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EX-21 - LIST OF SUBSIDIARIES OF THE COMPANY - PREMIER FINANCIAL CORPdex21.htm
EX-32.2 - SECTION 906 CFO CERTIFICATION - PREMIER FINANCIAL CORPdex322.htm
EX-99.1 - PEO TARP CAPTIAL PURCHASE PROGRAM CERTIFICATION - PREMIER FINANCIAL CORPdex991.htm
EX-23.1 - CONSENT OF CROWE HORWATH LLP - PREMIER FINANCIAL CORPdex231.htm
EX-32.1 - SECTION 906 CEO CERTIFICATION - PREMIER FINANCIAL CORPdex321.htm
EX-31.1 - SECTION 302 CEO CERTIFICATION - PREMIER FINANCIAL CORPdex311.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - PREMIER FINANCIAL CORPdex312.htm
EX-99.2 - PFO TARP CAPTIAL PURCHASE PROGRAM CERTIFICATION - PREMIER FINANCIAL CORPdex992.htm
EX-10.11 - DESCRIPTION OF ANNUAL CASH BONUS PLAN - PREMIER FINANCIAL CORPdex1011.htm
EX-4.1 - AGREEMENT TO FURNISH INSTRUMENTS AND AGREEMENTS RE: RIGHTS OF HOLDERS & DEBT - PREMIER FINANCIAL CORPdex41.htm
Table of Contents

 

 

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, 2010

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 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, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨

 

Accelerated filer  x

 

Non-accelerated filer  ¨

 

Smaller reporting Company  ¨

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

As of February 25, 2011, there were issued and outstanding 8,118,236 shares of the Registrant’s common stock.

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, 2010 was approximately $71.4 million

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 2010 Annual Shareholders’ Meeting

 

 

 


Table of Contents

First Defiance Financial Corp.

Annual report on Form 10-k

Table of Contents

 

            Page  

PART I

  

Item 1.

    

Business

     3   

Item 1A.

    

Risk Factors

     25   

Item 1B.

    

Unresolved Staff Comments

     34   

Item 2.

    

Properties

     34   

Item 3.

    

Legal Proceedings

     36   

Item 4.

    

Reserved

     36   

PART II

  

Item 5.

    

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

     36   

Item 6.

    

Selected Financial Data

     38   

Item 7.

    

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

     39   

Item 7A.

    

Quantitative and Qualitative Disclosures About Market Risk

     66   

Item 8.

    

Financial Statements and Supplementary Data

     68   

Item 9.

    

Changes in and Disagreements With Accountants on Accounting and Financial Disclosures

     130   

Item 9A.

    

Controls and Procedures

     130   

Item 9B.

    

Other Information

     130   

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

     132   

SIGNATURES

     133   

 

-2-


Table of Contents

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”) and First Insurance & Investments, Inc. (“First Insurance”) (collectively, “the Subsidiaries”), focuses on traditional banking and property and casualty and life and group health insurance products. The Company’s banking activities include originating and servicing residential, commercial, and consumer loans and providing a broad range of depository services. The Company’s insurance activities consist primarily of commissions relating to the sale of property and casualty and 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 internally and through acquisitions of financial institutions, branches and financial services businesses. The Company seeks merger or acquisition partners that are culturally similar and 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 a premium 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.

The Company successfully converted its core service systems in the fourth quarter of 2010. The conversion of core services to the new provider did not cause any significant service interruptions or negative client impact.

At December 31, 2010, the Company had consolidated assets of $2.04 billion, consolidated deposits of $1.58 billion, and consolidated stockholders’ equity of $240.3 million. The Company was incorporated in Ohio in June of 1995. Its principal executive offices are located at 601 N. 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 SEC.

The Subsidiaries

The Company’s core business operations are conducted through the Subsidiaries:

 

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Table of Contents

First Federal Bank of the Midwest: First Federal is a federally chartered stock savings bank headquartered in Defiance, Ohio. As of December 31, 2010, it conducts operations through 26 full service banking center offices in Allen, Defiance, Fulton, Hancock, Henry, Lucas, Ottawa, Paulding, Putnam, Seneca, Williams and Wood counties in northwest Ohio, 1 full service banking center office in Allen county in northeast Indiana and 6 full service banking center offices in Lenawee county in southeast Michigan.

On March 14, 2008, First Defiance completed the acquisition of Pavilion Bancorp, Inc (“Pavilion”) and its subsidiary, Bank of Lenawee. That acquisition added eight banking branch offices located in Lenawee and Hillsdale counties in Michigan. The one branch in Hillsdale county that was acquired in the Pavilion acquisition was closed in January 2010. On January 21, 2005, First Defiance completed the acquisition of ComBanc, Inc. (“ComBanc”) and its subsidiary, the Commercial Bank, Delphos, Ohio. That acquisition added four branch offices located in Allen County, Ohio, which is adjacent to First Defiance’s existing footprint. On April 8, 2005, First Defiance completed the acquisition of the Genoa Savings and Loan Company, (“Genoa”) which added three offices in the metropolitan Toledo, Ohio area.

First Federal is primarily engaged in community banking. It attracts deposits from the general public through its offices and uses those and other available sources of funds to originate residential real estate loans, non-residential 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 which are issued by federal agencies, including REMICs and 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 & Investments: First Insurance is a wholly owned subsidiary of First Defiance. First Insurance is an insurance agency that conducts business in the Defiance, Archbold, Bryan and Bowling Green, Ohio areas. First Insurance offers property and casualty insurance, life insurance and group health insurance. In May 2010, First Insurance acquired a group medical benefits business line from Andres O’Neil & Lowe Insurance Agency. See Note 4 – Acquisitions in the Notes to the financial statements for additional information.

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, the Chief Operating Officer, and the Chief Executive Officer of First Federal can each approve transactions up to $3 million. Two of the three officers are required to approve transactions between $3 million and $5 million. All transactions in excess of $5 million must be approved by the Board of Directors.

First Defiance’s investment portfolio includes 46 CMO and REMIC issues totaling $54.6 million, all of which are fully amortizing securities. Management does not believe the risks associated with any of its CMO or REMIC 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, 2010.

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

 

-4-


Table of Contents

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, 2010 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.

 

     Contractually Maturing     Total  
     Under 1
Year
     Weighted
Average
Rate
    1 - 5
Years
     Weighted
Average
Rate
    6-10
Years
     Weighted
Average
Rate
    Over 10
Years
     Weighted
Average
Rate
    Amount     Yield  
     (Dollars in Thousands)  

Mortgage-backed securities

   $ 10,308         4.53   $ 19,831         4.30   $ 8,259         4.04   $ 1,333         4.85   $ 39,731        4.29

REMICs and CMOs

     13,961         4.99        24,185         4.52        13,491         4.28        2,132         3.86        53,769        4.57   

U.S. government and federal agency obligations

     1,000         4.50        1,000         5.25        6,000         2.75        4,000         3.25        12,000        3.27   

Obligations of states and political subdivisions (1)

     1,465         3.29        1,834         4.74        11,956         4.23        37,774         4.23        53,029        4.22   

Trust preferred stock and preferred stock

     —             —             17         8.38        3,828         2.26        3,845        2.28   

Corporate bonds

     —           —          3,000         0.65        1,000         0.74        —           —          4,000        0.67   
                                                      

Total

   $ 26,734         $ 49,850         $ 40,723         $ 49,067         $ 166,374     
                                                

Unamortized premiums/ (discounts)

                         (332  

Unrealized gain on securities available for sale

                         49     
                              

Total

                       $ 166,091     
                              

 

(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  
     2010      2009      2008  
     (In Thousands)  

Available-for-sale securities:

        

Obligations of U.S. government corporations and agencies

   $ 11,985       $ 14,251       $ 14,685   

Obligations of state and political subdivisions

     52,750         44,733         37,013   

CMOs, REMICS and mortgage-backed securities

     95,174         76,798         61,955   

Trust preferred stock and preferred stock

     1,546         1,676         3,922   

Corporate bonds

     3,797         —           —     
                          

Total

   $ 165,252       $ 137,458       $ 117,575   
                          

Held-to-maturity securities:

        

Mortgage-backed securities

   $ 440       $ 530       $ 646   

Obligations of state and political subdivisions

     399         1,390         240   
                          

Total

   $ 839       $ 1,920       $ 886   
                          

 

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Table of Contents

For additional information regarding First Defiance’s investment portfolio refer to Note 6 – Investment Securities to the consolidated financial statements.

Interest-Bearing Deposits

At December 31, 2010 and 2009, the Company had $143.0 million and $90.0 million, respectively in overnight investments with the Federal Reserve, 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 $1.2 million and $1.5 million at December 31, 2010 and 2009, 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, 2010, First Federal serviced 13,580 loans totaling $1.28 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. In 2010, 56.62%, 4024% and 3.02% of the Company’s sold loans were to Freddie Mac, Fannie Mae and FHLB, respectively.

As compensation for its mortgage servicing activities, the Company receives servicing fees, usually 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  
     2010     2009     2008  

Rate

   Number of
Loans
     Aggregate
Principal
Balance
     Percentage of
Aggregate
Principal
Balance
    Number of
Loans
     Aggregate
Principal
Balance
     Percentage of
Aggregate
Principal
Balance
    Number of
Loans
     Aggregate
Principal
Balance
     Percentage of
Aggregate
Principal
Balance
 
     (Dollars in Thousands)  

Less than 5.00%

     5,074       $ 576,628         45.22     3,183       $ 355,467         29.10     1,089       $ 88,681         8.05

5.00% - 5.99%

     5,059         437,984         34.35        5,675         515,795         42.22        5,111         453,548         41.18   

6.00% - 6.99%

     2,923         229,524         18.00        3,688         310,368         25.41        5,302         502,811         45.66   

7.00% - 7.99%

     468         29,047         2.28        567         37,410         3.06        749         52,884         4.80   

8.00% - 8.99%

     49         1,719         0.13        56         2,140         0.18        70         2,931         0.27   

9.00% and over

     7         278         0.02        10         375         0.03        16         465         0.04   
                                                                              

Total

     13,580       $ 1,275,180         100.00     13,179       $ 1,221,555         100.00     12,337       $ 1,101,320         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.

 

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Table of Contents
     2010     2009     2008  

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

     400         2.95   $ 12,692         1.00     659         5.00   $ 37,562         3.07     941         7.63   $ 65,351         5.93

6–10 years

     1,961         14.44        90,706         7.11        2,181         16.55        111,117         9.10        2,312         18.74        126,206         11.46   

11–15 years

     2,944         21.68        273,714         21.46        2,382         18.07        210,332         17.22        1,795         14.55        141,168         12.82   

16–20 years

     865         6.37        84,865         6.66        682         5.17        62,182         5.09        634         5.14        54,303         4.93   

21–25 years

     2,426         17.86        231,232         18.13        2,239         16.99        213,477         17.48        2,097         17.00        203,117         18.44   

More than 25 years

     4,984         36.70        581,971         45.64        5,036         38.22        586,885         48.04        4,558         36.94        511,175         46.42   
                                                                                                      

Total

     13,580         100.00   $ 1,275,180         100.00     13,179         100.00   $ 1,221,555         100.00     12,337         100.00   $ 1,101,320         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, 2010, First Federal’s limit on loans-to-one borrower was $35.2 million and its five largest loans (including available lines of credit) or groups of loans to one borrower, including related entities, were $20.5 million, $19.9 million, $15.5 million, $15.2 million and $15.0 million. All of these loans or groups of loans were performing in accordance with their terms at December 31, 2010.

Loan Portfolio CompositionThe net increase or (decrease) in net loans receivable over the prior year was ($102.2 million), ($12.1 million), and $316.8 million in 2010, 2009, and 2008, respectively. First Defiance acquired net loans of $232.5 million in the Pavilion acquisition in 2008. The loan portfolio contains no foreign loans. The Company’s loan portfolio is concentrated geographically in its northwest 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 $407.7 million at December 31, 2010, which represents 27% 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.

 

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Table of Contents
     December 31  
     2010     2009     2008     2007     2006  
     Amount      %     Amount      %     Amount      %     Amount      %     Amount      %  
     (Dollars in Thousands)  

Real estate:

                         

Single family residential

   $ 205,938         13.5   $ 227,592         13.8   $ 251,807         15.4   $ 231,921         17.9   $ 250,808         20.1

Five or more family

residential

     120,534         7.9        103,169         6.3        78,427         4.8        56,774         4.4        57,263         4.6   

Nonresidential real estate

     646,478         42.2        703,721         42.8        677,313         41.3        545,077         42.1        522,597         41.9   

Construction

     30,340         2.0        48,625         3.0        72,938         4.4        13,146         1.0        17,339         1.4   
                                                                                     

Total real estate loans

     1,003,290         65.6        1,083,107         65.9        1,080,485         65.9        846,918         65.4        848,007         68.0   

Other:

                         

Consumer finance

     22,848         1.5        34,105         2.0        41,012         2.5        37,743         2.9        43,770         3.5   

Commercial

     369,959         24.2        379,408         23.1        356,574         21.8        283,072         21.8        232,914         18.7   

Home equity and improvement

     133,593         8.7        147,977         9.0        161,106         9.8        128,080         9.9        122,789         9.8   
                                                                                     

Total non-real estate loans

     526,400         34.4        561,490         34.1        558,692         34.1        448,895         34.6        399,473         32.0   
                                                                                     

Total loans

     1,529,690         100.0     1,644,597         100.0     1,639,177         100.0     1,295,813         100.0     1,247,480         100.0
                                                       

Less:

                         

Loans in process

     9,267           26,494           20,892           5,085           6,409      

Deferred loan origination fees

     920           981           1,050           1,032           1,182      

Allowance for loan losses

     41,080           36,547           24,592           13,890           13,579      
                                                       

Net loans

   $ 1,478,423         $ 1,580,575         $ 1,592,643         $ 1,275,806         $ 1,226,310      
                                                       

In addition to the loans reported above, First Defiance had $18.1 million, $10.3 million, $11.0 million, $5.8 million, and $3.4 million in loans classified as held for sale at December 31, 2010, 2009, 2008, 2007 and 2006, 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 RatesThe following table sets forth certain information at December 31, 2010 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, 2010  
     Due Less
than 1
     Due 1-2      Due 3-5      Due 5-10      Due 10-15      Due 15+      Total  
     (In Thousands)  

Real estate

   $ 249,514       $ 150,387       $ 486,863       $ 67,479       $ 15,007       $ 34,040       $ 1,003,290   

Non-real estate:

                    

Commercial

     241,325         47,525         76,748         4,361         —           —           369,959   

Home equity and improvement

     19,788         11,069         49,467         4,895         12,928         35,446         133,593   

Consumer finance

     9,911         6,402         6,047         411         66         11         22,848   
                                                              

Total

   $ 520,538       $ 215,383       $ 619,125       $ 77,146       $ 28,001       $ 69,497       $ 1,529,690   
                                                              

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.

 

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The following table sets forth the dollar amount of gross loans due after one year from December 31, 2010 which have fixed interest rates or which have floating or adjustable interest rates.

