend 
                         
Quarter ended:                              
March 31  $51.15   $46.27   $0.25   $40.98   $34.80   $0.22 
June 30   56.90    48.78    0.25    41.21    37.53    0.22 
September 30   53.99    47.01    0.25    46.83    35.90    0.22 
December 31   56.91    50.28    0.25    52.31    36.91    0.22 

 

The line graph below compares the yearly percentage change in cumulative total shareholder return on First Defiance common shares and the cumulative total return of the NASDAQ Composite Index, the SNL NASDAQ Bank Index and the SNL Midwest Thrift Index. An investment of $100 on December 31, 2012, and the reinvestment of all dividends are assumed. The performance graph represents past performance and should not be considered to be an indication of future performance.

 

   Period Ending 
Index  12/31/12   12/31/13   12/31/14   12/31/15   12/31/16   12/31/17 
First Defiance Financial Corp.   100.00    137.61    184.50    209.03    286.93    299.75 
NASDAQ Composite   100.00    140.12    160.78    171.97    187.22    242.71 
SNL Bank NASDAQ   100.00    143.73    148.86    160.70    222.81    234.58 
SNL Midwest Thrift   100.00    123.32    140.94    172.58    207.82    197.64 

 

 - 32 - 

 

 

 

The following table provides information regarding First Defiance’s purchases of its common shares during the fourth quarter period ended December 31, 2017:

 

Period  Total Number
of Shares
Purchased
   Average
Price Paid
Per Share
   Total Number of
Shares Purchased
as Part of
Publicly
Announced Plans
or Programs
   Maximum Number of
Shares (or Approximate
Dollar Value) that May
Yet Be Purchased Under
the Plans or Programs (1)
 
October 1 – October 31, 2017   -   $-    -    377,500 
November 1 – November 30, 2017   -    -    -    377,500 
December 1 – December 31, 2017   -    -    -    377,500 
Total   -   $-    -    377,500 

 

(1)On January 29, 2016, the Company announced that its Board of Directors authorized another program for the repurchase of up to 5% of the outstanding common shares or 450,000 shares. There is no expiration date for the new repurchase program.

 

The information set forth under the caption “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters - Equity Compensation Plans” of this Form 10-K is incorporated herein by reference.

 

 - 33 - 

 

 

Item 6.Selected Financial Data

 

The following table is derived from the Company’s audited financial statements as of and for the five years ended December 31, 2017. The following consolidated selected financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes included elsewhere in this Form 10-K. The operating results of acquired companies are included with the Company’s results of operations since their respective dates of acquisition.

 

   As of and For the Year Ended December 31 
   2017   2016   2015   2014   2013 
   (Dollars in Thousands, Except Per Share Data) 
Financial Condition:                         
Total assets  $2,993,403   $2,477,597   $2,297,676   $2,178,952   $2,137,148 
Investment securities   261,298    251,176    236,678    239,634    198,557 
Loans receivable, net   2,322,030    1,914,603    1,776,835    1,622,020    1,555,498 
Allowance for loan losses   26,683    25,884    25,382    24,766    24,950 
Nonperforming assets (1)   32,247    14,803    17,582    30,311    33,706 
Deposits and borrowers’ escrow balances   2,440,581    1,984,278    1,838,811    1,763,122    1,737,311 
FHLB advances   84,279    103,943    59,902    21,544    22,520 
Stockholders’ equity   373,286    293,018    280,197    279,505    272,147 
Share Information:                         
Basic earnings per share   3.23    3.21    2.87    2.55    2.28 
Diluted earnings per share   3.22    3.19    2.82    2.44    2.19 
Book value per common share   36.76    32.62    30.78    30.17    27.91 
Tangible book value per common share (2)   26.49    25.59    23.79    23.25    21.22 
Cash dividends per common share   1.00    0.88    0.775    0.625    0.40 
Dividend payout ratio   30.96%   27.41%   27.00%   24.51%   17.45%
Weighted average diluted shares outstanding   10,034    9,035    9,371    9,969    10,171 
Shares outstanding end of period   10,156    8,983    9,102    9,235    9,720 
Operations:                         
Interest income  $108,102   $87,383   $80,836   $76,248   $74,781 
Interest expense   11,431    8,440    6,781    6,559    7,170 
Net interest income   96,671    78,943    74,055    69,689    67,611 
Provision for loan losses   2,949    283    136    1,117    1,824 
Non-interest income   40,081    34,030    31,803    31,641    30,778 
Non-interest expense   85,351    71,093    67,889    66,758    65,052 
Income before tax   48,452    41,597    37,833    33,455    31,513 
Federal income tax   16,184    12,754    11,410    9,163    9,278 
Net Income   32,268    28,843    26,423    24,292    22,235 
Performance Ratios:                         
Return on average assets   1.13%   1.20%   1.19%   1.12%   1.08%
Return on average equity   9.19%   10.10%   9.52%   8.78%   8.39%
Interest rate spread (2)   3.74%   3.61%   3.71%   3.57%   3.65%
Net interest margin (2)   3.88%   3.74%   3.81%   3.68%   3.76%
Ratio of operating expense to average total assets   2.99%   2.97%   3.05%   3.09%   3.16%
Efficiency ratio (2)   61.81%   62.20%   63.01%   65.32%   64.81%
Other Ratios:                         
Equity to total assets at end of period   12.47%   11.83%   12.19%   12.83%   12.73%
Average equity to average assets   12.32%   11.91%   12.49%   12.79%   12.92%
Asset Quality Ratios:                         
Nonperforming assets to total assets at end of period (1)   1.08%   0.60%   0.77%   1.39%   1.58%
Allowance for loan losses to total loans*   1.14%   1.33%   1.41%   1.50%   1.58%
Net charge-offs (recoveries) to average loans   0.10%   -0.01%   -0.03%   0.08%   0.23%

 

(1)Nonperforming assets include non-accrual loans that are contractually past due 90 days or more and real estate, mobile homes and other assets acquired by foreclosure or deed-in-lieu thereof.

 

(2)Refer to Non-GAAP Financial Measures in Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

* Total loans are net of undisbursed loan funds and deferred fees and costs.

 

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Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Statements and Factors that Could Affect Future Results

 

Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (“Act”), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Company’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Corporation that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per common share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of First Defiance or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as “believes”, “anticipates”, “expects”, “intends”, “targeted”, “continue”, “remain”, “will”, “should”, “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

 

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

 

·Local, regional, national and international economic conditions and the impact they may have on the Company and its customers and the Company’s assessment of that impact.

 

·Volatility and disruption in national and international financial markets.

 

·Government intervention in the U.S. financial system.

 

·Changes in the level of non-performing assets and charge-offs.

 

·Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.

 

·The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve.

 

·Inflation, interest rate, securities market and monetary fluctuations.

 

·Political instability.

 

·Acts of God or of war or terrorism.

 

·The timely development and acceptance of new products and services and perceived overall value of these products and services by users.

 

·Changes in consumer spending, borrowing and saving habits.

 

·Changes in the financial performance and/or condition of the Company’s borrowers.

 

·Technological changes including core system conversions.

 

·Acquisitions and integration of acquired businesses.

 

·The ability to increase market share and control expenses.

 

·Changes in the competitive environment among financial holding companies and other financial service providers.

 

·The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Company and its subsidiaries must comply.

 

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·The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters.

 

·The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews.

 

·Greater than expected costs or difficulties related to the integration of new products and lines of business.

 

·The Company’s success at managing the risks involved in the foregoing items.

 

Forward-looking statements speak only as of the date on which such statements are made. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.

 

This Item 7 presents information to assess the financial condition and results of operations of First Defiance. This item should be read in conjunction with the Consolidated Financial Statements and the supplemental financial data contained elsewhere in this Annual Report on Form 10-K.

 

Non-GAAP Financial Measures

 

This Annual Report on Form 10-K contains GAAP financial measures and certain non-GAAP financial measures. Management believes that these measures are helpful in understanding the Company’s results of operations or financial position. Fully taxable-equivalent (“FTE”) is an adjustment to net interest income to reflect tax-exempt income on an equivalent before-tax basis. The following tables present a reconciliation of non-GAAP measures to their respective GAAP measures at December 31, 2017 and 2016.

 

Non-GAAP Financial Measures – Net Interest Income on an FTE basis, Net Interest Margin and Efficiency Ratio

 

($ in Thousands)  December 31,
2017
   December 31,
2016
 
Net interest income (GAAP)  $96,671   $78,943 
Add:  FTE adjustment   1,914    1,830 
Net interest income on a FTE basis (1)  $98,585   $80,773 
Noninterest income – less securities gains/losses (2)  $39,497   $33,521 
Noninterest expense (3)   85,351    71,093 
Average interest-earning assets less average unrealized gains/losses on securities(4)   2,542,129    2,160,561 
Average interest-earning assets   2,545,261    2,168,046 
Average unrealized gains/losses on securities   3,132    7,485 
Ratios:          
Net interest margin (1) / (4)   3.88%   3.74%
Efficiency ratio (3) / (1) + (2)   61.81%   62.20%

 

Non-GAAP Financial Measures – Tangible Book Value

 

($ in Thousands, except per share data)  December 31,  
2017
   December 31,
2016
 
Total Shareholders’ Equity (GAAP)  $373,286   $293,018 
Less:      Goodwill   (98,569)   (61,798)
Intangible assets   (5,703)   (1,336)
Tangible common equity (1)  $269,014   $229,884 
Common shares outstanding (2)   10,156    8,983 
Tangible book value per share (1) / (2)  $26.49   $25.59 

 

 - 36 - 

 

 

Overview

 

First Defiance is a unitary thrift holding company that conducts business through its wholly-owned subsidiaries, First Federal, First Insurance and First Defiance Risk Management.

 

First Federal is a federally chartered stock savings bank that provides financial services to communities based in northwest Ohio, northeast Indiana, and southeastern Michigan where it operates 43 full service banking centers in fourteen northwest and central Ohio counties, one northeast Indiana county, and one southeastern Michigan county. First Federal operates one loan production office in Ann Arbor, Michigan which is located in Washtenaw County.

 

First Federal provides a broad range of financial services including checking accounts, savings accounts, certificates of deposit, real estate mortgage loans, commercial loans, consumer loans, home equity loans and trust and wealth management services through its extensive branch network.

 

First Insurance sells a variety of property and casualty, group health and life and individual health and life insurance products. First Insurance is an insurance agency that does business in the Archbold, Bowling Green, Bryan, Defiance, Findlay, Fostoria, Lima, Maumee, Oregon, and Tiffin, Ohio areas. The Maumee and Oregon offices were consolidated into a new office in Sylvania, Ohio in January 2018.

 

First Defiance Risk Management is 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. First Defiance Risk Management pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. First Defiance Risk Management was incorporated on December 20, 2012.

 

Financial Condition

 

Assets at December 31, 2017, totaled $2.99 billion compared to $2.48 billion at December 31, 2016, an increase of $515.8 million or 20.8%. Cash and cash equivalents increased $14.7 million to $113.7 million at December 31, 2017 from $99.0 million at December 31, 2016. The increase in assets was due to an increase in loans receivable, net of undisbursed loan funds and deferred fees and costs, of $407.4 million, an increase in goodwill of $36.8 million and an increase in securities of $10.1 million. These increases were funded by increases in total deposits of $456.0 million. These increases were primarily due to the acquisition of CSB, which increased total assets by $367.1 million, loans by $285.4 million, goodwill and intangible assets by $33.8 million and deposits by $308.0 million. See Note 3 – Business Combinations to the Consolidated Financial Statements for further details regarding the CSB acquisition and the impact to the individual categories.

 

Securities

 

The securities portfolio increased $10.1 million to $261.3 million at December 31, 2017. The 2017 activity in the portfolio included $73.5 million of purchases, $4.3 million acquired from CSB, $1.4 million of amortization, $32.8 million of principal pay-downs and maturities, and $33.7 million of securities being sold. There was a net increase of $148,000 in the market value of available-for-sale securities. For additional information regarding First Defiance’s investment securities see Note 5 to the Consolidated Financial Statements.

 

Loans

 

Loans receivable, net of undisbursed loan funds and deferred fees and costs, increased $408.2 million to $2.35 billion at December 31, 2017. For more details on the loan balances, see Note 7 – Loans Receivable to the Consolidated Financial Statements.

 

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The majority of First Defiance’s commercial real estate and commercial loans are to small and mid-sized businesses. The combined commercial, commercial real estate and multi-family real estate loan portfolios totaled $1.76 billion and $1.51 billion at December 31, 2017 and 2016, respectively, and accounted for approximately 71.4% and 74.2% of First Defiance’s loan portfolio at the end of those respective periods. The net commercial and commercial real estate loan amounts acquired from CSB at the acquisition date were $194.6 million. First Defiance believes it has been able to establish itself as a leader in its market area in the commercial and commercial real estate lending area by hiring experienced lenders and providing a high level of customer service to its commercial lending clients.

 

The 1-4 family residential portfolio totaled $274.9 million at December 31, 2017, compared with $207.6 million at the end of 2016. At the end of 2017, those loans comprised 11.1% of the total loan portfolio, up from 10.2% at December 31, 2016. The net 1-4 family residential loans acquired from CSB at the acquisition date were $58.6 million.

 

Construction loans, which include one-to-four family and commercial real estate properties, increased to $265.5 million at December 31, 2017, compared to $182.9 million at December 31, 2016. These loans accounted for approximately 10.8% and 9.0% of the total loan portfolio at December 31, 2017 and 2016, respectively. The net construction loans acquired from CSB at the acquisition date were $5.6 million.