 

     Fixed
Rates
     Floating or
Adjustable
Rates
     Total  
     (In Thousands)  

Real estate

   $ 284,302       $ 469,474       $ 753,776   

Commercial

     101,230         27,404         128,634   

Other

     26,004         100,738         126,742   
                          
   $ 411,536       $ 597,616       $ 1,009,152   
                          

Originations, Purchases and Sales of LoansThe 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 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 and underwritten by one of the commercial loan officers, who may approve credits within their lending limit. Another loan officer with limits sufficient to cover the exposure must approve credits exceeding an individual’s lending limit. All credits which exceed $100,000 in aggregate exposure must be presented for review or approval to the Senior Loan Committee comprised of senior lending personnel. Credits which exceed $1,000,000 in aggregate exposure must be presented for approval to the Executive Loan Committee, a committee of First Federal’s Board of Directors.

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 Senior Loan Committee and, if necessary, by the Executive Loan Committee. Indirect consumer loans originated by auto dealers are underwritten and approved by a designated underwriter in accordance with company policy and lending limits.

First Defiance 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 Defiance’s primary market area has been a function of several factors, including customer preference, the level of interest rates, the

 

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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.

Adjustable-rate loans represented 6.6% of First Defiance’s total originations of one-to-four family residential mortgage loans in 2010 compared to 1.4% and 7.2% during 2009 and 2008, 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 Defiance’s total loans and loans held for sale during the periods indicated:

 

     Years Ended December 31  
     2010     2009      2008  
     (In Thousands)  

Loan originations:

       

Single family residential

   $ 420,644      $ 572,500       $ 262,338   

Multi-family residential

     44,173        75,632         44,853   

Non-residential real estate

     149,717        197,320         225,520   

Construction

     11,821        10,241         20,167   

Commercial

     290,501        341,477         341,657   

Home equity and improvement

     15,289        16,956         40,786   

Consumer finance

     12,230        16,530         24,751   
                         

Total loans originated

     944,375        1,230,656         960,072   

Loans acquired in acquisitions

     —          —           236,759   

Loan reductions:

       

Loan pay-offs

     254,537        317,239         387,475   

Loans sold

     390,908        518,453         186,204   

Periodic principal repayments

     406,056        390,158         274,579   
                         
     1,051,501        1,225,850         848,258   
                         

Net (decrease) increase in total loans and loans held for sale

   $ (107,126   $ 4,806       $ 348,573   
                         

The gross loans acquired in the Pavilion acquisition in 2008 by category were as follows: Single family residential – $50.0 million; multi-family residential – $6.0 million; non-residential real estate – $100.9 million; commercial – $49.2 million; home equity and improvement – $25.7 million; and consumer finance – $5.0 million.

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,

 

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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, 2010, 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.

 

     30 to 59 Days     60 to 89 Days     90 Days and Over and
Non accrual
    Total  
     Amount      Percentage     Amount      Percentage     Amount      Percentage     Amount      Percentage  
     (Dollars in Thousands)  

Single family residential and construction

   $ 1,126         0.07   $ 1,785         0.12   $ 7,225         0.47   $ 10,136         0.66

Nonresidential and Multi-family residential

     1,208         0.08        1,690         0.11        21,737         1.42        24,635         1.61   

Home equity and improvement

     2,711         0.18        330         0.02        517         0.03        3,558         0.23   

Consumer finance

     231         0.01        52         0.01        14         0.00        297         0.02   

Commercial

     402         0.03        1,580         0.10        11,547         0.76        13,529         0.89   
                                                                    

Total

   $ 5,678         0.37   $ 5,437         0.36   $ 41,040         2.68   $ 52,155         3.41
                                                                    

Overall, the level of delinquencies at December 31, 2010 has increased from the levels at December 31, 2009, when First Defiance reported that 3.21% of its outstanding loans were at least 30 days delinquent. The level of total loans 90 or more days delinquent has increased to 2.68% at December 31, 2010 from 2.51% at December 31, 2009. The level of total loans 60-89 days delinquent has increased to 0.36% at December 31, 2010 from 0.21% at December 31, 2009. Overall, the level of loans that were 30 to 59 days past due past due decreased from 0.49% at December 31, 2009 to 0.37% at December 31, 2010. 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 AssetsAll loans are reviewed on a regular basis and are placed on a non-accrual status when, in the opinion of management, the collectability of additional interest is deemed insufficient to warrant further accrual. Generally, First Defiance places all loans more than 90 days past due on non-accrual status. We also place loans on non-accrual where the loan is paying as agreed but where 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.

Impaired loans acquired in the ComBanc, Genoa and Pavilion acquisitions have been accounted for under the provisions of FASB ASC Topic 310 Subtopic 30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Such loans were recorded at their fair value, which was estimated based on

 

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the expected cash flow of the acquired loan. In the Genoa acquisition, 10 loan relationships with a stated value of $1.5 million were recorded at $721,000. In the ComBanc acquisition, 12 loan relationships with a stated value of $3.4 million were recorded at $2.0 million. In the Pavilion acquisition, 12 loan relationships with a stated value of $6.4 million were recorded at $4.4 million. Of all these impaired loans that were acquired in an acquisition, as of December 31, 2010, 12 loan relationships remained with a contractual balance of $3.5 million and were recorded at $2.2 million. If management’s expectations about the cash flow of those loans changes over time, the difference will be recognized as a yield adjustment over the remaining life of the respective loan. In 2010, $32,000 of impairment was recognized as a yield adjustment. There were no significant changes in the expected cash flows of the remaining loan relationships in 2010.

Loans originated by First Federal having principal balances of $70.9 million, $58.8 million, and $27.5 million were considered impaired as of December 31, 2010, 2009 and 2008, respectively. These amounts exclude large groups of small-balance homogeneous loans that are collectively evaluated for impairment such as residential mortgage, consumer installment and credit card loans. There was $2,017,000 of interest received and recorded in income during 2010 related to impaired loans. There was $913,000 and $1,067,000 recorded in 2009 and 2008, respectively. Unrecorded interest income based on the loan’s contractual terms on these impaired loans and all non-performing loans in 2010, 2009 and 2008 was $2.0 million, $2.7 million, and $1.8 million, respectively. The average recorded investment in impaired loans during 2010, 2009 and 2008 (excluding loans accounted for under Topic 310 Subtopic 30) was $64.4 million, $38.9 million and $25.7 million, respectively. The total allowance for loan losses related to these loans was $16.6 million, $12.2 million, and $6.0 million at December 31, 2010, 2009 and 2008, respectively.

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 2010, First Defiance recognized $3.2 million of expense related to write-downs in value of real estate acquired by foreclosure. The balance of real estate owned at December 31, 2010 was $9.6 million.

As of December 31, 2010, First Defiance’s total non-performing loans amounted to $47.0 million or 3.10% of total loans (net of undisbursed loan funds and deferred fees and costs), compared to $47.9 million or 2.96% of total loans, at December 31, 2009. Non-performing loans are loans which are more than 90 days past due or loans which have been restructured and identified as troubled debt restructurings. The nonperforming loan balance includes $32.2 million of loans originated by First Federal also considered impaired or acquired loans accounted for under Topic 310 Subtopic 30.

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.

 

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     December 31  
     2010     2009     2008     2007     2006  
     (Dollars in Thousands)  

Nonperforming loans:

          

Single family residential, construction and home improvement

   $ 7,742      $ 6,475      $ 5,088      $ 2,608      $ 1,980   

Nonresidential and multi-family residential real estate

     21,737        24,042        19,979        5,917        4,977   

Commercial

     11,547        10,615        2,881        675        272   

Consumer finance

     14        59        69        17        54   

Troubled debt restructurings

     6,001        6,715        6,250        —          —     
                                        

Total nonperforming loans

     47,041        47,906        34,267        9,217        7,283   

Real estate owned

     9,591        13,413        6,973        2,410        2,321   

Other repossessed assets

     —          114        27        50        71   
                                        

Total repossessed assets

     9,591        13,527        7,000        2,460        2,392   
                                        

Total nonperforming assets

   $ 56,632      $ 61,433      $ 41,267      $ 11,677      $ 9,675   
                                        

Total nonperforming assets as a percentage of total assets

     2.78     2.99     2.11     0.73     0.63
                                        

Total nonperforming loans as a percentage of total loans*

     3.10     2.96     2.12     0.71     0.59
                                        

Allowance for loan losses as a percent of total nonperforming assets

     72.54     59.49     59.59     118.95     140.35
                                        

 

*

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

In addition to the $47.0 million of non-performing loans reported above and $39.3 million of loans considered impaired (including loans accounted for under Topic 310 Subtopic 30), which are not included in the non-performing loans reported above, there are approximately $54.3 million of performing nonresidential real estate and commercial loans where known information about possible credit problems of the borrowers causes management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in the inclusion of such loans in non-performing loans at some future date. In analyzing these loans for the purpose of determining the adequacy of the allowance for loan losses, management has determined that these loans generally have significant collateral, strong guarantors, or both.

Allowance for Loan LossesFirst 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. Quantitative factors are primarily the historical loss experience of the portfolio for the most recent weighted two years. Qualitative factors that may lead the Company to add additional general reserves on the non-impaired loan portfolio include such things as: changes in international, national and local economic business conditions, changes in the value of underlying collateral for collateral dependent loans, changes in the political and regulatory environment and changes in the trends of the loan portfolio.

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. In establishing specific reserves, the Company analyzes all substandard, doubtful and loss graded loans quarterly and makes

 

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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. The Company also considers the impacts of any Small Business Association or Farm Service Agency guarantees. An internal loan review of all loan relationships between $250,000 and $750,000 is performed annually. Management also engages a third-party to do an annual review of all loan relationships in excess of $750,000. Both of these loan reviews, among other things, independently assess management’s loan grades.

Loans charged-off 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. To the extent that the portfolio grows at a rapid rate or overall quality deteriorates, the provision generally will exceed charge-offs, as happened in 2008 through 2010. However, in certain circumstances, including in 2006, 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. 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, 2010, First Defiance’s allowance for loan losses amounted to $41.1 million compared to $36.5 million at December 31, 2009. The following table sets forth the activity in First Defiance’s allowance for loan losses during the periods indicated.

 

     Years Ended December 31  
     2010     2009     2008     2007     2006  
     (Dollars in Thousands)  

Allowance at beginning of year

   $ 36,547      $ 24,592      $ 13,890      $ 13,579      $ 13,673   

Provision for credit losses

     23,177        23,232        12,585        2,306        1,756   

Allowance acquired in acquisitions

     —          —          4,258        —          —     

Charge-offs:

          

Single family residential real estate

     (3,092     (2,281     (1,185     (256     (513

Commercial real estate

     (9,928     (5,799     (3,758     (1,803     (1,028

Commercial

     (5,118     (2,664     (813     (99     (177

Consumer finance

     (124     (320     (380     (161     (392

Home equity and improvement

     (1,066     (762     (363     (81     (166
                                        

Total charge-offs

     (19,328     (11,826     (6,499     (2,400     (2,276

Recoveries

     684        549        358        405        426   
                                        

Net charge-offs

     (18,644     (11,277     (6,141     (1,995     (1,850
                                        

Ending allowance

   $ 41,080      $ 36,547      $ 24,592      $ 13,890      $ 13,579   
                                        

Allowance for loan losses to total non-performing loans at end of year

     87.33     76.29     71.77     150.70     186.45

Allowance for loan losses to total loans at end of year*

     2.70     2.26     1.52     1.08     1.10

Allowance for loan losses to net charge-offs for the year

     220.34     324.08     400.46     696.24     734.00

Net charge-offs for the year to average loans

     1.21     0.70     0.41     0.16     0.15

 

*

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

 

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The provision for credit losses, as well as charge-offs, has increased significantly from 2008 through 2010 due mainly to continued deteriorating national and local economic conditions and the declining values of the underlying collateral of collateral dependent loans. The level of charge-offs increased in 2007 and 2006 because of general growth in the overall portfolio and deteriorating economic conditions, while in 2008, 2009 and 2010 there were some large relationships in the commercial real estate portfolio that were charged off due to the effect of the slowing economy. Management anticipates similar charge-off activity in 2011 compared to 2010, but believes the level of allowance for loan losses at December 31, 2010 is sufficient to cover the estimated losses incurred but not yet recognized in the loan portfolio.

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.”

 

     December 31  
     2010     2009     2008     2007     2006  
     Amount      Percent
of total
loans by
category
    Amount      Percent
of total
loans by
category
    Amount      Percent
of total
loans by
category
    Amount      Percent
of total
loans by
category
    Amount      Percent
of total
loans by
category
 
     (Dollars in Thousands)  

Single family residential and construction

   $ 6,029         15.5   $ 6,048         16.8   $ 3,678         19.8   $ 2,112         18.9   $ 2,077         21.5

Nonresidential and Multi-family residential real estate

     22,355         50.1        18,876         49.1        13,436         46.1        7,750         46.5        7,478         46.5   

Other:

                         

Commercial loans

     10,871         24.2        9,444         23.1        6,351         21.8        3,420         21.8        3,317         18.7   

Consumer and home equity and improvement loans

     1,825         10.2        2,179         11.0        1,127         12.3        608         12.8        707         13.3   
                                                                                     
   $ 41,080         100.0   $ 36,547         100.0   $ 24,592         100.0   $ 13,890         100.0   $ 13,579         100.0
                                                                                     

Sources of Funds

GeneralDeposits 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, regular 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.

 

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To supplement its funding needs, First Defiance also utilizes the national market for Certificates of Deposit. Such deposits have maturities ranging from one to thirty-five months. These deposits are issued at the current rates available to customers in our market areas. The total balance of national certificates of deposit was $41.8 million and $47.4 million at December 31, 2010 and 2009, respectively.

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

 

     Years Ended December 31  
     2010     2009     2008  
     Amount      Rate     Amount      Rate     Amount      Rate  
     (Dollars in Thousands)  

Non-interest-bearing demand deposits

   $ 200,864         —        $ 176,513         —        $ 159,452         —     

Interest bearing demand deposits

     529,078         0.59     447,858         0.77     381,627         1.28

Savings deposits

     139,049         0.26        132,589         0.35        135,374         1.02   

Time deposits

     721,203         2.18        790,379         2.81        714,362         3.51   
                                                   

Totals

   $ 1,590,194         1.21   $ 1,547,339         1.69   $ 1,390,815         2.25
                                                   

The following table sets forth the maturities of First Defiance’s retail certificates of deposit having principal amounts of $100,000 or more at December 31, 2010 (in thousands):

 

Retail certificates of deposit maturing in quarter ending:

  

March 31, 2011

   $ 23,639   

June 30, 2011

     27,201   

September 30, 2011

     28,567   

December 31, 2011

     9,721   

After December 31, 2011

     62,130   
        

Total retail certificates of deposit with balances of $100,000 or more

   $ 151,258   
        

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

 

     2010      2009  
     (In Thousands)  

Interest bearing demand deposits and money market accounts

   $ 40       $ 48   

Certificates of deposit

     211         665   
                 
   $ 251       $ 713   
                 

For additional information regarding First Defiance’s deposits see Note 12 to the financial statements.

BorrowingsFirst Defiance may obtain advances from the FHLB of Cincinnati by pledging certain of its residential mortgage loans, non-residential 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.