 

Home equity and home improvement loans increased to $135.5 million at December 31, 2017, from $118.4 million at the end of 2016. At the end of 2017, those loans comprised 5.5% of the total loan portfolio, down slightly from 5.8% at December 31, 2016. The net home equity and home improvement loans acquired from CSB at the acquisition date was $15.7 million.

 

Consumer finance and mobile home loans were $29.1 million at December 31, 2017 up from $16.7 million at the end of 2016. These loans accounted for approximately 1.2% and 0.8% of the total loan portfolio at December 31, 2017 and 2016, respectively. The net consumer loans acquired from CSB at the acquisition date were $10.9 million.

 

In order to properly assess the collateral dependent loans included in its loan portfolio, the Company has established policies regarding the monitoring of the collateral underlying such loans. The Company requires an appraisal that is less than one year old for all new collateral dependent real estate loans, and all renewed collateral dependent real estate loans where significant new money is extended. The appraisal process is handled by the Credit Department, which selects the appraiser and orders the appraisal. First Defiance’s loan policy prohibits the account officer from talking or communicating with the appraiser to insure that the appraiser is not influenced by the account officer in any way in making a determination of value.

 

First Federal generally does not require updated appraisals for performing loans unless significant new money is requested by the borrower.

 

When a collateral dependent loan is downgraded to classified status, First Federal reviews the most current appraisal on file and if appropriate, based on First Federal’s assessment of the appraisal, such as age, market, etc. First Federal will discount the appraisal amount to a more appropriate current value based on inputs from lenders and realtors. This amount may then be discounted further by First Federal’s estimation of the selling costs. In most instances, if the appraisal is more than twelve to fifteen months old, a new appraisal may be required. Finally, First Federal assesses whether there is any collateral short fall, taking into consideration guarantor support and liquidity, and determines if a charge off is necessary.

 

All loans over 90 days past due and/or on non-accrual are classified as non-performing loans. Non-performing status automatically occurs in the month in which the 90-day delinquency occurs. When a collateral dependent loan moves to non-performing status, First Federal generally gets a new third party appraisal and charges the loan down appropriately based upon the new appraisal and an estimate of costs to liquidate the collateral. All properties that are moved into the Other Real Estate Owned (“OREO”) category are supported by current appraisals, and the OREO is carried at the lower of cost or fair value, which is determined based on appraised value less First Federal’s estimate of the liquidation costs.

 

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First Federal does not adjust any appraisals upward without written documentation of this valuation change from the appraiser. When setting reserves and charge offs on classified loans, appraisal values may be discounted downward based upon First Federal’s experience with liquidating similar properties.

 

Appraisals are received within approximately 60 days after they are requested. The First Federal Loan Loss Reserve Committee reviews the amount of each new appraisal and makes any necessary charge off decisions at its meeting prior to the end of each quarter.

 

Any partially charged-off collateral dependent loans are considered non-performing, and as such, would need to show an extended period of time with satisfactory payment performance as well as cash flow coverage capability supported by current financial statements before First Federal will consider an upgrade to performing status. First Federal may consider moving the loan to accruing status after approximately six months of satisfactory payment performance.

 

For loans where First Federal determines that an updated appraisal is not necessary, other means are used to verify the value of the real estate, such as recent sales of similar properties on which First Federal had loans as well as calls to appraisers, brokers, realtors and investors. First Federal monitors and tracks its loan to value quarterly to determine accuracy and any necessary charge offs. Based on these results, changes may occur in the processes used.

 

Loan modifications constitute a troubled debt restructuring (“TDR”) if First Federal, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. For loans that are considered TDRs, First Federal either computes the present value of expected future cash flows discounted at the original loan’s effective interest rate or it may measure impairment based on the fair value of the collateral. For those loans measured for impairment utilizing the present value of future cash flows method, any discount is carried as a specific reserve in the allowance for loan and lease losses. For those loans measured for impairment utilizing the fair value of the collateral, any shortfall is charged off. As of December 31, 2017 and December 31, 2016, First Federal had $13.8 million and $10.5 million, respectively, of loans that were still performing and which were classified as TDRs.

 

Allowance for Loan Losses

 

The allowance for loan losses represents management’s assessment of the estimated probable incurred credit losses in the loan portfolio at each balance sheet date. Management analyzes the adequacy of the allowance for loan losses regularly through reviews of the loan portfolio. Consideration is given to economic conditions, changes in interest rates and the effect of such changes on collateral values and borrower’s ability to pay, changes in the composition of the loan portfolio and trends in past due and non-performing loan balances. The allowance for loan losses is a material estimate that is susceptible to significant fluctuation and is established through a provision for loan losses based on management’s evaluation of the inherent risk in the loan portfolio. In addition to extensive in-house loan monitoring procedures, the Company utilizes an outside party to conduct an independent loan review of commercial loan and commercial real estate loan relationships. The goal is to have approximately 55% to 60% of the portfolio reviewed annually. This includes all relationships over $5.0 million with new exposure greater than $2.0 million and a sample of other relationships greater than $5.0 million; loan relationships between $1.0 million and $5.0 million with new exposure greater than $750,000 and a sample of other relationships between $1.0 million and $5.0 million; and a sample of relationships less than $1.0 million. Management utilizes the results of this outside loan review to assess the effectiveness of its internal loan grading system as well as to assist in the assessment of the overall adequacy of the allowance for loan losses associated with these types of loans.

 

 - 39 - 

 

 

The allowance for loan loss is made up of two basic components. The first component of the allowance for loan loss is the specific reserve in which the Company sets aside reserves based on the analysis of individual impaired credits. In establishing specific reserves, the Company analyzes all substandard, doubtful and loss graded loans quarterly and makes judgments about the risk of loss based on the cash flow of the borrower, the value of any collateral and the financial strength of any guarantors. If the loan is impaired and cash flow dependent, then a specific reserve is established for the discount on the net present value of expected future cash flows. If the loan is impaired and collateral dependent, then any shortfall is usually charged off. The Company also considers the impacts of any Small Business Association or Farm Service Agency guarantees. The specific reserve was $758,000 at December 31, 2017, and $809,000 at December 31, 2016.

 

The second component is a general reserve, which is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolio based on quantitative and qualitative factors. For purposes of the general reserve analysis, the loan portfolio is stratified into nine different loan pools based on loan type to allocate historic loss experience. The loss experience factor is then applied to the non-impaired loan portfolio. The Company utilizes loss migration measurement for each loan portfolio segment with differentiation between loan risk grades in calculating the general reserve component for non-impaired loans. Beginning December 31, 2016 the historical loss calculation was changed from using a an average of four (4) four-year loss migration periods to using an average of all four-year loss migration periods to the present beginning with data from the second quarter 2011. Management believes this enhancement is consistent with the rationale of the previous measurement but provides a more precise calculation of historical losses by incorporating more data points for the average loss ratio and including periods that provide a more complete coverage of the full business cycle. Management believes that capturing the risk grade changes and cumulative losses over the life cycle of a loan more accurately depicts management’s estimate of historical losses as well as being more reflective of the ongoing risks in the loan portfolio.

 

The quantitative general allowance decreased $2.7 million to $6.0 million at December 31, 2017 from $8.7 million at December 31, 2016 primarily due to a decrease in the historical loss rates from the migration analysis.

 

In addition to the quantitative analysis, a qualitative analysis is performed each quarter to provide additional general reserves on the non-impaired loan portfolio for various factors. The overall qualitative factors are based on nine sub-factors. The nine sub-factors have been aggregated into three qualitative factors: economic, environment and risk.

 

ECONOMIC

 

1)Changes in international, national and local economic business conditions and developments, including the condition of various market segments.
2)Changes in the value of underlying collateral for collateral dependent loans.

 

ENVIRONMENT

 

3)Changes in the nature and volume in the loan portfolio.
4)The existence and effect of any concentrations of credit and changes in the level of such concentrations.
5)Changes in lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices.
6)Changes in the quality and breadth of the loan review process.
7)Changes in the experience, ability and depth of lending management and staff.

 

RISK

 

8)Changes in the trends of the volume and severity of delinquent and classified loans, and changes in the volume of non-accrual loans, trouble debt restructuring, and other loan modifications.
9)Changes in the political and regulatory environment.

 

 - 40 - 

 

 

The qualitative analysis at December 31, 2017, indicated a general reserve of $20.0 million compared with $16.4 million at December 31, 2016, an increase of $3.6 million. Management reviews the overall economic, environmental and risk factors quarterly and determines appropriate adjustments to these sub-factors based on that review.

 

The economic factors for all loan segments were decreased in 2017 due to economic conditions showing continued strength and sustainability, as well as strong employment data.

 

The environmental factors decreased slightly in 2017 in all loan segments. This is due to there being no major changes to loan policy or underwriting guidelines, the stability of the characteristics and terms of the loan portfolio and the continued favorable results of loan review, audits and examinations.

 

The decrease in the economic and environmental facts was offset by an increase in risk factors in all loan segments, but primarily in commercial and commercial real estate. This is due to unfavorable trends in the levels of non-performing loans and classified assets.

 

First Defiance’s general reserve percentages for main loan segments not otherwise classified ranged from 0.44% for construction loans to 1.59% for home equity and improvement loans.

 

As a result of the quantitative and qualitative analysis, along with the change in specific reserves, the Company’s provision for loan losses for 2017 was $2.9 million compared to $283,000 for 2016. The allowance for loan losses was $26.7 million at December 31, 2017, and $25.9 million at December 31, 2016, and represented 1.14% and 1.33% of loans, net of undisbursed loan funds and deferred fees and costs, respectively. The decrease in the allowance for loan loss as a percentage of total loans versus a year ago was primarily attributable to the CSB acquisition. The CSB loans acquired were recorded at fair value with purchase accounting adjustments discounting the loan balance instead of an allowance for loan losses. The recorded investment and purchase accounting adjustment of loans acquired from CSB totaled $208.4 million and $3.9 million, respectively, at December 31, 2017. The provision was offset by charge offs of $3.4 million and recoveries of $1.3 million resulting in an increase to the overall allowance for loan loss of $800,000. In management’s opinion, the overall allowance for loan losses of $26.7 million as of December 31, 2017, is adequate.

 

Management also assesses the value of OREO as of the end of each accounting period and recognizes write-downs to the value of that real estate in the income statement if conditions dictate. In 2017, First Defiance recorded OREO write-downs that totaled $20,000. These amounts were included in other non-interest expense. Management believes that the values recorded at December 31, 2017, for OREO and repossessed assets represent the realizable value of such assets.

 

Total classified loans increased to $59.4 million at December 31, 2017, compared to $27.5 million at December 31, 2016, an increase of $31.9 million. There were two loan relationships totaling $11.0 million that were downgraded and resulted in an increase in net charge offs in the second quarter of 2017. In addition, there were $17.4 million of newly classified loans from the CSB acquisition due to new financial information received.

 

First Defiance’s ratio of allowance for loan losses to non-performing loans was 86.9% at December 31, 2017, compared with 180.4% at December 31, 2016. Management monitors collateral values of all loans included on the watch list that are collateral dependent and believes that allowances for those loans at December 31, 2017, are appropriate.

 

At December 31, 2017, First Defiance had total non-performing assets of $32.2 million, compared to $14.8 million at December 31, 2016. Non-performing assets include loans that are 90 days past due, real estate owned and other assets held for sale.

 

The decrease in non-performing assets between December 31, 2017, and December 31, 2016, is in commercial loans and commercial real estate loans. The balance of commercial non-performing loans was $7.8 million higher at December 31, 2017, compared to December 31, 2016. The balance of commercial real estate loans was $8.6 million higher at December 31, 2017, compared to December 31, 2016.

 

 - 41 - 

 

 

Non-performing loans in the single-family residential, commercial real estate and commercial loan categories represent 1.10%, 1.47% and 1.68% of the total loans in those categories respectively at December 31, 2017, compared to 1.41%, 0.92% and 0.21% respectively for the same categories at December 31, 2016. Management believes that the current allowance for loan losses is appropriate and that the provision for loan losses recorded in 2017 is consistent with both charge-off experience and the risk inherent in the overall credits in the portfolio.

 

First Federal’s Asset Review Committee meets monthly to review the status of work-out strategies for all criticized relationships, which include all non-accrual loans. Based on such factors as anticipated collateral values in liquidation scenarios, cash flow projections, assessment of net worth of guarantors and all other factors which may mitigate risk of loss, the Asset Review Committee makes recommendations regarding proposed charge-offs which are approved by the Senior Loan Committee or the Loan Loss Reserve Committee.

 

The net charge-offs and nonaccrual loan balances as a percentage of total are presented in the table below at December 31, 2017 and 2016.