 

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

 

     December 31  
     2010     2009     2008  
     (Dollars in Thousands)  

Long-term:

      

FHLB advances

   $ 116,885      $ 146,927      $ 146,967   

Weighted average interest rate

     3.68     3.36     4.00

Short-term:

      

FHLB advances

   $ —        $ —        $ 9,100   

Weighted average interest rate

     —          —          0.54

Securities sold under agreement to repurchase

   $ 56,247      $ 48,398      $ 49,454   

Weighted average interest rate

     0.98     1.05     1.79

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  
     2010     2009     2008  
     (Dollars in Thousands)  

Long-term:

      

FHLB advances:

      

Maximum balance

   $ 146,927      $ 146,967      $ 153,153   

Average balance

     127,281        146,946        146,054   

Weighted average interest rate

     3.70     3.48     4.17

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  
     2010     2009     2008  
     (Dollars in Thousands)  

Short-term:

      

FHLB advances:

      

Maximum balance

   $ —        $ —        $ 44,900   

Average balance

     —          33        14,004   

Weighted average interest rate

     —          0.84     2.17

Revolving credit agreements:

      

Maximum balance

   $ —        $ —        $ 23,200   

Average balance

     —          —          14,416   

Weighted average interest rate

     —          —          4.45

Securities sold under agreement to repurchase:

      

Maximum balance

   $ 56,247      $ 50,920      $ 50,679   

Average balance

     47,088        44,287        36,926   

Weighted average interest rate

     0.97     1.29     2.69

 

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First Defiance borrows funds under a variety of programs at the FHLB. As of December 31, 2010, there was $116.9 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, 2010 and December 31, 2009, no outstanding balances existed under First Defiance’s Cash Management Advance Line of Credit. The total available under this 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, 2010, other than amounts available on the REPO and Cash Management line, First Federal had additional borrowing capacity with the FHLB of $29.5 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 is in compliance with the minimum requirement with an investment in stock of the FHLB of Cincinnati of $19.3 million at December 31, 2010. First Federal also acquired $2.0 million in stock of the FHLB of Indianapolis from the Pavilion acquisition, which had a balance of $1.7 million at December 31, 2010. This stock is required to be held for a minimum of five years from the date the stock was acquired by First Federal, March 14, 2008.

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 13 and 15 to the financial statements.

Subordinated DebenturesIn March 2007, the Company sponsored an affiliated trust, First Defiance Statutory Trust II (“Trust Affiliate II”) that issued $15 million of Guaranteed Capital Trust Securities (Trust Preferred Securities). In connection with 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 fixed rate equal to 6.441% for the first five years and a floating rate of three-month LIBOR plus 1.50%, repricing quarterly, thereafter.

The Trust Preferred Securities are subject to mandatory redemption, in whole or in part, upon repayment of the Subordinated Debentures. The Company has 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 may be redeemed at the Company’s option at any time on or after June 15, 2012, or at any time upon certain events.

In October 2005, the Company formed an affiliated trust, First Defiance Statutory Trust I (“Trust Affiliate I”) that issued $20 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

 

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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 1.67% as of December 31, 2010. The rate was 1.63% at December 31, 2009.

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 has 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 may be redeemed by the issuer at par after October 28, 2010. The Subordinated Debentures mature on December 15, 2035.

Due to the Company’s participation in the U.S. Treasury’s Capital Purchase Program, permission must be obtained from the U.S. Treasury in order to call these securities.

Participation in the Capital Purchase Program

In December 2008, First Defiance participated in the U.S. Treasury’s Capital Purchase Program (“CPP”). Under the CPP, First Defiance issued $37.0 million of First Defiance non-voting preferred stock and a warrant to purchase 550,595 shares of First Defiance’s common stock at an exercise price of $10.08 per share, subject to certain anti-dilution and other adjustments. The $37.0 million of preferred stock issued by First Defiance under the CPP qualifies as Tier 1 capital. The cash received from the preferred stock issuance is reflected in the financing activities section of the Consolidated Statements of Cash Flows in Item 8 of this Form 10-K. The general purpose of the funds was to maintain and create lending opportunities in our market area.

Employees

First Defiance had 536 employees at December 31, 2010. None of these employees are represented by a collective bargaining agent, and First Defiance believes that it enjoys good relations with its personnel.

Competition

Competition in originating non-residential mortgage 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.

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

 

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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 and First Federal are subject to regulation, examination and oversight by the OTS. Because the FDIC insures First Federal’s deposits, First Federal is also subject to examination and regulation by the FDIC. First Defiance and First Federal must file periodic reports with the OTS and examinations are conducted periodically by the OTS and the FDIC to determine whether First Federal is in compliance with various regulatory requirements and is operating in a safe and sound manner. First Federal is subject to various consumer protection and fair lending laws. These laws govern, among other things, truth-in-lending disclosure, equal credit opportunity, and, in the case of First Federal, fair credit reporting and community reinvestment. Failure to abide by federal laws and regulations governing community reinvestment could limit the ability of First Federal to open a new branch or engage in a merger transaction. Community reinvestment regulations evaluate how well and to what extent First Federal lends and invests in its designated service area, with particular emphasis on low-to-moderate income communities and borrowers in such areas. Provisions of The Dodd-Frank Wall Street Reform and Consumer Protections Act (the “Dodd-Frank Act”) require the transfer of OTS functions to the Office of the Comptroller of the Currency (“OCC”), the FDIC, the Federal Reserve Board and the Bureau of Consumer Financial Protection on July 21, 2011. Effective with the change, First Federal’s primary regulator will be the OCC and First Defiance’s primary regulator will be the Federal Reserve Board. See “Proposed Changes in Reporting Requirements for OTS-Regulated Savings Associations and Holding Companies” below for more information.

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.

Regulatory Capital Requirements – First Federal is required by OTS regulations to meet certain minimum capital requirements. Current capital requirements call for tangible capital of 1.5% of adjusted total assets, core capital of 4.0% of adjusted total assets, except for associations with the highest examination rating and acceptable levels of risk, and risk-based capital of 8.0% of risk-weighted assets. The OTS does not have defined capital requirements for unitary thrift holding companies.

The following table sets forth the amount and percentage level of regulatory capital of First Federal at December 31, 2010, and the amount by which it exceeds the minimum capital requirements. Tangible and core capital are reflected as a percentage of adjusted total assets. Total (or risk-based) capital, which consists of core and supplementary capital, is reflected as a percentage of risk-weighted assets. Assets are weighted at percentage levels ranging from 0% to 100% depending on their relative risk.

 

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     December 31, 2010  
     Amount      Percent  
     (In Thousands)  

Tangible Capital

   $ 213,625         10.81

Requirement

     29,646         1.50   
                 

Excess

   $ 183,979         9.31
                 

Core Capital

   $ 213,625         10.81

Requirement

     79,055         4.00   
                 

Excess

   $ 134,570         6.81
                 

Total risked-based capital

   $ 234,576         14.09

Risk-based requirement

     133,141         8.00   
                 

Excess

   $ 101,435         6.09
                 

To be categorized as a well-capitalized institution, institutions need to maintain a tier 1 (core) capital ratio of 5%, a tier 1 capital to risk-weighted assets ratio of 6%, and a risk-based capital ratio of 10%. First Federal’s capital at December 31, 2010, meets the standards for a well-capitalized institution. There are no conditions or events since the most recent notification from the OTS regarding those capital standards that management believes have changed any of the well-capitalized categorizations of First Federal.

Dividends – First Defiance’s payment of dividends to its shareholders is generally funded by the payment of dividends by the Subsidiaries. Dividends paid by First Federal to First Defiance are subject to various regulatory restrictions. First Federal can initiate dividend payments equal to its net profits (as defined by statute) for the current year plus the preceding two calendar years. First Federal is required to receive prior approval from its primary regulator, the OTS, before it can pay any dividends to First Defiance, its parent company. At this time, the Company believes it is unlikely that OTS approval would be received. First Federal paid $5.4 million in dividends in 2009 and $10.0 million in 2008. As a result of its participation in the CPP, First Defiance is prohibited, without prior approval from the U.S. Treasury, from paying a quarterly cash dividend of more than $0.26 per share until the earlier of December 5, 2011 or the date the U.S. Treasury’s preferred stock is redeemed or transferred to an unaffiliated third party.

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 comport with Sections 23A and 23B of the Federal Reserve Act (FRA) and the Federal Reserve Board’s (FRB) 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 and First Insurance are affiliates of First Federal.

Holding Company Regulation – First Defiance is a unitary thrift holding company and is subject to OTS regulations, examination, supervision and reporting requirements. Federal law generally

 

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prohibits a thrift holding company from controlling any other savings association or thrift holding company, without prior approval of the OTS, 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. If First Defiance was to acquire control of another savings institution, other than through a merger or other business combination with First Federal, First Defiance would become a multiple thrift holding company and its activities would thereafter be limited generally to those activities authorized by the FRB as permissible for bank holding companies.

Deposit Insurance – First Federal is a member of the Deposit Insurance Fund (“DIF”), which is administered by the FDIC. Deposit accounts at First Federal are insured by the FDIC, generally up to a maximum of $250,000. Further, from December 31, 2010 through December 31, 2012, deposits held in noninterest-bearing transaction accounts will be fully insured by the FDIC regardless of the amount in the account. The Bank has opted to participate in the FDIC’s Transaction Account Guarantee Program. See “Temporary Liquidity Guarantee Program” below.

During 2008, there were higher levels of bank failures which dramatically increased resolution costs of the FDIC and depleted the DIF. In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, on December 16, 2008, the FDIC issued a final rule that raised the then current assessment rates of insured institutions uniformly by 7 basis points (7 cents for every $100 of deposits), beginning with the first quarter of 2009. Further, beginning April 1, 2009, the FDIC required higher risk institutions to pay a larger share of premiums by factoring in rate adjustments based on secured liabilities and unsecured debt levels. On May 22, 2009, the FDIC issued a final rule that imposed a special assessment for the second quarter of 2009 of 5 basis points on each insured depositary institution’s assets minus its Tier 1 capital as of June 30, 2009, which was collected on September 30, 2009 in the amount of $906,000 for First Federal. On November 12, 2009, the FDIC issued a final rule requiring insured depository institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The prepaid assessments for these periods were collected on December 30, 2009, along with the regular quarterly risk-based deposit insurance assessment for the third quarter of 2009. For the fourth quarter of 2009 and for all of 2010, the prepaid assessment rate was based on each institution’s total base assessment rate in effect on September 30, 2009, modified to assume that the assessment rate in effect for the institution on September 30, 2009, was in effect for the entire third quarter of 2009. As of December 31, 2010, $5.2 million in prepaid deposit insurance assessments is included in other assets in the accompanying consolidated balance sheet.

In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. Under the new restoration plan, the FDIC will maintain the current schedule of assessment rates for all depository institutions. At least semi-annually, the FDIC will update its loss and income projections for the fund and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.

In November 2010, the FDIC issued a notice of proposed rulemaking to change the deposit insurance assessment base from total domestic deposits to average total assets minus average tangible equity, as required by the Dodd-Frank Act, effective April 1, 2011.

Insurance of deposits may be terminated by the FDIC upon finding that an institution has engaged in unsafe or 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. Management does

 

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not currently know of any practice, condition or violation that might lead to termination of the deposit insurance.

Temporary Liquidity Guarantee Program – On October 14, 2008, the FDIC announced a new program, the Temporary Liquidity Guarantee Program. This program has two components – The Debt Guarantee Program and the Transaction Account Guarantee Program. The Debt Guarantee Program guarantees newly issued senior unsecured debt of a participating organization, up to certain limits established for each institution, issued between October 14, 2008 and June 30, 2009. The FDIC will pay the unpaid principal and interest on an FDIC-guaranteed debt instrument upon the uncured failure of the participating entity to make a timely payment of principal or interest in accordance with the terms of the instrument. The guarantee will remain in effect until June 30, 2012. In return for the FDIC’s guarantee, participating institutions will pay the FDIC a fee based on the amount and maturity of the debt. The Company opted to participate in the Debt Guarantee Program.

The Transaction Account Guarantee Program provides full deposit insurance coverage for non-interest bearing transaction deposit accounts, regardless of dollar amount, until December 31, 2012, which was extended twice from December 31, 2009 and June 30, 2010, respectively. An annualized 25 basis point assessment (increased from 10 basis points) on balances in noninterest-bearing transaction accounts that exceed the existing deposit insurance limit of $250,000 will be assessed on a quarterly basis to insured depository institutions that have not opted out of this component of the Temporary Liquidity Guarantee Program. The Company has opted to participate in the Transaction Account Guarantee Program.

Proposed Changes in Reporting Requirements for OTS-Regulated Savings Associations and Holding Companies

On February 3, 2011, the federal bank and thrift regulatory agencies announced proposed changes to the reporting requirements for savings associations, such as First Federal, and savings and loan holding companies, such as First Defiance, regulated by the OTS as required by the Dodd-Frank Act.

The February 3, 2011 proposed changes would:

 

   

Require savings associations to file quarterly Call reports, beginning with the March 31, 2012 report date. Effective on that date, all schedules of the Thrift Financial Report (including Schedules CMR and HC) would be eliminated;

 

   

Require savings associations to file data through the Summary of Deposits with the FDIC, beginning with the June 30, 2011 report date. Effective on that date, the OTS’s Branch Office Survey would be eliminated;

 

   

End collection of monthly median cost of funds data from savings associations, effective January 31, 2012; the last cost of funds indices would be published as of December 31, 2011; and

 

   

Require savings and loan holding companies to file the same reports with the Federal Reserve that bank holding companies file, beginning with the March 31, 2012 report date.

Under the proposals, savings associations and their holding companies would continue their current processes until the effective dates cited above.

 

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This also means that the regulation and examination of First Federal and First Defiance will be transferred from OTS to the OCC on July 21, 2011.

 

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Item 1A. Risk Factors

An investment in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. 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.

If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Company’s common stock could decline significantly, and you could lose all or part of your investment.

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

Local Economic Conditions – First Defiance conducts its banking and insurance business primarily in northwest Ohio, northeast Indiana and southeast Michigan. Unemployment rates for most of the counties within our geographic market area are above the median rate for the United States and above the median rates for the States of Ohio, Indiana, and Michigan. As reported for December 2010, the 15 counties in which our offices are located had unemployment rates between 8.1% and 16.3%, and all experienced an improvement in their unemployment rate in 2010 compared to 2009. In addition, real estate values in First Defiance’s markets have declined and may continue to decline. High unemployment and declining real estate values have a negative impact on the Company’s earnings and financial condition because:

 

   

more borrowers are unable to make payments on their loans;

 

   

the value of collateral securing loans has declined; and

 

   

the overall quality of the loan portfolio has declined.

General Economic Conditions – Dramatic declines in real estate values, along with high unemployment, have disrupted the national credit and capital markets over the last two years. As a result, many financial institutions have had to seek additional capital, to merge with larger and stronger institutions, to seek government assistance or bankruptcy protection and, in some cases, they have been forced into a sale or closed by the bank regulatory agencies. Many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers, including to other financial institutions, because of concern about the stability of the financial markets and the strength of counterparties. It is difficult to predict how long these economic conditions will exist, which of our markets, products or other businesses will ultimately be affected, and whether management’s actions will effectively mitigate these external factors. The reduced availability of credit, the lack of confidence in the financial sector, decreased consumer confidence, increased volatility in the financial markets and reduced business activity could materially and adversely affect our business, financial condition and results of operations.