 

Table 1 – Net Charge-offs and Non-accruals by Loan Type

 

   For the Twelve Months Ended December 31, 2017   As of December 31, 2017 
   Net   % of Total Net         
   Charge-offs   Charge-offs   Nonaccrual   % of Total Non- 
   (Recoveries)   (Recoveries)   Loans   Accrual Loans 
   (In Thousands)       (In Thousands)     
Residential  $164    7.63%  $3,037    9.89%
Construction   -    0.00%   -    0.00%
Commercial real estate   (260)   (12.09)%   18,219    59.32%
Commercial   2,058    95.77%   8,841    28.78%
Consumer finance   54    2.46%   28    0.09%
Home equity and improvement   134    6.23%   590    1.92%
Total  $2,150    100.00%  $30,715    100.00%

 

   For the Twelve Months Ended December 31, 2016   As of December 31, 2016 
   Net   % of Total Net   Nonaccrual   % of Total Non- 
   Charge-offs   Charge-offs   Loans   Accrual Loans 
   (In Thousands)       (In Thousands)     
Residential  $184    84.02%  $2,928    20.41%
Construction   -    0.00%   -    0.00%
Commercial real estate   (831)   (379.45)%   9,592    66.85%
Commercial   280    127.85%   1,007    7.02%
Consumer finance   30    13.70%   91    0.63%
Home equity and improvement   118    53.88%   730    5.09%
Total  $(219)   (100.00)%  $14,348    100.00%

 

The following table sets forth information concerning the allocation of First Defiance’s allowance for loan losses by loan categories at December 31, 2017 and 2016.

 

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Table 2 – Allowance for Loan Loss Allocation by Loan Category

 

   December 31, 2017   December 31, 2016 
       Percent of       Percent of 
       total loans       total loans 
   Amount   by category   Amount   by category 
   (Dollars in Thousands) 
1-4 family residential  $2,532    11.1%  $2,627    10.2%
Multi-family  residential real estate   2,702    10.1    2,228    9.7 
Commercial real estate   10,354    40.0    10,625    41.5 
Construction   647    10.8    450    9.0 
Commercial loans   7,965    21.3    7,361    23.0 
Home equity and improvement loans   2,255    5.5    2,386    5.8 
Consumer loans   228    1.2    207    0.8 
   $26,683    100.0%  $25,884    100.0%

 

Loans Acquired with Impairment

 

The Company has purchased loans, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.

 

As of December 31, 2017, the total contractual receivable for those loans was $4.8 million and the recorded value was $3.8 million.

 

High Loan-to-Value Mortgage Loans

 

The majority of First Defiance’s mortgage loans are collateralized by one-to-four-family residential real estate, have loan-to-value ratios of 80% or less, and are made to borrowers in good credit standing. First Federal usually requires residential mortgage loan borrowers whose loan-to-value is greater than 80% to purchase private mortgage insurance (“PMI”). Management also periodically reviews and monitors the financial viability of its PMI providers.

 

First Federal originates and retains a limited number of residential mortgage loans with loan-to-value ratios that exceed 80% where PMI is not required if the borrower possesses other demonstrable strengths. The loan-to-value ratios on these loans are generally limited to 85% and exceptions must be approved by First Federal’s senior loan committee. Management monitors the balance of one-to-four family residential loans, including home equity loans and committed lines of credit that exceed certain loan to value standards (90% for owner occupied residences, 85% for non-owner occupied residences and one-to-four family construction loans, 75% for developed land and 65% for raw land). Total loans that exceed those standards described above at December 31, 2017, totaled $50.8 million, compared to $42.8 million at December 31, 2016. These loans are generally paying as agreed.

 

First Defiance does not make interest-only first-mortgage residential loans, nor does it have residential mortgage loan products or other consumer products that allow negative amortization.

 

Goodwill and Intangible Assets

 

Goodwill was $98.6 million at December 31, 2017, compared to $61.8 million at December 31, 2016. The acquisition of CSB increased goodwill by $28.9 million and the acquisition of Corporate One increased goodwill by $7.9 million. Core deposit intangibles and other intangible assets increased $4.4 million to $5.7 million at December 31, 2017, compared to $1.3 million at December 31, 2016. The acquisition of CSB and Corporate One increased core deposit and other intangibles by $4.9 million and $756,000, respectively. In addition there was $1.3 million of amortization expense for core deposit and other intangibles in 2017. No impairment of goodwill was recorded in 2017 or 2016.

 

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Deposits

 

Total deposits at December 31, 2017 were $2.44 billion compared to $1.98 billion at December 31, 2016, an increase of $456.0 million or 23.0%. Non-interest bearing checking accounts grew by $83.7 million, interest bearing checking accounts and money markets grew by $188.9 million, savings grew by $58.7 million and retail certificates of deposit grew by $124.8 million. The net deposit amounts acquired from CSB at the acquisition date resulted in a $56.1 million increase in non-interest bearing demand deposits, $122.0 million increase in interest bearing demand and money market deposits, $31.6 million increase in savings deposits and $98.2 million increase in retail time deposits. Management can utilize the national market for certificates of deposit to supplement its funding needs if necessary. For more details on the deposit balances in general see Note 11 – Deposits to the Consolidated Financial Statements.

 

Borrowings

 

FHLB advances totaled $84.3 million at December 31, 2017 compared to $103.9 million at December 31, 2016. The balance at the end of 2017 includes $5.0 million of convertible advances with a rate of 2.35%. This advance is callable by the FHLB, at which point it would convert to a three-month LIBOR advance if not paid off. This advance has a final maturity date in March 2018. In addition, First Defiance has fifteen fixed-rate advances totaling $72.0 million with rates ranging from 1.09% to 2.16% and two amortizing advances totaling $7.3 million with rates ranging from 1.78% to 2.14%.

 

At December 31, 2017, First Defiance also had $26.0 million of securities that were sold with agreements to repurchase, compared to $31.8 million at December 31, 2016.

 

Equity

 

Total stockholders’ equity increased $80.3 million to $373.3 million at December 31, 2017 compared to $293.0 million at December 31, 2016. The increase in stockholders’ equity was the result of recording net income of $32.3 million and an increase of $56.5 million due to the acquisition of CSB as a result of issuing 1.1 million shares of common stock. These amounts were partially offset by $9.9 million of common stock dividends paid in 2017.

 

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Results of Operations

 

Summary

 

First Defiance reported net income of $32.3 million for the year ended December 31, 2017, compared to $28.8 million and $26.4 million for the years ended December 31, 2016 and 2015, respectively. On a diluted per common share basis, First Defiance earned $3.22 in 2017, $3.19 in 2016 and $2.82 in 2015.

 

Net Interest Income

 

First Defiance’s net interest income is determined by its interest rate spread (i.e. the difference between the yields on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.

 

Net interest income was $96.7 million for the year ended December 31, 2017, compared to $78.9 million and $74.1 million for the years ended December 31, 2016 and 2015, respectively. The tax-equivalent net interest margin was 3.88%, 3.74% and 3.81% for the years ended December 31, 2017, 2016 and 2015, respectively. The margin increased 14 basis points between 2016 and 2017. The increase in margin in 2017 was primarily due to CSB’s earning asset mix as well an increase in interest rates. Interest-earning asset yields increased 20 basis points (to 4.33% in 2017 from 4.13% in 2016) and the cost of interest bearing liabilities between the two periods increased 7 basis points (to 0.59% in 2017 from 0.52% in 2016).

 

Total interest income increased by $20.7 million or 23.7% to $108.1 million for the year ended December 31, 2017, from $87.4 million for the year ended December 31, 2016. This is due to continued loan growth, the CSB acquisition, the increase in interest rates and a more profitable earning asset mix. Interest income from loans increased to $99.5 million for 2017 compared to $80.2 million in 2016, which represents an increase of 24.1%. The average balance of loans receivable increased $345.2 million to $2.2 billion at December 31, 2017, from $1.9 billion at December 31, 2016, due primarily to the CSB acquisition.

 

During the same period, the average balance of investment securities increased to $258.8 million in 2017 from $233.4 million for the year ended December 31, 2016. Interest income from investment securities increased to $6.9 million in 2017 compared to $6.2 million in 2016, which represents an increase of 11.1%. The overall duration of investments increased to 3.40 years at December 31, 2017, from 3.38 years at December 31, 2016.

 

Interest expense increased by $3.0 million in 2017 compared to 2016, to $11.4 million from $8.4 million. This increase was mainly due to a seven basis point increase in the average cost of interest-bearing liabilities in 2017 and a $297.3 million increase in the average balance of interest-bearing liabilities. The average balance of interest bearing deposits increased $305.9 million to $1.77 billion at December 31, 2017, from $1.46 billion at December 31, 2016, primarily due to the CSB acquisition. Interest expense related to interest-bearing deposits was $8.8 million in 2017 compared to $6.3 million in 2016.

 

Interest expenses on FHLB advances and other interest-bearing funding sources were $1.5 million and $208,000 respectively, in 2017 and $1.3 million and $138,000 respectively in 2016. The increase in FHLB advance expense was due to rising interest rates and a $16.3 million increase in the average balance of FHLB advances to $102.2 million at December 31, 2017, compared to $85.9 million at December 31, 2016. Interest expense recognized by the Company related to subordinated debentures was $935,000 in 2017 and $753,000 in 2016 due to rising rates.

 

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Total interest income increased by $6.6 million or 8.1% to $87.4 million for the year ended December 31, 2016 from $80.8 million for the year ended December 31, 2015. The increase in interest income was due to the significant increase in loan volume. The average balance of loans receivable increased $166.0 million to $1.85 billion at December 31, 2016 from $1.69 billion at December 31, 2015. Interest income from loans increased to $80.2 million for 2016 compared to $73.3 million in 2015, which represents an increase of 9.4%.

 

During the same period, the average balance of investment securities decreased to $233.4 million for 2016 from $239.9 million for the year ended December 31, 2015. Interest income from investment securities decreased to $6.2 million in 2016 compared to $6.8 million in 2015, which represents a decrease of 7.7%. The overall duration of investments decreased to 3.6 years at December 31, 2016, from 4.2 years at December 31, 2015.

 

Interest expense increased by $1.6 million in 2016 compared to 2015, to $8.4 million from $6.8 million. This increase was mainly due to an eight basis point increase in the average cost of interest-bearing liabilities in 2016 and a $110.2 million increase in the average balance of interest-bearing liabilities. The average balance of interest bearing deposits increased $64.3 million to $1.46 billion at December 31, 2016, from $1.40 billion at December 31, 2015. Interest expense related to interest-bearing deposits was $6.3 million in 2016 compared to $5.3 million in 2015.

 

Interest expenses on FHLB advances and other interest-bearing funding sources were $1.3 million and $138,000 respectively, in 2016 and $675,000 and $152,000 respectively in 2015. The increase in FHLB advance expense was due to a $47.7 million increase in the average balance of FHLB advances to $85.9 million at December 31, 2016, compared to $38.1 million at December 31, 2015. Interest expense recognized by the Company related to subordinated debentures was $753,000 in 2016 and $613,000 in 2015 due to rising rates.

 

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The following table shows an analysis of net interest margin on a tax equivalent basis for the years ended December 31, 2017, 2016 and 2015:

 

Table 3 – Net Interest Margin

 

   Year Ended December 31 
 (In Thousands) 
   2017   2016   2015 
   Average
Balance
   Interest
(1)
   Yield/
Rate (2)
   Average
Balance
   Interest
(1)
   Yield/
Rate
   Average
Balance
   Interest
(1)
   Yield/
Rate
 
     
Interest-Earning Assets:                                             
Loans receivable (5)  $2,198,639   $99,742    4.54%  $1,853,419   $80,423    4.34%  $1,687,413   $73,544    4.36%
Securities (6)   258,775    8,654    3.39%   233,407    7,871    3.48%   239,852    8,476    3.64%
Interest-earning deposits   72,215    836    1.16%   67,420    367    0.54%   59,410    169    0.27%
FHLB stock   15,632    784    5.02%   13,800    552    4.00%   13,802    552    4.00%
Total interest-earning assets   2,545,261    110,016    4.33%   2,168,046    89,213    4.13%   2,000,477    82,741    4.15%
Non-interest-earning  assets   306,270              229,393              222,389           
                                              
Total Assets  $2,851,531             $2,397,439             $2,222,866           
                                              
Interest-Bearing Liabilities:                                             
Interest-bearing deposits  $1,769,786   $8,818    0.50%  $1,463,890   $6,261    0.43%  $1,399,619   $5,341    0.38%
FHLB advances   102,155    1,470    1.44%   85,856    1,288    1.50%   38,134    675    1.77%
Subordinated debentures   36,156    935    2.58%   36,141    753    2.09%   36,129    613    1.70%
Other borrowings   27,929    208    0.74%   52,826    138    0.26%   54,619    152    0.28%
Total interest-bearing  liabilities   1,936,026    11,431    0.59%   1,638,713    8,440    0.52%   1,528,501    6,781    0.44%
Non-interest bearing demand deposits   528,926    -         441,731    -         388,257    -      
Total including non-  interest- bearing  demand deposits   2,464,952    11,431    0.46%   2,080,444    8,440    0.41%   1,916,758    6,781    0.35%
Other non-interest   liabilities   35,343              31,361              28,463           
Total Liabilities   2,500,295              2,111,805              1,945,221           
Stockholders’ equity   351,236              285,634              277,645           
Total liabilities and   stockholders’ equity  $2,851,531             $2,397,439             $2,222,866           
Net interest income;  interest rate spread (3)       $98,585    3.74%       $80,773    3.61%       $75,960    3.71%
                                              
Net interest margin (4)             3.88%             3.74%             3.81%
Average interest-earning  assets to average interest-  bearing liabilities             131.5%             132.3%             130.9%

 