As a result of the challenges presented by economic conditions, First Defiance faces the following risks:

 

   

inability of borrowers to make timely repayments of their loans, or decreases in value of real estate collateral securing the payment of such loans resulting in significant credit

 

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losses, which could result in increased delinquencies, foreclosures and customer bankruptcies, any of which could have a material adverse effect on our operating results;

 

   

increased regulation of the financial services industry, including heightened legal standards and regulatory requirements or expectations; compliance with such regulation will likely increase costs and may limit the Company’s ability to pursue business opportunities;

 

   

further disruptions in the capital markets or other events, including actions by rating agencies and deteriorating investor expectations, may result in an inability to borrow on favorable terms or at all from other financial institutions;

 

   

increased competition among financial services companies due to the consolidation of financial institutions, which may adversely affect our ability to market the Company’s products and services; and

 

   

further increases in FDIC insurance premiums due to the market developments which have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

Declining Real Estate Values – Approximately 74.3% of the loans in First Federal’s portfolio are secured in whole or in part by real estate. As residential real estate prices have declined in the last two years, defaults and foreclosures have increased. Commercial real estate values have also declined, and the owners of many income-producing properties are experiencing declines in their revenue, which may adversely affect their ability to repay their loans. Foreclosures and resolutions of nonperforming loans require significant personnel resources and involve other costs that may increase our operating expenses. Properties acquired through foreclosure or by deed in lieu of foreclosure are taking longer to sell in the current economy, which increases the Company’s expenses for managing, maintaining and insuring real estate owned. If First Federal is unable to sell properties at a price that will cover its expenses as well as the unpaid principal and interest on the loan, the resulting write-downs and losses will adversely affect First Defiance’s net income.

Volatile Capital Markets – The capital and credit markets have been experiencing volatility and disruption for more than a year. In some cases, the markets have produced downward pressure on credit availability for certain issuers. Continuing market disruption and volatility could have an adverse effect on the Company’s ability to access capital and on its business, financial condition and results of operations.

First Defiance’s stock price may fluctuate significantly in the future and these fluctuations may be unrelated to the underlying performance of First Defiance. General market price declines and overall market volatility in the future could adversely affect the price of its common stock, and the current market price of the stock may not be indicative of future market prices.

First Defiance’s stock price has been volatile in the past and several factors could cause the price to fluctuate substantially in the future. These factors include:

 

   

Actions by government regulators;

 

   

First Defiance’s announcements of developments related to its business;

 

   

Fluctuation in our results of operation;

 

   

Sales of substantial amounts of our securities into the marketplace;

 

   

New reports of trends, concerns and other issues related to the financial services industry.

 

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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, 2010, First Federal’s portfolio of commercial real estate loans totaled $767.0 million, 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, 2010, First Federal’s portfolio of commercial loans totaled $370.0 million, or approximately 24.2% 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 Defiance 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 Defiance 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 Defiance’s allowance for loan losses may not be sufficient to cover actual losses, resulting in additions to the allowance. Material additions to the allowance and any loan losses that exceed First Defiance’s reserves would materially adversely affect our results of operations and financial condition.

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

First Defiance’s earnings and financial condition are dependent to a large degree upon net interest income, which is the difference, or spread, between interest earned from loans and investments and interest paid on deposits and borrowings. Interest rates are highly sensitive to many factors, including:

 

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the rate of inflation;

 

   

economic conditions;

 

   

federal monetary policies; and

 

   

stability of domestic and foreign markets.

Because First Defiance’s interest-bearing liabilities may reprice or mature more quickly than its interest-earning assets, an increase in interest rates could result in a decrease in First Defiance’s net interest income.

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.

Financial reform legislation recently enacted will, among other things, eliminate the OTS, tighten capital standards, create a new Bureau of Consumer Financial Protection and result in new laws and regulations that are expected to increase our costs of operations.

The recently enacted Dodd-Frank Act will significantly change the current bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

Certain provisions of the Dodd-Frank Act are expected to have a near term impact on First Defiance. For example, the new law provides that the OTS, which is currently the primary federal regulator for First Defiance and First Federal, will cease to exist on July 21, 2011. The OCC, which is currently the primary federal regulator for national banks, will become the primary federal regulator for federal thrifts, including First Federal. Additionally, the Federal Reserve Board will supervise and regulate all savings and loan holding companies that were formerly regulated by the OTS, including First Defiance. Also effective one year after the date of enactment is a provision that eliminates the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts. Depending on competitive responses, this significant change to existing law could have an adverse impact on First Defiance’s interest expense.

The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments will now be based on a financial institution’s average consolidated total assets less tangible equity. The Dodd-Frank Act also permanently increases the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2009, and noninterest-bearing transaction accounts have unlimited deposit insurance through December 31, 2013.

 

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The Dodd-Frank Act will require publicly traded companies to give shareholders a non-binding vote on executive compensation and so-called “golden parachute” payments, and authorizes the SEC to promulgate rules that would allow shareholders to nominate their own candidates using a company’s proxy materials. The legislation also directs the Federal Reserve Board to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded or not.

The Dodd-Frank Act also creates the Bureau of Consumer Financial Protection and gives it broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. Additionally, the Bureau of Consumer Financial Protection has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Savings institutions with $10 billion or less in assets, such as First Federal, will continue to be examined for compliance with the consumer laws by their primary bank regulators. The Dodd-Frank Act also weakens the federal preemption rules that have been applicable for national banks and federal savings associations, and gives state attorneys general the ability to enforce federal consumer protection laws.

It is difficult to predict the specific impact the Dodd-Frank Act, and the yet to be written implementing rules and regulations, will have on financial institutions. However, it is expected that they will increase our operating and compliance costs and could increase our interest expense.

Other 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 Board, which regulates the money supply, and the OTS, which regulates the Company and First Federal, and the FDIC, which regulates First Federal. The OTS 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 for First Defiance’s depositors and customers and the deposit insurance fund, rather than First Defiance’s shareholders.

In connection with its supervision of First Defiance, the OTS asked the Company to enter into a memorandum of understanding, which is a tool employed by bank regulatory agencies to address areas of concern to the regulator. The memorandum for the Company requires that it submit to the OTS specific strategies for increasing and maintaining capital at targets, to be established by First Defiance’s board of directors that are commensurate with First Defiance’s risk profile. At December 31, 2010, First Federal’s capital ratios were 10.81% for tangible capital and 14.09% for total risk-based capital, both of which exceed the regulatory thresholds to be considered “well-capitalized.” The memorandum also requires that First Defiance obtain approval from the OTS before it pays any dividends, including dividends on common shares, or incur, issue, renew, or rollover any debt. First Federal also agreed to a memorandum of understanding, the principal terms of which relate to First Federal’s risk profile and asset quality. Compliance with the First Federal memorandum may restrict First Defiance’s operations and adversely affect its financial results.

First Defiance issued $37.0 million of our Series A Preferred Shares to the U.S. Treasury

 

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pursuant to the CPP. The rules and policies applicable to CPP participants continue to evolve and their scope, timing and effect cannot be predicted. Current restrictions include limits on First Defiance’s ability to pay retention awards, bonuses and other incentive compensation during the period in which it has any outstanding securities held by the U.S. Treasury that were issued under the CPP. These limitations may adversely affect First Defiance’s ability to recruit and retain key personnel, especially if it is competing for talent against institutions that are not subject to the same restrictions.

The laws and regulations applicable to the banking industry could change at any time. As a result of ongoing challenges facing the U. S. economy in particular, 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.

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. Pursuant to the MOU, First Defiance must obtain OTS approval before incurring or issuing any debt.

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

 

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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.

First Defiance’s operations are also dependent on its existing infrastructure, including equipment and facilities. Extended disruption of vital infrastructure as a result of fire, power loss, natural disaster, telecommunications failures, computer hacking or viruses, terrorist activity or the domestic response to such activity, or other events outside of the control of management could have a material adverse impact on its business, results of operations, cash flows and financial condition. First Defiance has a business recovery plan, but there are no assurances that such a plan will work as intended or that it will prevent significant interruptions to operations.

Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of our computer systems or otherwise, could severely harm our business.

In the normal course of business, First Defiance collects, processes and retains sensitive and confidential client and customer information on behalf of First Defiance and other third parties. Despite the security measures the Company has in place, First Defiance’s facilities and systems, and those of the Company’s third party service providers, may be vulnerable to security breaches, act of vandalism, computer viruses, lost or misplace data, or other similar events. Any security breach involving the unauthorized disclosure or loss of confidential customer information, whether by First Defiance or by the Company’s third party vendors, could severely damage First Defiance’s reputation, expose the Company to risks of litigation and liability, disrupt First Defiance’s operations and have a material adverse effect on First Defiance’s business.

The issuance of Series A Preferred Shares and Warrants to the U. S. Government may adversely affect the holders of our Common Shares.

First Defiance issued 37,000 Series A Preferred Shares and warrants to purchase 550,595 shares of First Defiance Common Shares to the U.S. Department of the Treasury under the Capital Purchase

 

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Program. The dividends accrued and the accretion on discount on the Series A Preferred Shares issued to the U.S. Treasury reduce the net income available to the holders of our Common Shares and our earnings per Common Share. Because the Series A Preferred Shares are cumulative, any dividends not declared or paid will accumulate and will be payable when the payment of dividends is resumed. If the Series A Preferred Shares are not redeemed within five years after their original date of issuance, the annual dividend rate on the Series A Preferred Shares will increase from 5.0% per annum to 9.0% per annum. If we are unable to redeem the Series A Preferred Shares by December 5, 2013, the increase in the annual dividend rate on the Series A Preferred Shares could have a material adverse effect on our earnings and could also adversely affect our ability to declare and pay dividends on our Common Shares. Series A Preferred Shares will also receive preferential treatment in the event of a liquidation, dissolution or winding up of First Defiance.

The Common Shares underlying the Warrant represent approximately 6.4% of the Common Shares outstanding as of December 31, 2010 (including the shares issuable upon exercise of the Warrant in our total outstanding Common Shares). If the Warrant is exercised, the interest of the existing holders of our Common Shares will be diluted. Although the Treasury Department has agreed not to vote any of the Common Shares acquired upon exercise of the Warrant, a transferee of the Warrant or of any Common Shares acquired upon exercise of the Warrant is not bound by this restriction. Finally, the terms of the Series A Preferred Shares allow the U.S. Treasury to impose additional restrictions, including those on dividends and to unilaterally amend the terms of the Series A Preferred Shares to comply with changes in applicable federal law.

If we fail to pay dividends on the Series A Preferred Shares for six quarterly dividend periods (whether or not consecutive), the Treasury Department will have the right to appoint two directors to our Board of Directors until all accrued but unpaid dividends have been paid. As long as the Series A Preferred Shares are outstanding, in addition to any other vote or consent of shareholders required by law or our Articles of Incorporation, as amended (the “Articles”), the vote or consent of holders owning at least 66 2/3% of the Series A Preferred Shares outstanding is required for:

 

   

any authorization or issuance of shares ranking senior to the Series A shares;

 

   

any amendments to the rights of the Series A Preferred Shares that would adversely affect the rights, preferences, privileges or voting power of the Series A shares; or

 

   

the consummation of any merger, share exchange or similar transaction unless the Series A shares remain outstanding, or if we are not the surviving entity in such transaction, are converted into or exchanged for preference securities of the surviving entity and the Series A shares remaining outstanding or such preference securities have the rights, preferences, privileges and voting power of the Series A shares.

The holders of Series A Preferred Shares, including the U.S. Treasury, may have different interests from the holders of our common shares, and could vote to block transactions that may be in the best interest of the present holders of our common shares.

We may need to raise additional capital in the future, which may result in significant dilution to holders of First Defiance Common Shares.

There can be no assurance that we will not in the future determine that it is advisable, or that we will not encounter circumstances where we determine that it is necessary, to issue additional Common Shares, securities convertible into or exchangeable for Common Shares or common-equivalent securities to fund strategic initiatives or other business needs or to build additional capital. In addition, if we decide to repurchase the Series A Preferred Stock issued to the U.S. Treasury, we may elect or be

 

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required by our regulators to increase the amount of our Tier 1 common equity through the sale of additional Common Shares. Further, there can be no assurance that our regulators will not require us to generate additional capital, including Tier 1 common equity, in the future in the event of further negative economic circumstances, in order for us to redeem our Series A Preferred Stock held by the U.S. Treasury under the CPP or otherwise. The market price of our Common Shares could decline as a result of such exchange offerings, as well as other sales of a large block of our Common Shares or similar securities in the market thereafter, or the perception that such sales could occur. These factors could have a material adverse effect on the Company.

We may not be permitted to repurchase the U.S. Treasury’s CPP investment if and when we request approval to do so.

While it is our plan to repurchase the Series A Preferred Stock as soon as practicable, in order to repurchase such securities, in whole or in part, we must establish to our regulators’ satisfaction that we have met all of the conditions to repurchase and must obtain the approval of our primary federal regulator and the U.S. Treasury. There can be no assurance that we will be able to repurchase the U.S. Treasury’s CPP investment in our Series A Preferred Stock subject to conditions that we find acceptable, or at all. In addition to limiting our ability to return capital to our shareholders, the U.S. Treasury’s investment could limit our ability to retain key executives and other key employees because of the limits on compensation that may be paid to employees of CPP participants, and limit our ability to develop business opportunities.

If we are unable to redeem our Series A Preferred Stock within five years from the issuance date, the cost of this capital to us will increase substantially.

If we are unable to redeem our Series A Preferred Stock prior to December 5, 2013, the cost of this capital will increase substantially on that date, from 5.0% per annum (approximately $1.9 million annually) to 9.0% per annum (approximately $3.3 million annually). Depending on our financial condition at the time, this increase in the annual dividend rate could have a material negative effect on our liquidity.

Regulatory restriction on dividends and our ability to repurchase shares may adversely affect our shareholders and the market price of our common shares.

As long as the Series A shares are outstanding and held by the Treasury Department, we cannot increase the quarterly dividend on our common shares above $.26 per share without prior approval from the Treasury Department. In addition to this restriction, the OTS has directed First Defiance to seek approval of the OTS before paying any dividends on our common shares.

Our principal source of funds to pay dividends on our common shares is distributions from First Federal, which require the prior approval of the OTS. The OTS has advised us that it is not likely to approve any distributions from First Federal for this purpose in the foreseeable future. The OTS has also advised us that we should not pay dividends utilizing borrowings or other sources of funds that we may have access to.

As long as the Series A shares are outstanding and held by the Treasury Department, we cannot repurchase our common shares without the consent of the Treasury Department (other than repurchases in connection with the administration of any employee benefit plan in the ordinary course of business and consistent with past practice and certain other exemptions). Further, the OTS has directed First Defiance to seek approval of the OTS before repurchasing any common shares.

 

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Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

At December 31, 2010, First Federal conducted its business from its main office at 601 Clinton Street, Defiance, Ohio, and thirty-two other full service banking centers in northwest Ohio, northeast Indiana and southeast Michigan. First Insurance conducted its business from leased office space at 419 5th Street, Suite 1200, Defiance, Ohio; 209 West Poe Road, Bowling Green, Ohio; 214 N. Defiance Street, Archbold, Ohio and 926 East High Street, Bryan, Ohio.

In 2009, the Company closed two branch locations, the Cole Street branch in Lima, Ohio which is owned, and the Hillsdale, Michigan branch which was leased. As of December 31, 2009, the Cole Street branch in Lima, Ohio was transferred at its fair value of $300,000 to other real estate owned and is currently held for sale. Also, the Hillsdale branch leasehold improvements were written down to a value of $0. These two branches were closed on January 22, 2010.

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 Road, Defiance, Ohio.

 

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The following table sets forth certain information with respect to the office and other properties of the Company at December 31, 2010. See Note 10 to the Consolidated Financial Statements.