(1)Interest on certain tax exempt loans (amounting to $375,000, $383,000 and $368,000 in 2017, 2016 and 2015 respectively) and tax-exempt securities ($3.2 million, $3.0 million and $3.2 million in 2017, 2016, and 2015) is not taxable for Federal income tax purposes. The average balance of such loans was $11.5 million, $11.8 million and $10.7 million in 2017, 2016, and 2015 while the average balance of such securities was $91.2 million, $83.4 million and $86.0 million in 2017, 2016, and 2015, respectively. In order to compare the tax-exempt yields on these assets to taxable yields, the interest earned on these assets is adjusted to a pre-tax equivalent amount based on the marginal corporate federal income tax rate of 35%.
(2)At December 31, 2017, the yields earned and rates paid were as follows: loans receivable, 4.45%; securities, 3.12%; FHLB stock, 5.50%; total interest-earning assets, 4.32%; deposits, 0.30%; FHLB advances, 1.51%; other borrowings, 0.19%, subordinated debentures, 3.02%; total including non- interest-bearing liabilities, 0.39%; and interest rate spread, 3.93%.
(3)Interest rate spread is the difference in the yield on interest-earning assets and the cost of interest-bearing liabilities.
(4)Net interest margin is net interest income divided by average interest-earning assets excluding average unrealized gains/losses. See Non-GAAP Financial Measure discussion for further details.
(5)For the purpose of the computation for loans, non-accrual loans are included in the average loans outstanding.
(6)Securities yield = annualized interest income divided by the average balance of securities, excluding average unrealized gains/losses.

 

See Non-GAAP Financial Measure discussion for further details.

 

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The following table describes the extent to which changes in interest rates and changes in volume of interest-related assets and liabilities have affected First Defiance’s tax-equivalent interest income and interest expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) change in rate (change in rate multiplied by prior year volume), and (iii) total change in rate and volume. The combined effect of changes in both rate and volume has been allocated proportionately to the change due to rate and the change due to volume.

 

Table 4 – Changes in Interest Rates and Volumes (1)

 

  

Year Ended December 31

(In Thousands)

 
   2017 vs. 2016   2016 vs. 2015 
   Increase
(decrease)
due to
rate
   Increase
(decrease)
due to
volume
   Total
increase
(decrease)
   Increase
(decrease)
due to
rate
   Increase
(decrease)
due to
volume
   Total
increase
(decrease)
 
Interest-Earning Assets                              
Loans  $3,792   $15,527   $19,319   $(326)  $7,205   $6,879 
Securities   (66)   849    783    (381)   (224)   (605)
Interest-earning deposits   441    28    469    173    25    198 
FHLB stock   152    80    232    -    -    - 
Total interest-earning assets  $4,319   $16,484   $20,803   $(534)  $7,006   $6,472 
                               
Interest-Bearing Liabilities                              
Deposits  $1,128   $1,429   $2,557   $667   $253   $920 
FHLB advances   (54)   236    182    (117)   730    613 
Subordinated Debentures   182    -    182    140    -    140 
Notes Payable   159    (89)   70    (9)   (5)   (14)
Total interest- bearing liabilities  $1,415   $1,576   $2,991   $681   $978   $1,659 
Increase (decrease) in net interest income            $17,812             $4,813 

 

(1)The change in interest rates due to both rate and volume has been allocated between the factors in proportion to the relationship of the absolute dollar amounts of the change in each.

 

Provision for Loan Losses First Defiance’s provision for loan losses was $2.9 million for the year ended December 31, 2017, compared to $283,000 for December 31, 2016, and $136,000 for December 31, 2015.

 

Provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level deemed appropriate by management to absorb probable losses incurred in the loan portfolio. Factors considered by management include identifiable risk in the portfolios, historical experience, the volume and type of lending conducted by First Defiance, the amount of non-performing loans (including loans which meet the FASB ASC Topic 310 definition of impaired), the amount of loans graded by management as substandard, doubtful, or loss, general economic conditions (particularly as they relate to First Defiance’s market areas) and other factors related to the collectability of First Defiance’s loan portfolio. See also Allowance for Loan Losses in this Management’s Discussion and Analysis and Note 7 to the Consolidated Financial Statements.

 

Noninterest Income Noninterest income increased by $6.1 million or 17.8% in 2017 to $40.1 million from $34.0 million for the year ended December 31, 2016. That followed an increase of $2.2 million or 7.0% in 2016 from $31.8 million in 2015.

 

Service fees and other charges increased to $12.1 million for the year ended December 31, 2017, from $10.9 million for 2016 and increased from $10.8 million for 2015. The increase in noninterest income in 2017 from 2016 and 2015 is due to increased number of deposit accounts primarily from the CSB acquisition.

 

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First Federal’s overdraft privilege program generally provides for the automatic payment of modest overdraft limits on all accounts deemed to be in good standing when the account is accessed using paper-based check processing, a teller withdrawal, a point-of-sale terminal, an ACH transaction, an online banking or voice-response transfer, or an ATM. To be in good standing, an account must be brought to a positive balance within a 30-day period and have not excessively used the overdraft privilege program. Overdraft limits are established for all customers without discrimination using a risk assessment approach for each account classification. The approach includes a systematic review and evaluation of the normal deposit flows made to each account classification to establish reasonable and prudent negative balance limits that would be routinely repaid by normal, expected and reoccurring deposits. The risk assessment by portfolio approach assumes a minimal degree of undetermined credit risk associated with unidentified individual accounts that are overdrawn for 30 or more days. Consumer accounts overdrawn for more than 60 days are automatically charged off. Fees are charged as a one-time fee per occurrence, up to five charges per day, and the fee charged for an item that is paid is equal to the fee charged for a non-sufficient fund item that is returned.

 

Overdrawn balances, net of allowance for losses, are reflected as loans on First Defiance’s balance sheet. The fees charged for this service are established based both on the return of processing costs plus a profit, and on the level of fees charged by competitors in the Company’s market area for similar services. These fees are considered to be compensation for providing a service to the customer and therefore deemed to be noninterest income rather than interest income. Fee income recorded for the years ending December 31, 2017 and 2016 related to the overdraft privilege product, net of adjustments to the allowance for uncollectible overdrafts, were $2.8 million and $2.4 million, respectively. Accounts charged off are included in noninterest expense. The allowance for uncollectible overdrafts was $24,000 at December 31, 2017, and $14,000 at December 31, 2016.

 

Noninterest income also includes gains, losses and impairment on investment securities. In 2017, First Defiance realized a $584,000 gain on sale of securities. In 2016, a $509,000 gain was recognized compared to a $22,000 gain in 2015.