 

Description/address

  

Leased/ Owned

   Net Book Value
of Property
     Deposits  
     (In Thousands)  

Main Office, First Federal

        

601 Clinton St., Defiance, OH

   Owned    $ 4,520       $ 257,088   

Operations Center

        

25600 Elliott Rd., Defiance, OH

   Owned      5,814         N/A   

Mobile Banking

        

1011 W. Beecher St., Adrian, MI

   Owned      211         N/A   

Branch Offices, First Federal

        

204 E. High St., Bryan, OH*

   Owned      762         120,807   

211 S. Fulton St., Wauseon, OH

   Owned      528         51,905   

625 Scott St., Napoleon, OH

   Owned      1,144         70,686   

1050 East Main St., Montpelier, OH

   Owned      385         36,867   

926 East High St., Bryan, OH*

   Owned      89         —     

1800 Scott St., Napoleon, OH

   Owned      1,411         27,814   

1177 N. Clinton St., Defiance, OH

   Owned, Land Lease Leased      1,019         36,140   

905 N. Williams St., Paulding, OH

   Owned      832         42,083   

201 E. High St., Hicksville, OH

   Owned      404         24,250   

3900 N. Main St., Findlay, OH

   Owned      1,061         43,138   

11694 N. Countyline St., Fostoria, OH

   Owned      688         36,148   

1226 W. Wooster, Bowling Green, OH

   Owned      1,081         81,211   

301 S. Main St., Findlay, OH

   Owned      1,134         42,346   

405 E. Main St., Ottawa, OH

   Owned      369         74,210   

124 E. Main St., McComb, OH

   Owned      213         21,330   

7591 Patriot Dr., Findlay, OH

   Owned      1,201         33,501   

417 W Dussell Dr., Maumee, OH

   Owned, Land Lease      953         41,404   

230 E. Second St., Delphos, OH

   Owned      1,117         94,132   

105 S. Greenlawn Ave., Elida, OH

   Owned      353         40,037   

2600 Allentown Rd., Lima, OH

   Owned      847         41,556   

22020 W. State Rt. 51, Genoa, OH

   Owned      926         33,000   

3426 Navarre Ave., Oregon, OH

   Owned      1,010         28,631   

1077 Louisiana Ave., Perrysburg, OH

   Owned      1,145         25,475   

2565 Shawnee Rd., Lima, OH

   Owned      1,559         27,667   

7437 Coldwater Rd., Fort Wayne, IN

   Leased      129         12,471   

135 South Main St., Glandorf, OH

   Leased      —           13,161   

300 N. Main St., Adrian, MI

   Owned      795         59,513   

1701 W. Maumee St., Adrian, MI

   Owned      166         56,097   

211 W. Main St., Morenci, MI

   Owned      177         26,320   

539 S. Meridian, Hudson, MI

   Owned      617         37,915   

1449 W. Chicago Blvd., Tecumseh, MI

   Owned      1,559         22,290   

501 E. Chicago Blvd., Tecumseh, MI

   Leased      11         16,226   

First Insurance & Investments

        

419 5th Street, Suite 1200, Defiance, OH

   Leased      137         N/A   

209 West Poe Road, Bowling Green, OH

   Leased      16         N/A   

214 N. Defiance St., Archbold, OH

   Leased      —           N/A   

926 E. High St., Bryan, OH**

   Leased      —           N/A   
                    
      $ 34,383       $ 1,575,419   
                    

 

*

The Bryan East (926 East High St.) deposits are now included in the Bryan Main (204 E. High Street) totals.

 

**

Located in the Bryan East branch.

 

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Item 3. Legal Proceedings

First Defiance is involved in routine legal proceedings occurring 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. Reserved

PART II

 

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

The Company’s common stock trades on The NASDAQ Global Select Market under the symbol “FDEF.” As of February 25, 2011, the Company had 2,296 shareholders of record.

The table below shows the reported high and low sales prices of the common stock and cash dividends declared per share of common stock during the periods indicated in 2010 and 2009.

 

     Years Ending  
     December 31, 2010      December 31, 2009  
     High      Low      Dividend      High      Low      Dividend  

Quarter ended:

                 

March 31

   $ 12.33       $ 9.20       $ —         $ 8.95       $ 3.76       $ .17   

June 30

     14.85         8.53         —           14.25         6.10         .085   

September 30

     10.63         8.55         —           18.33         12.00         .04   

December 31

     12.32         9.94         —           18.93         10.06         —     

First Defiance’s ability to pay dividends to its shareholders is primarily dependent on the ability of the Subsidiaries to pay dividends to First Defiance. The OTS imposes various restrictions or requirements on the ability of a subsidiary of a savings and loan holding company to make capital distributions. The OTS has advised the Company that it is not likely to approve any distributions from First Federal for this purpose in the foreseeable future. The OTS also advised the Company that prior approval would be required to pay dividends utilizing borrowings or other sources of funds to which the Company may have access to. Capital distributions include, without limitation, payments of cash dividends, repurchases and certain other acquisitions by an association of its shares and payments to stockholders of another association in an acquisition of such other association.

Even if the OTS approves a distribution from First Federal to First Defiance, as a result of participating in the CPP, First Defiance is prohibited, without prior approval of the U.S. Treasury, from paying a quarterly cash dividend of more than $0.26 per share until the earlier of December 5, 2011 or the date the U.S. Treasury’s preferred stock is redeemed or transferred to an unaffiliated third party.

First Federal paid $4.8 million in dividends to First Defiance during 2010 and $5.4 million in 2009. First Insurance paid $1.0 million in dividends to First Defiance during 2010 and $700,000 in 2009.

The line graph below compares the yearly percentage change in cumulative total shareholder return on First Defiance common stock 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, 2005, 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.

 

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     Period Ending  

Index

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

First Defiance Financial Corp.

     100.00         115.76         87.38         32.85         50.43         53.15   

NASDAQ Composite

     100.00         110.39         122.15         73.32         106.57         125.91   

SNL Bank NASDAQ Index

     100.00         112.27         88.14         64.01         51.93         61.27   

SNL Midwest Thrift Index

     100.00         113.49         95.86         85.19         71.76         58.17   

LOGO

First Defiance did not purchase any of its common shares during 2010, but has 93,124 shares that may be purchased under a plan announced by the Board of Directors on July 18, 2003. Participation in the CPP prohibits the Company from repurchasing any of its common shares without the prior approval of the U.S. Treasury until the earlier of December 5, 2011 or the date the U.S. Treasury’s preferred stock is redeemed or transferred to an unaffiliated third party. The OTS has also prohibited First Defiance from repurchasing its common shares without prior approval of the OTS.

 

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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, 2010. 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 the 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  
     2010     2009     2008     2007     2006  
     (Dollars in Thousands, Except Per Share Data  

Financial Condition:

          

Total assets

   $ 2,035,517      $ 2,057,523      $ 1,957,400      $ 1,609,404      $ 1,527,879   

Investment securities

     166,091        139,378        118,461        113,487        112,123   

Loans receivable, net

     1,478,423        1,580,575        1,592,643        1,275,806        1,226,310   

Allowance for loan losses

     41,080        36,547        24,592        13,890        13,579   

Nonperforming assets (1)

     56,632        61,433        41,267        11,677        9,675   

Deposits and borrowers’ escrow balances

     1,576,356        1,580,891        1,470,564        1,218,620        1,139,112   

FHLB advances

     116,885        146,927        156,067        139,536        162,228   

Stockholders’ equity

     240,331        234,086        229,159        165,954        159,825   

Share Information:

          

Basic earnings per share

     0.75        0.64        0.91        1.96        2.22   

Diluted earnings per share

     0.75        0.63        0.91        1.94        2.18   

Book value per common share

     25.00        24.26        23.67        23.51        22.38   

Tangible book value per common share

     17.16        16.44        15.67        17.79        16.99   

Cash dividends per common share

     —          0.295        0.95        1.01        0.97   

Dividend payout ratio

     NM        46.09     10.44     51.53     43.69

Weighted average diluted shares outstanding

     8,153        8,196        7,919        7,178        7,163   

Shares outstanding end of period

     8,118        8,118        8,117        7,059        7,142   

Operations:

          

Interest income

   $ 95,865      $ 100,579      $ 103,463      $ 98,751      $ 93,065   

Interest expense

     25,702        33,257        41,268        50,089        44,043   

Net interest income

     70,163        67,322        62,195        48,662        49,022   

Provision for loan losses

     23,177        23,232        12,585        2,306        1,756   

Non-interest income

     27,590        26,295        19,069        22,130        19,624   

Non-interest expense

     63,463        60,524        57,794        48,113        43,839   

Income before tax

     11,113        9,861        10,885        20,373        23,051   

Federal income tax

     3,005        2,667        3,528        6,469        7,451   

Net Income

     8,108        7,194        7,357        13,904        15,600   

Performance Ratios:

          

Return on average assets

     0.39     0.36     0.40     0.90     1.04

Return on average equity

     3.40     3.09     3.85     8.48     10.03

Interest rate spread (2)

     3.68     3.50     3.51     3.17     3.36

Net interest margin (2)

     3.89     3.76     3.80     3.55     3.68

Ratio of operating expense to average total assets

     3.09     2.99     3.12     3.12     2.93

Efficiency ratio (3)

     63.89     61.50     67.74     67.29     63.31

Capital Ratios:

          

Equity to total assets at end of period

     11.81     11.38     11.71     10.31     10.46

Tangible common equity to tangible assets at end of period

     7.06     6.69     6.72     8.00     8.15

Average equity to average assets

     11.62     11.49     10.30     10.62     10.40

Asset Quality Ratios:

          

Nonperforming assets to total assets at end of period (1)

     2.78     2.99     2.11     0.73     0.63

Allowance for loan losses to total loans*

     2.70     2.26     1.52     1.08     1.10

Net charge-offs to average loans

     1.21     0.70     0.41     0.16     0.15

 

(1)

Nonperforming assets consist of non-accrual loans that are contractually past due 90 days or more; loans that are deemed impaired under the criteria of FASB ASC Topic 310; loans that have been restructured; and real estate, mobile homes and other assets acquired by foreclosure or deed-in-lieu thereof.

 

(2)

Interest rate spread represents the difference between the weighted average yield on interest-earnings assets and the weighted average rate on interest-bearing liabilities. Net interest margin represents net interest income as a percentage of average interest-earnings assets. Interest income on tax-exempt securities and loans has been adjusted to a tax-equivalent basis using the statutory federal income tax rate of 35%.

 

(3)

Efficiency ratio represents non-interest expense divided by the sum of tax-equivalent net interest income plus non-interest income, excluding securities gain or losses, net.

 

*

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 Board.

 

   

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 the 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.

Recent Market Developments

The Dodd-Frank Act was signed into law on July 21, 2010. This new law has and will continue to significantly change the current bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies, and will fundamentally change the system of regulatory oversight of the Company, including through the creation of the Financial Stability Oversight Council. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and, as a result, many of the details and much of the impact of the Dodd-Frank Act is not yet known. The Dodd-Frank Act, however, could have a material adverse impact either on the financial services industry as a whole, or on First Defiance’s business, results of operations, financial condition and liquidity.

The Dodd-Frank Act broadens the base for FDIC insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution. The Dodd-Frank Act also permanently increases the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2009, and non-interest bearing transaction accounts have unlimited deposit insurance through December 31, 2013.

The legislation also requires that publicly traded companies give shareholders a non-binding vote on executive compensation and “golden parachute” payments, and authorizes the Securities and Exchange Commission to promulgate rules that would allow shareholders to nominate their own candidates using a company’s proxy materials. The Dodd-Frank Act also directs the Federal Reserve Board to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded.

The Dodd-Frank Act established a new Bureau of Consumer Financial Protection with broad powers to supervise and enforce consumer protection laws. The Bureau of Consumer Financial Protection has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The Bureau of Consumer Financial Protection has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets.

In addition, the Dodd-Frank Act, among other things:

 

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Amends the Electronic Fund Transfer Act (“EFTA”) which has resulted in, among other things, the Federal Reserve Board issuing rules aimed at limiting debit-card interchange fees;

 

   

Applies the same leverage and risk-based capital requirements that apply to insured depository institutions to most financial holding companies;

 

   

Changes the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminates the ceiling on the size of the DIF, and increases the floor on the size of the DIF, which generally will require an increase in the level of assessments for institutions with assets in excess of $10 billion;

 

   

Repeals the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;

 

   

Provides mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring the ability to repay to be determined for variable-rate loans by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions;

 

   

Creates the Financial Stability Oversight Council, which will recommend to the Federal Reserve Board increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity; and

 

   

Eliminate the OTS one year from the date of the new law’s enactment, making the OCC, which is currently the primary federal regulator for national banks, the primary federal regulator for federal thrifts, including First Federal. In addition, the Board of Governors of the Federal Reserve System will supervise and regulate all savings and loan holding companies that were formerly regulated by the OTS, including First Defiance.

The environment in which banking organizations will operate after the financial crisis, including legislative and regulatory changes affecting capital, liquidity, supervision, permissible activities, corporate governance and compensation, changes in fiscal policy and steps to eliminate government support for banking organizations, may have long-term effects on the business model and profitability of banking organizations, the full extent of which cannot now be foreseen. Many aspects of the Dodd-Frank Act remain subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on First Defiance, its customers or the financial industry more generally. Provisions in the legislation that affect deposit insurance assessments, payment of interest on demand deposits and interchange fees could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate.

The following section presents information to assess the financial condition and results of operations of First Defiance. This section 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.

Overview

First Defiance is a unitary thrift holding company which conducts business through its subsidiaries, First Federal and First Insurance.

 

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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 33 full service banking centers in 12 northwest Ohio counties, 1 northeast Indiana county, and 1 southeastern Michigan county. In 2009, First Federal announced the closings of two branch facilities, one located in the Lima, Ohio and the other in Hillsdale, Michigan. Both branches were closed in January 2010. First Federal also relocated its office facility in Oregon, Ohio during 2009.

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. Insurance products are sold through First Insurance’s offices in Defiance, Archbold, Bryan and Bowling Green, Ohio. In May 2010, First Insurance acquired a group medical benefits business line from Andres O’Neil & Lowe Insurance Agency. See Note 4 – Acquisitions in the Notes to the Financial Statements.

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 Trusted Advisor initiative. First Defiance also has a tagline of “Bank with the people you know and trust” 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 segments of First Defiance’s business strategy is 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.

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 with 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 were 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, NOW, money market, certificates of deposits, 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,

 

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installment loans and education loans. First Federal also offers online banking services, which include online bill pay along with debit cards.

Fee Income Development – Generation of fee income and the diversification of revenue sources are accomplished through the mortgage banking operation, insurance subsidiary 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 has initiated a pricing strategy that considers the whole relationship of the customer. First Federal will continue 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 compliment its overall market share and compliment 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 on loan types and markets that it knows well and in which its has historically been successful in. First Federal strives to have loan relationships that are well diversified in both size and industry, and monitor 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.

Expansion Opportunities – First Defiance believes it is well positioned to take advantage of acquisitions or other business opportunities in its market areas, including FDIC-assisted transactions. 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 has successfully integrated acquired institutions in the past with the most recent acquisition completed in 2008. 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.

Financial Condition

Assets at December 31, 2010 totaled $2.04 billion compared to $2.06 billion at December 31, 2009, a decrease of $22.0 million or 1.1%. Cash and equivalents increased $48.1 million to $169.2 million at December 31, 2010 from $121.1 million at December 31, 2009. The decrease in assets was a result in a decline in net loans receivable (excluding loans held for sale) of $102.2 million in 2010 due to the continued economic weakness in the market areas served by the Company.

Securities

The securities portfolio increased $26.7 million to $166.1 million at December 31, 2010. The 2010 activity in the portfolio included $76.4 million of purchases, $28.0 million of amortization and maturities, $20.3 million of principal pay-downs and $456,000 of securities being sold. There was a net decrease of $672,000 in market value on available-for-sale securities. The Company also recorded $331,000 of other-than-temporary impairment on three collateralized debt obligations in 2010. See Note 6 – Investment Securities in the Notes to the financial statements for additional information.

 

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Loans

Gross loans receivable declined $97.6 million to $1.52 billion at December 31, 2010. For more details on the loan balances, see Note 8 – Loans Receivable in the Notes to the Financial Statements.

The majority of First Defiance’s non-residential real estate and commercial loans are to small and mid-sized businesses. The combined commercial, non-residential real estate and multi-family real estate loan portfolios totaled $1.14 billion and $1.19 billion at December 31, 2010 and 2009 respectively and accounted for approximately 74.3% and 72.1% of First Defiance’s loan portfolio at the end of those respective periods. 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 one-to-four family residential portfolio totaled $205.9 million at December 31, 2010, compared with $227.6 million at the end of 2009. At the end of 2010, those loans comprised 13.5% of the total loan portfolio, down from 13.8% at December 31, 2009.

Construction loans, which include one to four family and commercial real estate properties, declined to $30.3 million at December 31, 2010 compared to $48.6 million at December 31, 2009. These loans accounted for approximately 2.0% and 3.0% of the total loan portfolio at December 31, 2010 and 2009, respectively.

Home equity and home improvement loans declined to $133.6 million at December 31, 2010, from $148.0 million at the end of 2009. At the end of 2010, those loans comprised 8.7% of the total loan portfolio, down from 9.0% at December 31, 2009.

Consumer finance and mobile home loans were just $22.8 million at December 31, 2010, down from $34.1 million at the end of 2009. These loans comprised just 1.5% and 2.1% of the total portfolio at December 31, 2010 and 2009, respectively.

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 their 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 necessary, based on First Federal’s assessment of the appraisal, such as age, market, etc, First Federal will discount this 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 carrying and selling costs. In some instances, we may require a new appraisal. Finally, First Federal assesses whether there is any collateral short fall, considering guarantor support and determines if a reserve is necessary.

When a collateral dependent loan moves to non-performing status, First Federal generally gets a new third party appraisal and adjusts the reserve as necessary 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 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 on classified loans, appraisal values may be discounted downward based upon First Federal’s experience with liquidating similar properties.

All loans over 90 days past due and/or on non-accrual as well as all Troubled Debt Restructured loans are classified as non-performing loans. Non-performing status automatically occurs in the month in which the 90 day delinquency occurs. For Troubled Debt Restructured loans, the loans are put into non-performing status in the month in which the restructure occurs.

As stated above, once a collateral dependent loan is identified as non-performing, First Federal generally gets an appraisal. Troubled Debt Restructure collateral dependent loans receive an appraisal as part of the restructure credit decision.

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 adjustment to the reserve 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. If the loan maintains a rate at restructuring that is lower than the market rate for similar credits, the loan will remain classified as Troubled Debt Restructuring until such time as it is paid off or restructured at prevailing rates and terms. First Federal may consider moving the loan to accruing status after 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 reserves quarterly to determine accuracy. Based on these results, changes may occur in the processes used. The most recent analysis indicates that our actual charge-offs are on average within 10% of the specific reserves previously established for these loans.

Loan modifications constitute a Troubled Debt Restructuring 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 Troubled Debt Restructurings, First Federal either computes the present value of expected future cash flows discounted at the original loan’s effective interest rate or, as a practical expedient, it may measure impairment based on the observable market price of the loan or the fair value of the collateral even though Troubled Debt Restructurings are not expected to be deemed collateral dependent. The difference between the carrying value and fair value of the loan is recorded as a valuation allowance.

Allowance for Loan Losses

The allowance for loan losses represents management’s assessment of the estimated probable 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 all commercial loan and commercial real estate loan relationships that exceed $750,000 of aggregate

 

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exposure over a twelve month period. 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.

The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable credit losses within the existing loan portfolio in the normal course of business. The allowance for loan loss is made up of two basic components. The first component is the specific allowance in which the company sets aside reserves based on the analysis of individual credits. The second component is the general reserve. The general reserve is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolios based on quantitative and qualitative factors. Due to the uncertainty of risks in the loan portfolio, the Company’s judgment on the amount of the allowance necessary to absorb loans losses is approximate. Table 3 presents the allocation of the specific and general components of the allowance by signification loan types.

In establishing specific reserves, First Federal analyzes all loans on its classified and special mention lists at least 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 guarantor in determining the amount of impairment of individual loans and the specific reserve to be recorded.

For purpose of the general reserve analysis, the loan portfolio is stratified into ten different loan pools based on loan type and by market area to allocate historic loss experience. The loss experience factor applied to the non-impaired loan portfolio was based upon historical losses of the most recent weighted two years used at December 31, 2010.

The stratification of the loan portfolio resulted in a quantitative general allowance of $14.0 million at December 31, 2010 compared to $10.5 million at December 31, 2009. The increase in the quantitative allowance was due to the increase in the historical loss factors relating to commercial, commercial real estate, residential and credit card loans.

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 that have a bearing on its loss content, including but not limited to the following:

 

   

Changes in international, national and local economic and business conditions and developments, including the condition of various market segments

 

   

Changes in the nature and volume of the loan portfolio

 

   

Changes in the trends of the volume and severity of past due and classified loans; and changes in trends in the volume of non-accrual loans, troubled debt restructurings and other loan modifications

 

   

The existence and effect of any concentrations of credit and changes in the level of such concentrations

 

   

Changes in the value of underlying collateral for collateral dependent loans

 

   

Changes in the political and regulatory environment

 

   

Changes in lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices

 

   

Changes in the experience, ability and depth of lending management and staff

 

   

Changes in the quality and breadth of the loan review process

 

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The qualitative analysis at December 31, 2010 indicated a general reserve of $10.5 million compared with $8.7 million at December 31, 2009. This decrease was mainly driven by improved cash flows and operating results of borrowers in 2010. In light of the continued environment of high unemployment, declining real estate values and sustained economic weakness in the Midwest, management feels it is prudent to maintain a higher level of general loan loss reserves. All 14 counties that represent the footprint of the Company have seen improvements in their unemployment rates in 2010, with only three below the national average of 9.1%. The Company operated one branch in Hillsdale county in 2009, but that office was closed in January 2010, therefore, that data is not being presented in this comparison. The unemployment rates in December 2010 for the following counties in Ohio were: Allen 9.8%, Defiance 9.9%, Fulton 10.6%, Hancock 8.1%, Henry 11.1%, Lucas 10.1%, Ottawa 16.3%, Paulding 9.8%, Putnam 8.4%, Seneca 10.2%, Williams 11.1% and Wood 9.0%, compared to December 2009 in Allen 11.6%, Defiance 12.8%, Fulton 14.3%, Hancock 9.6%, Henry 13.9%, Lucas 12.3%, Ottawa 17.3%, Paulding 12.7%, Putnam 11.0%, Seneca 13.0%, Williams 14.9% and Wood 11.1%. The Company operates in one county in Michigan, Lenawee which had an unemployment rate of 12.4% in December 2010 compared to 16.6% in December 2009. The Company operates in one county in Indiana, Allen, which had an unemployment rate of 9.4% in December 2010 compared to 10.0% in December 2009. First Defiance’s general reserve percentages for main loan segments not otherwise classified ranged from 0.29% for construction loans to 1.70% for commercial loans. Credit cards were 10.56%.

As a result of the quantitative and qualitative analyses, along with the change in specific reserves, the Company’s provision for loan losses for 2010 was $23.2 million, which is unchanged since December 31, 2009. The allowance for loan losses was $41.1 million and $36.5 million and represented 2.70% and 2.26% of loans, net of undisbursed loan funds and deferred fees and costs, as of December 31, 2010 and December 31, 2009, respectively. That increase was mainly the result of the decline in real estate values and some collateral dependent loans no longer having enough collateral value to support the outstanding balance. Management has expanded its credit monitoring functions even further beyond its traditionally strong focus. Additional asset review functions and more delinquent loan reporting requirements have been added to assist in this monitoring. Management will continually review credit concentrations by industry and has placed lower limits on lending within certain types of loan categories. Management has also segmented the commercial real estate portfolio to track the general performance of these segments to further refine the predictive process of identifying potential problem loans. The provision was offset by charge offs of $9.1 million against specific reserves and $10.2 million against general reserves and recoveries of $684,000 resulting in an increase to the overall allowance for loan loss of $4.5 million. In management’s opinion, the overall allowance for loan losses of $41.1 million as of December 31, 2010 is adequate.

Management also assesses the value of real estate owned 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 2010, First Defiance recorded OREO write-downs that totaled $3.2 million. These amounts were included in other non-interest expense. Management believes that the values recorded at December 31, 2010 for real estate owned and repossessed assets represent the realizable value of such assets.

Total classified loans increased to $133.1 million at December 31, 2010, compared to $128.9 million at December 31, 2009. At December 31, 2010, a total of $47.5 million of loans were classified as substandard for which a specific reserve is required. A total of $83.2 million in additional credits were classified as substandard at December 31, 2010 for which no specific reserve is required because of factors such as the level of collateral or the strength of guarantors. First Defiance also classified $2.4 million of loans doubtful at December 31, 2010. By contrast, at December 31, 2009, a total of $46.3 million of loans were classified as substandard for which some level of specific reserve was required and $78.0 million were classified as substandard which did not require any reserve. At December 31, 2009, $4.6 million of loans were classified as doubtful.

First Defiance’s ratio of allowance for loan losses to non-performing loans was 87.3% at December 31, 2010 compared with 76.3% at December 31, 2009. Management monitors collateral values

 

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of all loans included on the watch list that are collateral dependent and believes that allowances for those loans at December 31, 2010 are appropriate.

At December 31, 2010, First Defiance had total non-performing assets of $56.6 million, compared to $61.4 million at December 31, 2009. Non-performing assets include loans that are 90 days past due, troubled debt restructured loans and real estate owned and other assets held for sale. Non-performing assets at December 31, 2010 and 2009 by category were as follows:

Table 1 – Nonperforming Asset

 

     December 31  
     2010     2009  
     (In thousands)  

Non-performing loans:

    

Single-family residential

   $ 7,161      $ 5,349   

Construction

     64        675   

Non-residential and multi-family residential real estate

     21,737        24,042   

Commercial

     11,547        10,615   

Consumer finance

     14        59   

Home equity and improvement

     517        451   

Troubled debt restructured loans, accruing

     6,001        6,715   
                

Total non-performing loans

     47,041        47,906   

Real estate owned and repossessed assets

     9,591        13,527   
                

Total non-performing assets

   $ 56,632      $ 61,433   
                

Allowance for loan losses as a percentage of total loans*

     2.70     2.26

Allowance for loan losses as a percentage of non- performing assets

     72.54     59.49

Allowance for loan losses as a percentage of non- performing loans

     87.33     76.29

Total non-performing assets as a percentage of total assets

     2.78     2.99

Total non-performing loans as a percentage of total loans*

     3.10     2.96

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

    

The decrease in non-performing loans between December 31, 2009 and December 31, 2010 is primarily in non-residential and multi-family real estate loans. The balance of these types of non-performing loans was $2.3 million higher at December 31, 2009 compared to December 31, 2010. Approximately $14.5 million of 2009 non-performing loans are still considered non-performing loans at December 31, 2010 and $2.8 million of real estate owned at December 31, 2010 was in real estate owned at December 31, 2009. The commercial and non-residential real estate and multi-family real estate loans that are non-performing at December 31, 2010 are comprised of 74 relationships, with 8 relationships making up $22.2 million of the $33.3 million total. The allowance for loan losses includes $4.4 million for those 8 relationships. By comparison, at December 31, 2009, 10 relationships made up the $21.0 million of commercial and non-residential real estate and multi-family real estate loans total of $34.7 million.

Non-performing loans in the single-family residential, non-residential and multi-family residential real estate and commercial loan categories represent 3.48%, 2.83% and 3.12% of the total loans in those categories respectively at December 31, 2010 compared to 2.35%, 2.98% and 2.80% respectively for the same categories at December 31, 2009. Management believes that the current allowance for loan losses is appropriate and that the provision for loan losses recorded in 2010 is consistent with both charge-off experience and the risk inherent in the overall credits in the portfolio.

 

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Non-performing assets, which include non-accrual loans, accruing troubled debt restructured loans and real estate owned, decreased to $56.6 million at December 31, 2010 from $61.4 million at December 31, 2009.

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 required allowances and proposed charge-offs which are approved by the Senior Loan Committee (in the case of charge-offs) or the Loan Loss Reserve Committee (in the case of specific allowances).

The following table discloses charge-offs, recoveries and provision expense for the year ended December 31, 2010 by loan category ($ in thousands).

Table 2 – Charge-offs, Recoveries and Provision by Category

 

     Commercial
Real Estate
    Commercial     Consumer     Residential     Construction      Home Equity
and
Improvement
    Total  

Year Ended December 31, 2010

               

Allowance for loans individually evaluated

               

Beginning Specific Allocations

   $ 6,917      $ 3,450      $ —        $ 1,882      $ —         $ —        $ 12,249   

Charge-Offs

     (5,174     (3,085     —          (879     —           —          (9,138

Recoveries

     —          —          —          —          —           —          —     

Provisions

     8,700        3,997        —          738        13         36        13,484   
                                                         

Ending Specific Allocations

   $ 10,443      $ 4,362      $ —        $ 1,741      $ 13       $ 36      $ 16,595   
                                                         

Allowance for loans collectively evaluated

               

Beginning General Allocations

   $ 11,959      $ 5,994      $ 515      $ 4,166      $ —         $ 1,664      $ 24,298   

Charge-Offs

     (4,754     (2,033     (124     (2,213     —           (1,066     (10,190

Recoveries

     50        259        107        170        —           98        684   

Provisions

     4,657        2,289        (201     2,092        60         796        9,693   
                                                         

Ending General Allocations

   $ 11,912      $ 6,509      $ 297      $ 4,215      $ 60       $ 1,492      $ 24,485   
                                                         

The following table details net charge-offs and nonaccrual loans by loan type. For the twelve months ended and as of December 31, 2010, commercial real estate, which represented 50.14% of total loans, accounted for 52.98% of net charge-offs and 52.97% of nonaccrual loans, and commercial loans, which represented 24.19% of total loans, accounted for 26.06% of net charge-offs and 28.14% of nonaccrual loans. For the twelve months ended and as of December 31, 2009, Commercial real estate, which represented 49.06% of total loans, accounted for 51.09% of net charge-offs and 58.37% of nonaccrual loans, and commercial loans, which represented 23.07% of total loans, accounted for 21.93% of net charge-offs and 25.77% of nonaccrual loans.