 

Mortgage banking income includes gains from the sale of mortgage loans, fees for servicing mortgage loans for others, an offset for amortization of mortgage servicing rights, and adjustments for impairment in the value of mortgage servicing rights. Mortgage banking income totaled $7.0 million, $7.3 million and $6.7 million in 2017, 2016 and 2015, respectively. The $266,000 decrease in 2017 from 2016 is attributable to a $647,000 decrease in the gain on sale of loans, along with a $33,000 negative change in the valuation adjustments on mortgage servicing rights. These were partially offset by a decrease of $260,000 in mortgage servicing rights amortization expense along with a $154,000 increase in servicing revenue. First Defiance originated $213.5 million of residential mortgages for sale into the secondary market in 2017 compared with $263.7 million in 2016. The balance of the mortgage servicing right valuation allowance stands at $432,000 at the end of 2017. The $557,000 increase in 2016 from 2015 is attributable to a $747,000 increase in the gain on sale of loans, along with a $57,000 positive change in servicing revenue. These were partially offset by an increase of $104,000 in mortgage servicing rights amortization expense along with a $143,000 negative change in the valuation adjustments on mortgage servicing rights. First Defiance originated $263.7 million of residential mortgages for sale into the secondary market in 2016 compared with $213.4 million in 2015. The balance of the mortgage servicing right valuation allowance stands at $522,000 at the end of 2016. See Note 8 to the Consolidated Financial Statements.

 

Gains on the sale of non-mortgage loans, which include SBA and FSA loans, totaled $217,000 in 2017 compared to $753,000 in 2016 and $824,000 in 2015. The volume of eligible small business administration loans has decreased in 2017 from levels in 2016 and 2015.

 

Insurance commission income increased $2.4 million or 23.2% to $12.9 million in 2017 from $10.4 million in 2016 mainly due to the acquisition of Corporate One and an increase in general production in the property and casualty and group employee benefits lines of business. Insurance commission income increased $365,000 or 3.6% to $10.4 million in 2016 from $10.1 million in 2015.

 

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Income from bank owned life insurance increased $2.1 million in 2017 to $3.1 million from $909,000 in 2016. In 2017, the Company surrendered an underperforming BOLI policy and recorded a tax penalty of $1.7 million (recorded in income tax expense) and purchased a new BOLI policy receiving a $1.5 million enhancement value gain. There was a slight increase in income in 2016 to $909,000 from $895,000 in 2015.

 

Trust income increased $631,000 to $2.3 million in 2017 from $1.7 million in 2016 and $1.5 million. The increase in 2017 included a $428,000 positive adjustment to accrual basis accounting.

 

Other income increased $316,000 to $1.9 million in 2017 compared to $1.5 million in 2016 and $1.1 million in 2015. The $316,000 increase in 2017 is due mainly to group benefit referral fees. The $479,000 increase in 2016 from 2015 is due to a $231,000 increase in the value of the assets of the Company’s deferred compensation plan as well as a $139,000 increase in the gain on sale of other real estate owned.

 

Noninterest Expense Total noninterest expense for 2017 was $85.4 million compared to $71.1 million for the year ended December 31, 2016, and $67.9 million for the year ended December 31, 2015.

 

Compensation and benefits increased $9.7 million or 24.0% to $49.8 million from $40.2 million in 2016. The increase is mainly related to personnel expenses both from certain benefit payouts associated with the CSB merger as well as operating the new CSB and Corporate One locations, merit increases and other new staff for growth strategies. Other non-interest expenses increased $2.8 million or 17.5% to $18.8 million in 2017 from $16.0 million in 2016. This is due mainly to $2.1 million increase in expenses associated with the acquisition of CSB and Corporate One, as well as an increase in the amortization of intangibles of $754,000. Occupancy expense increased $289,000, to $7.7 million in 2017 compared to $7.4 million in 2016 and data processing expense increased $1.4 million to $7.7 million in 2017 from $6.4 million in 2016.

 

Compensation and benefits increased $2.4 million or 6.4% to $40.2 million from $37.8 million in 2015. The increase is mainly related to merit increases and new staff for growth strategies, higher incentive compensation accruals and higher medical insurance costs. Other non-interest expenses increased $436,000 or 2.8% to $16.0 million in 2016 from $15.5 million in 2015 mainly due to acquisition related costs for the pending acquisition of CSB and $300,000 for a termination of a lease partially offset by a decrease in the amortization of intangibles of $164,000. Occupancy expense increased by $221,000 to $7.4 million in 2016 compared to $7.2 million in 2015 and data processing expense increased by $284,000 to $6.4 million in 2016 from $6.1 million in 2015. These increases were partially offset by decreases in FDIC insurance premiums of $155,000.

 

Income Taxes – Income taxes totaled $16.2 million in 2017 compared to $12.8 million in 2016 and $11.4 million in 2015. The effective tax rates for those years were 33.4%, 30.7%, and 30.2%, respectively. The tax rate is lower than the statutory 35% tax rate for the Company mainly because of investments in tax-exempt securities. The increase in the effective tax rate in 2017 primarily relates to the surrender of a bank-owned life insurance policy which added $1.7 million to income tax expense. The earnings on tax-exempt securities are not subject to federal income tax. See Note 18 – Income Taxes to the Consolidated Financial Statements for further details.

 

Concentrations of Credit Risk

 

Financial institutions such as First Defiance generate income primarily through lending and investing activities. The risk of loss from lending and investing activities includes the possibility that losses may occur from the failure of another party to perform according to the terms of the loan or investment agreement. This possibility is known as credit risk.

 

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Lending or investing activities that concentrate assets in a way that exposes the Company to a material loss from any single occurrence or group of occurrences increases credit risk. Diversifying loans and investments to prevent concentrations of risks is one way a financial institution can reduce potential losses due to credit risk. Examples of asset concentrations would include multiple loans made to a single borrower and loans of inappropriate size relative to the total capitalization of the institution. Management believes adherence to its loan and investment policies allows it to control its exposure to concentrations of credit risk at acceptable levels. First Defiance’s loan portfolio is concentrated geographically in its northwest Ohio, northeast Indiana, central Ohio and southeast Michigan market areas. Management has also identified lending for income-generating rental properties as an industry concentration. Total loans for income-generating property totaled $838.1 million at December 31, 2017, which represents 34.9% of the Company’s loan portfolio. Management believes it has the skill and experience to manage any risks associated with this type of lending. Loans in this category are generally paying as agreed without any unusual or unexpected levels of delinquency. The delinquency rate in this category, which is any loan 30 days or more past due, was 0.19% at December 31, 2017. There are no other industry concentrations that exceed 10% of the Company’s loan portfolio.

 

Liquidity and Capital Resources

 

The Company’s primary source of liquidity is its core deposit base, raised through First Federal’s branch network, along with wholesale sources of funding and its capital base. These funds, along with investment securities, provide the ability to meet the needs of depositors while funding new loan demand and existing commitments.

 

Cash generated from operating activities was $36.0 million, $27.0 million and $30.7 million in 2017, 2016 and 2015, respectively. The adjustments to reconcile net income to cash provided by or used in operations during the periods presented consist primarily of proceeds from the sale of loans (less the origination of loans held for sale), the provision for loan losses, depreciation expense, the origination, amortization and impairment of mortgage servicing rights and increases and decreases in other assets and liabilities.

 

The primary investing activity of First Defiance is lending, which is funded with cash provided from operating and fin