 

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Table 3 – Net Charge-offs and Non-accruals by Loan Type

 

     For the Twelve Months Ended December 31, 2010     As of December 31, 2010  
     Net
Charge-offs
     % of Total Net
Charge-offs
    Nonaccrual
Loans
     % of Total Non-
Accrual Loans
 
     (in thousands)     (in thousands)  

Residential

   $ 2,922         15.67   $ 7,161         17.45

Construction

     —           0.00     64         0.16

Commercial real estate

     9,878         52.98     21,737         52.96

Commercial

     4,859         26.06     11,547         28.14

Consumer finance

     17         0.09     14         0.03

Home equity and improvement

     968         5.19     517         1.26
                                  

Total

   $ 18,644         100.00   $ 41,040         100.00
                                  

 

     For the Twelve Months Ended December 31, 2009     As of December 31, 2009  
     Net
Charge-offs
     % of Total Net
Charge-offs
    Nonaccrual
Loans
     % of Total Non-
Accrual Loans
 
     (in thousands)     (in thousands)  

Residential

   $ 2,176         19.29   $ 5,349         12.99

Construction

     —           0.00     675         1.64

Commercial real estate

     5,761         51.09     24,042         58.37

Commercial

     2,473         21.93     10,615         25.77

Consumer finance

     159         1.41     59         0.14

Home equity and improvement

     708         6.28     451         1.09
                                  

Total

   $ 11,277         100.00   $ 41,191         100.00
                                  

 

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Table 4 – Allowance for Loan Loss Activity

 

     For the Quarter Ended  
     4th 2010      3rd 2010      2nd 2010      1st 2010      4th 2009  
     (dollars in thousands)  

Allowance at beginning of period

   $ 41,343       $ 38,852       $ 38,980       $ 36,547       $ 31,248   

Provision for credit losses

     5,652         5,196         5,440         6,889         8,470   

Charge-offs:

              

Residential

     467         1,164         1,135         326         884   

Commercial real estate

     4,806         688         1,243         3,191         1,912   

Commercial

     388         842         3,153         735         354   

Consumer finance

     55         28         16         25         75   

Home equity and improvement

     363         148         156         399         135   
                                            

Total charge-offs

     6,079         2,870         5,703         4,676         3,360   

Recoveries

     164         165         135         220         189   
                                            

Net charge-offs

     5,915         2,705         5,568         4,456         3,171   
                                            

Ending allowance

   $ 41,080       $ 41,343       $ 38,852       $ 38,980       $ 36,547   
                                            

The following table sets forth information concerning the allocation of First Defiance’s allowance for loan losses by loan categories at the dates indicated.

Table 5 – Allowance for Loan Loss Allocation by Loan Category

 

    December 31, 2010     September 30, 2010     June 30, 2010     March 31, 2010     December 31, 2009  
          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)  

Residential

  $ 5,956        13.46   $ 6,161        13.69   $ 6,585        13.72   $ 6,093        13.92   $ 5,827        13.84

Construction

    73        1.98     189        2.03     214        2.73     717        2.91     221        2.96

Commercial real estate

    22,355        50.14     22,294        49.82     19,939        49.85     19,354        49.98     18,876        49.06

Commercial

    10,871        24.19     10,679        23.89     10,381        22.97     10,672        22.12     9,444        23.07

Consumer

    297        1.49     527        1.74     494        1.83     402        1.99     515        2.07

Home equity and
improvement

    1,528        8.74     1,493        8.83     1,239        8.89     1,742        9.08     1,664        9.00
                                                                               
  $ 41,080        100.00   $ 41,343        100.00   $ 38,852        100.00   $ 38,980        100.00   $ 36,547        100.00
                                                                               

Key Asset Quality Ratio Trends

Table 6 – Key Asset Quality Ratio Trends

 

     4th Qtr  2010     3rd Qtr  2010     2nd Qtr  2010     1st Qtr  2010     4th Qtr  2009  

Allowance for loan losses / loans*

     2.70     2.67     2.47     2.47     2.26

Allowance for loan losses to net charge-offs

     694.51     1,528.39     697.77     874.78     1,152.54

Allowance for loan losses / non-performing assets

     72.54     72.17     72.68     73.05     59.49

Allowance for loan losses / non-performing loans

     87.33     89.56     95.41     96.03     76.29

Non-performing assets / loans plus REO*

     3.70     3.67     3.37     3.36     3.77

Non-performing assets / total assets

     2.78     2.81     2.62     2.59     2.99

Net charge-offs / average loans (annualized)

     1.58     0.70     1.44     1.14     0.79

 

*

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

 

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Loans Acquired with Impairment

Certain loans acquired in the ComBanc, Genoa, and Pavilion acquisitions had evidence that the credit quality of the loan had deteriorated since its origination and in management’s assessment at the acquisition date it was probable that First Defiance would be unable to collect all contractually required payments due. In accordance with FASB ASC Topic 310 Subtopic 30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, these loans were recorded based on management’s estimate of the fair value of the loans. At the acquisition date of January 21, 2005, loans with a contractual receivable of $3.4 million were acquired from ComBanc and were deemed impaired. Those loans were recorded at a net realizable value of $2.0 million. On April 8, 2005, loans with a contractual receivable of $1.5 million were acquired from Genoa and were deemed impaired. Those loans were recorded at a net realizable value of $721,000. On March 14, 2008, loans with a contractual receivable of $6.4 million were acquired from Pavilion and were deemed impaired. Those loans were recorded at a net realizable value of $4.4 million.

As of December 31, 2010, the total contractual receivable for those loans was $3.5 million and the recorded value was $2.2 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 at December 31, 2010 totaled $25.9 million, compared to $32.8 million at December 31, 2009. 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 at December 31, 2010 was $57.6 million compared to $56.6 million at December 31, 2009. The change in goodwill is due to the acquisition of the group medical benefits business line in May 2010 resulting in an addition to goodwill of $971,000. No impairment of goodwill was recorded in 2010 or 2009. Core deposit intangibles and other intangible assets declined $760,000 during 2010 to $6.1 million from $6.9 million at the end of 2009. The change in the core deposit intangibles and other intangibles is due to the recognition of $1.5 million of amortization expense during the year partially offset by addition of $598,000 to the customer relationship intangible asset and $138,000 to the non-compete intangible asset as a result of the May 2010 acquisition mentioned above.

 

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Deposits

Total deposits at December 31, 2010 were $1.575 billion compared to $1.580 billion at December 31, 2009, a decrease of $4.8 million or 0.3%. Non-interest bearing deposits increased $27.6 million or 14.6% and interest bearing deposits decreased $32.4 million or 2.3%. Non-interest bearing checking accounts grew by $27.6 million, money market and interest bearing checking accounts grew by $55.9 million, savings grew by $14.3 million while retail certificates of deposit declined by $97.0 million. Management periodically utilizes the national market for certificates of deposit to supplement its funding needs. The balance of national CD’s decreased to $41.8 million at December 31, 2010, from $47.4 million at December 31, 2009. For more details on the deposit balances in general see Note 12 – Deposits.

Borrowings

FHLB advances totaled $116.9 million at December 31, 2010 compared to $146.9 million at December 31, 2009. The balance at the end of 2010 includes $54.0 million of convertible advances with rates ranging from 2.35% to 5.44%. These advances are all callable by the FHLB, at which point they would convert to a three-month LIBOR advance if not paid off. Those advances have final maturity dates ranging from 2011 to 2018. In addition, First Defiance has advances totaling $27.0 million that are callable by the FHLB only if the three-month LIBOR rate exceeds a strike rate ranging from 7.5% to 8.0%. The rate on those advances ranges from 3.48% to 5.14%. Lastly, First Defiance has $35.9 million of fixed-rate advances with rates ranging from 1.86% to 4.10%. The change in FHLB advances is the result of paying off a $20.0 million LIBOR advance in the first quarter of 2010 and a $10.0 convertible advance in the third quarter of 2010.

First Defiance also has $56.2 million of securities that have been sold at December 31, 2010 with agreements to repurchase, compared to $48.4 million of repurchase funding at December 31, 2009.

In March 2007, the Company issued $15.5 million of Subordinated Debentures. These debentures were issued to an unconsolidated affiliated trust that purchased them with the proceeds from a $15 million issue of trust preferred securities to an outside party. The proceeds of the Subordinated Debentures were used for general corporate purposes. The Subordinated Debentures have a fixed rate equal to 6.441% for the first five years and a floating interest rate based on three-month LIBOR plus 1.50% thereafter. First Defiance also has $20.6 million of subordinated debentures issued in 2005, which have a rate equal to three-month LIBOR plus 1.38%, or 1.67% at December 31, 2010.

Capital Resources

Total shareholders’ equity increased $6.2 million to $240.3 million at December 31, 2010. This increase is primarily the result of the Company’s $8.1 million of net income. This increase was mostly offset by a $1.9 million of preferred stock dividends at December 31, 2010. In 2003, the Company’s Board of Directors authorized the repurchase of 640,000 shares, 93,124 of which remain available for repurchase. During 2010, no shares were repurchased but a total of 250 stock options were exercised by three employees, resulting in a $3,000 increase in shareholders equity. During 2009, no shares were repurchased but a total of 400 stock options were exercised by one employee, resulting in a $5,000 increase in shareholders equity. Participation in the CPP prohibits the Company from buying back any of its common shares during the period it has CPP funds outstanding. Further, the OTS has required First Defiance to obtain OTS approval prior to the repurchase of any of its common stock.

 

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Results of Operations

Summary

First Defiance reported net income of $8.1 million for the year ended December 31, 2010 compared to $7.2 million and $7.4 million for the years ended December 31, 2009 and 2008, respectively. Net income applicable to common shares was $6.1 million in 2010 compared with $5.2 million in 2009 and $7.2 million in 2008. On a diluted per common share basis, First Defiance earned $0.75 in 2010, $0.63 in 2009 and $0.91 in 2008.

First Defiance’s 2010 net income of $8.1 million included $63,000 of acquisition related costs resulting from the Andres O’Neil & Lowe Insurance Agency (“AOL”) acquisition earlier in 2010. The 2009 net income did not include any acquisition related costs. The 2008 net income amount includes $1.1 million of acquisition related costs that were incurred as part of the Pavilion acquisition. These costs included such items as the expense to terminate certain contracts, retention bonuses with key employees and other costs resulting from the acquisition or related transition efforts. After tax, these costs amounted to $726,000, or $0.09 per diluted common share. Excluding these items, core earnings were $8.1 million, $7.2 million and $8.1 million for the years ended December 31, 2010, 2009 and 2008 respectively. On a diluted per share basis, core earnings amounted to $0.75, $0.63 and $1.00 for those same three periods. Management believes that the presentation of the non-GAAP financial measures assists when comparing results period-to-period in a meaningful and consistent manner and provides a better measure of results for First Defiance’s ongoing operations. A reconciliation of GAAP earnings to core earnings is as follows:

 

     Year Ended December 31  
     2010     2009      2008  
     (in thousands)  

GAAP Net Income

   $ 8,108      $ 7,194       $ 7,357   

One-time acquisition related charges

     63        —           1,117   

Tax effect

     (22     —           (391
                         

Core Operating Earnings

   $ 8,149      $ 7,194       $ 8,083   
                         

Basic earnings per common share:

       

GAAP

   $ 0.75      $ 0.64       $ 0.91   
                         

Core Operating Earnings

   $ 0.75      $ 0.64       $ 1.01   
                         

Diluted earnings per common share:

       

GAAP

   $ 0.75      $ 0.63       $ .91   
                         

Core Operating Earnings

   $ 0.75      $ 0.63       $ 1.00   
                         

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.

As demand for new lending opportunities remained soft in 2010, the Company invested some of its liquidity into investment securities. This may continue into 2011 as management deems it appropriate within its liquidity strategy.

Net interest income was $70.2 million for the year ended December 31, 2010 compared to $67.3 million and $62.2 million for the years ended December 31, 2009 and 2008 respectively. The tax-equivalent net interest margin was 3.89%, 3.76% and 3.80% for the years ended December 31, 2010, 2009 and 2008 respectively. The increase in margin between 2009 and 2010 is due to a widening of the interest rate spread, which increased to 3.68% for the year ended December 31, 2010 compared to 3.50% for 2009. The increase in spread between 2009 and 2010 occurred due to interest-earning asset yields

 

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decreasing by 29 basis points (to 5.29% in 2010 from 5.58% in 2009) which was more than offset by the cost of interest bearing liabilities between the two periods decreasing by 47 basis points (to 1.61% in 2010 from 2.08% in 2009).

The decrease in margin between 2008 and 2009 is due to a narrowing of the interest rate spread, which decreased to 3.50% for the year ended December 31, 2009 compared to 3.51% for 2008. The decrease in spread between 2008 and 2009 occurred due to interest-earning asset yields decreasing by 72 basis points (to 5.58% in 2009 from 6.30% in 2008) which was mostly offset by the cost of interest bearing liabilities between the two periods decreasing by 71 basis points (to 2.08% in 2009 from 2.79% in 2008).

Total interest income decreased by $4.7 million or 4.7% to $95.9 million for the year ended December 31, 2010 from $100.6 million for the year ended December 31, 2009. The decrease in interest income was due to a decline in asset yields, mainly as a result of a drop in yields on loans receivable which declined 9 basis points to 5.77% at December 31, 2010. Interest income from loans decreased to $88.6 million for 2010 compared to $93.7 million in 2009 which represents a decline of 5.4%.

During the same period the average balance of investment securities increased to $154.6 million for 2010 from $128.8 million for the year ended December 31, 2009. Interest income from the investment portfolio increased $282,000 from 2009 to 2010. The tax-equivalent yield on the investment portfolio was 4.71% in 2010 compared to 5.23% in 2009. The investment portfolio yield decreased despite a widening of the overall duration of investments to 3.9 years at December 31, 2010 from 4.3 years at December 31, 2009.

Interest expense decreased by $7.6 million in 2010 compared to 2009, to $25.7 million from $33.3 million. This decrease was due to a 47 basis point decline in the average cost of interest-bearing liabilities in 2010 which more than offset the $1.6 million increase in the average balance of those liabilities in 2010. The average balance of interest-bearing deposits increased by $18.5 million at December 31, 2010 compared to December 31, 2009. Interest expense related to interest-bearing deposits was $19.2 million in 2010 and $26.1 million in 2009. Expenses on FHLB advances and other interest bearing funding sources were $4.7 million and $455,000 respectively in 2010 and $5.1 million and $570,000 respectively in 2009. Interest expense recognized by the Company related to subordinated debentures was $1.3 million in 2010 compared to $1.5 million in 2009.

Total interest income decreased by $2.9 million or 2.8% to $100.6 million for the year ended December 31, 2009 from $103.5 million for the year ended December 31, 2008. The decrease in interest income was due to a decline in asset yields, mainly as a result of a drop in yields on loans receivable which declined 53 basis points to 5.86% at December 31, 2009. Interest income from loans decreased to $93.7 million for 2009 compared to $96.5 million in 2008 which represents a decline of 2.9%.

During the same period the average balance of investment securities increased to $128.8 million for 2009 from $118.0 million for the year ended December 31, 2008. Interest income from the investment portfolio increased $17,000 from 2008 to 2009. The tax-equivalent yield on the investment portfolio was 5.23% in 2009 compared to 5.43% in 2008. The investment portfolio yield decreased despite a widening of the overall duration of investments to 4.3 years at December 31, 2009 from 4.0 years at December 31, 2008.

Interest expense decreased by $8.0 million in 2009 compared to 2008, to $33.3 million from $41.3 million. This decrease was due to a 71 basis point decline in the average cost of interest-bearing liabilities in 2009 which more than offset the $119.3 million increase in the average balance of those liabilities in 2009. The average balance of interest-bearing deposits increased by $139.5 million at December 31, 2009 compared to December 31, 2008. Interest expense related to interest-bearing deposits was $26.1 million in 2009 and $31.4 million in 2008. Expenses on FHLB advances and other interest bearing funding sources were $5.1 million and $570,000 respectively in 2009 and $6.4 million and $1.6

 

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million respectively in 2008. Interest expense recognized by the Company related to subordinated debentures was $1.5 million in 2009 compared to $1.9 million in 2008.

The following table shows an analysis of net interest margin on a tax equivalent basis for the years ended December 31, 2010, 2009 and 2008:

Table 7 – Net Interest Margin

 

    Year Ended December 31  
    (In Thousands)  
    2010     2009     2008  
    Average
Balance
    Interest
(1)
    Yield/
Rate
(2)
    Average
Balance
    Interest (1)     Yield/
Rate
    Average
Balance
    Interest (1)     Yield/
Rate
 
    (Dollars in Thousands)  

Interest-Earning Assets:

                 

Loans receivable

  $ 1,538,388      $ 88,775        5.77   $ 1,600,725      $ 93,850        5.86   $ 1,511,877      $ 96,627        6.39

Securities

    154,648        7,151        4.71     128,806        6,773        5.23     117,972        6,548        5.43

Interest-earning deposits

    121,911        303        0.25     71,366        149        0.21     5,383        123        2.28

FHLB stock

    21,375        879        4.11     21,376        955        4.47     20,493        1,062        5.18
                                                                       

Total interest-earning assets

    1,836,322        97,108        5.29     1,822,273        101,727        5.58     1,655,725        104,360        6.30

Non-interest-earning assets

    218,486            202,960            196,620       
                                   

Total Assets

  $ 2,054,808          $ 2,025,233          $ 1,852,345       
                                   

Interest-Bearing Liabilities:

                 

Interest-bearing deposits

  $ 1,389,330      $ 19,222        1.38   $ 1,370,826      $ 26,102        1.90   $ 1,231,363      $ 31,354        2.55

FHLB advances

    127,281        4,711        3.70     146,978        5,114        3.48     160,407        6,375        3.97

Other borrowings

    47,046        455        0.97     44,247        570        1.29     50,962        1,632        3.20

Subordinated debentures

    36,228        1,314        3.63     36,208        1,471        4.06     36,242        1,907        5.26
                                                                       

Total interest-bearing liabilities

    1,599,885        25,702        1.61     1,598,259        33,257        2.08     1,478,974        41,268        2.79

Non-interest bearing demand deposits

    200,864        —            176,513        —            159,452        —       
                                                     

Total including non-interest- bearing demand deposits

    1,800,749        25,702        1.43     1,774,772        33,257        1.87     1,638,426        41,268        2.52

Other non-interest liabilities

    15,264            17,742            23,047       
                                   

Total Liabilities

    1,816,013            1,792,514            1,661,473       

Stockholders’ equity

    238,795            232,719            190,872       
                                   

Total liabilities and stockholders’ equity

  $ 2,054,808          $ 2,025,233          $ 1,852,345       
                                   

Net interest income; interest rate spread (3)

    $ 71,406        3.68     $ 68,470        3.50     $ 63,092        3.51
                                                     

 

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Net interest margin (4)

        3.89 %               3.76           3.80
                                          

Average interest-earning assets to average interest-bearing liabilities

        114.8 %               114.0           112.0
                                          

 

(1)

Interest on certain tax exempt loans (amounting to $274,000, $275,000 and $195,000 in 2010, 2009 and 2008 respectively) and tax-exempt securities ($2.0 million, $1.8 million and $1.4 million in 2009, 2008 and 2007) is not taxable for Federal income tax purposes. The average balance of such loans was $6.1 million, $6.4 million and $4.2 million in 2010, 2009 and 2008 while the average balance of such securities was $47.0 million, $41.9 million and $32.5 million in 2010, 2009 and 2008 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, 2010, the yields earned and rates paid were as follows: loans receivable, 5.69%; securities,4.10%; FHLB stock, 3.84%; total interest-earning assets, 5.52%; deposits, 0.76%; FHLB advances, 3.68%; other borrowings, 1.00%, subordinated debentures, 3.72%; total interest-bearing liabilities, 1.02%; and interest rate spread, 4.50%.

 

(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.

 

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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 have been allocated proportionately to the change due to rate and the change due to volume.

Table 8 – Changes in Interest Rates and Volumes

 

     Year Ended December 31  
     2010 vs. 2009     2009 vs. 2008  
     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

   $ (1,461   $ (3,614   $ (5,075   $ (8,261   $ 5,484      $ (2,777

Securities

     (878     1,256        378        (356     581        225   

Interest-earning deposits

     33        121        154        (206     232        26   

FHLB stock

     (76     —          (76     (151     44        (107
                                                

Total interest-earning assets

   $ (2,382   $ (2,237   $ (4,619   $ (8,974   $ 6,341      $ (2,633
                                                

Interest-Bearing Liabilities

            

Deposits

   $ (7,228   $ 348      $ (6,880   $ (8,526   $ 3,274      $ (5,252

FHLB advances

     312        (715     (403     (754     (507     (1,261

Term notes

     (149     34        (115     (870     (192     (1,062

Subordinated Debentures

     (158     1        (157     (434     (2     (436
                                                

Total interest- bearing liabilities

   $ (7,223   $ (332   $ (7,555   $ (10,584   $ 2,573      $ (8,011
                                                

Increase (decrease) in net interest income

       $ 2,936          $ 5,378   
                        

Provision for Loan Losses First Defiance’s provision for loan losses was $23.2 million for the year ended December 31, 2010 compared to $23.2 million and $12.6 million for the years ended December 31, 2009 and 2008 respectively.

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 assets (including loans which meet the FASB ASC Topic 310 definition of impaired), the amount of assets 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 Management’s Discussion and Analysis and Note 8 to the audited financial statements.

Noninterest IncomeNoninterest income increased by $1.3 million or 4.9% in 2010 to $27.6 million from $26.3 million for the year ended December 31, 2009. That followed an increase of $7.2 million or 37.9% in 2009 from $19.1 million in 2008.

Service fees and other charges decreased to $12.7 million for the year ended December 31, 2010 from $13.5 million for 2009 and $13.3 million for 2008. The decline in income in 2010 mainly related to a new rule issued by the Federal Reserve Board that became effective in the third quarter of 2010. This rule prohibits financial institutions from charging consumers fees for paying overdrafts on automated teller machines and one-time debit card transactions, unless a consumer consents, or opts in, to the

 

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overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumer’s choices. The Company cannot provide any assurance as to the ultimate impact of this rule on the amount of overdraft/insufficient funds charges reported in future periods. The fee income in 2009 related to an increase in customer accounts offset by a change in customer behavior patterns that slightly lowered the per average account fee.

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, or an ATM. To be in good standing, an account must be brought to a positive balance within a 30-day period. 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. Accounts overdrawn for more than 60 days are automatically charged off. Fees are charged as a one-time fee per occurrence 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, 2010 and 2009 related to the overdraft privilege product, net of adjustments to the allowance for uncollectible overdrafts, were $7.3 million and $8.4 million, respectively. Accounts charged off are included in noninterest expense. The allowance for uncollectible overdrafts was $83,000 at December 31, 2010 and $114,000 at December 31, 2009.

Noninterest income also includes gains, losses and impairment on investment securities. In 2010, First Defiance realized a $339,000 net loss on securities compared to a $3.7 million net loss in 2009 and a $3.2 million net loss in 2008. In 2010, 2009 and 2008, First Defiance recognized other-than-temporary impairment (“OTTI”) charges for certain impaired investment securities, where in management’s opinion, the value of the investment will not be recovered. The total OTTI charges in 2010 were $331,000 and losses on sale or call of securities were $8,000. Management recorded $214,000 of OTTI on its investments of three trust preferred collateralized debt obligations (“CDOs”) and a $117,000 write-down of its perpetual preferred securities issued by Fannie Mae and Freddie Mac as a result of management’s analysis of the securities. The Company held nine CDOs at December 31, 2010. Four of those CDOs were written down in full prior to January 1, 2010. The remaining five CDOs have a total amortized cost of $3.8 million at December 31, 2010. Of these five, two, with a total amortized cost of $860,000, were identified as OTTI in prior periods and one with an amortized cost of $902,000 was identified as OTTI during 2010. The final two CDOs, with a total amortized cost of $2.0 million, continue to pay principal and interest payments in accordance with the contractual terms of the securities and no credit loss impairment has been identified in management’s analysis. Therefore, these two CDO investments have not been deemed by management to be OTTI. In 2010, there were 30 securities called or matured and four securities sold, resulting in a net loss of $8,000. The total OTTI charges in 2009 were $3.9 million and gains on sale or call of securities were $284,000. Management recorded $3.9 million of OTTI on its investment of nine CDOs as a result of management’s analysis of the securities. In 2008, a $1.9 million OTTI charge was recorded relating to the perpetual preferred securities issued by Fannie Mae and Freddie Mac. The OTTI was determined by management as a result of the action taken by the U.S. Treasury and the Federal Housing Finance Agency on September 7, 2008, which placed Fannie Mae and Freddie Mac into conservatorship. First Defiance invested $1.0 million each in preferred stock of Fannie Mae and Freddie Mac in January of 2008. Also in 2008, management recorded $1.3 million of OTTI on its investment in the equity notes of three CDOs as a result of management’s analysis

 

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of the securities. In 2009, there were 21 securities called or matured and 13 securities sold, resulting in a net gain of $284,000. There was only a minor amount of sales activity in the investment portfolio in 2008.

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 $7.8 million, $9.7 million and $3.0 million in 2010, 2009 and 2008, respectively. The $1.9 million decrease in 2010 from 2009 is attributable to a $1.7 million decrease in the gain on sale of loans and a $961,000 negative change in the valuation adjustments on mortgage servicing rights which were partially offset by an increase of $259,000 in servicing revenue and a decrease of $530,000 in the amortization of mortgage servicing rights expense. The negative change of $961,000 in servicing rights valuation adjustments was due to a recapture of $353,000 in 2010 compared with a recapture of $1.3 million in 2009. This was driven by a steady increase in market mortgage rates during 2009. This increase in rates decreased the assumed prepayment speed of the mortgage servicing rights. First Defiance originated $388.1 million of residential mortgages for sale into the secondary market in 2010 compared with $513.6 million in 2009. The primary reason for the decrease was the low interest rate environment in the first half of 2009 which led to higher refinance activity. The $6.8 million increase in mortgage banking income in 2009 from 2008 is attributable to a $4.3 million increase in the gain on sale of loans, a $4.0 million positive change in the valuation adjustments on mortgage servicing rights and an increase of $323,000 in servicing revenue which was partially offset by an increase of $1.9 million in the amortization of mortgage servicing rights expense. The positive change of $4.0 million in servicing rights valuation adjustments was due to a recapture of $1.3 million in 2009 compared with an impairment charge of $2.7 million in 2008. This was driven by a steady increase in market mortgage rates during 2009. This increase in rates decreased the assumed prepayment speed of the mortgage servicing rights. First Defiance originated $513.6 million of residential mortgages for sale into the secondary market in 2009 compared with $182.3 million in 2008. The primary reason for the increase was the low interest rate environment in the first half of 2009 which led to higher refinance activity. The balance of the mortgage servicing right valuation allowance stands at $1.1 million at the end of 2010. See Note 9 to the financial statements.

Insurance and investment commission income increased $119,000 or 2.3% in 2010 primarily due to an increase in employee benefits premiums of $469,000 mostly offset by a decline in contingent income of $328,000. Contingent commissions are bonus payments received by First Defiance’s insurance subsidiary for effective underwriting. Insurance and investment commission income declined $475,000 or 8.6% in 2009 primarily due to a decline in contingent income of $353,000 and a decline in property and casualty premiums of $184,000. Contingent commissions are bonus payments received by First Defiance’s insurance subsidiary for effective underwriting. In May 2010, First Insurance acquired a group medical benefits business line from Andres O’Neil & Lowe Insurance Agency.

Noninterest Expense Total noninterest expense for 2010 was $63.5 million compared to $60.5 million for the year ended December 31, 2009 and $57.8 million for the year ended December 31, 2008. The 2010 total includes $63,000 of acquisition related charges and the 2008 total includes $1.1 million of acquisition related charges. Noninterest expense, excluding the acquisition related charges in 2010 and 2008 was $63.4 million and $56.7 million, respectively.

Compensation and benefits decreased $495,000 or 1.8% in 2010 to $27.4 million from $27.9 million in 2009. Compensation declined $813,000 due to the reduction of approximately 17 full time equivalent positions during the year. Throughout 2009 and 2010, the Company has focused on staffing levels and has worked to reduce levels without negatively impacting our level of customer service. Work patterns and volumes did change in 2009 due in large part to the economy and lower levels of commercial lending. This decline was partially offset by an increase of $319,000 in benefits and other associated costs. Occupancy cost decreased $804,000 or 10.2% in 2010 to $7.0 million from $7.9 million in 2009. The Company made the decision to close two branch facilities and relocate a third during the fourth quarter of 2009. The closures were completed in January 2010. The costs associated with these closures were reflected in the fourth quarter of 2009 and recorded in other operating expense. FDIC

 

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insurance costs increased $416,000 or 12.4% to $3.8 million from $3.4 million in 2009. The increase reflects a general increase in premium rates. Data processing increased $368,000 or 8.1% in 2010 to $4.9 million from $4.5 million in 2009. The other noninterest expense category (including acquisition related charges in 2010 and 2008) increased $3.4 million due to credit, collection and OREO charges increasing $2.1 million, legal and consulting increasing $284,000, and $1.3 million of core conversion related costs which were partially offset by a reduction on the loss on the sale of fixed assets of $549,000.

Compensation and benefits decreased $931,000 or 3.2% in 2009 to $27.9 million from $28.8 million in 2008. Compensation declined $1.1 million due to the reduction of approximately 38 full time equivalent positions during the year. The Company has focused on staffing levels and has worked to reduce levels without negatively impacting our level of customer service. Work patterns and volumes did change in 2009 due in large part to the economy and lower levels of commercial lending. This decline was partially offset by an increase of $351,000 in benefits and other associated costs. Occupancy cost increased $368,000 or 4.9% in 2009 to $7.9 million from $7.5 million in 2008. The Company made the decision to close two branch facilities and relocate a third during the fourth quarter of 2009. The closures were completed in the early part of 2010. The costs associated with these closures were reflected in the fourth quarter of 2009 and recorded in other operating expense. FDIC insurance costs increased $2.3 million or 209.6% to $3.4 million from $1.1 million in 2008. The increase reflects a special assessment of $906,000, a general increase in premium rates and the level of premium due to higher balances of insured deposits. Data processing declined $117,000 or 2.5% in 2009 to $4.5 million from $4.7 million in 2008. The other noninterest expense category (including acquisition related charges in 2008) increased $1.1 million due to credit, collection and OREO charges increasing $2.1 million, legal and consulting increasing $586,000, and loss on the sale of fixed assets increasing $562,000 which were offset by a reduction of $1.1 in acquisition costs, a reduction of $992,000 in fraud losses and a reduction of $326,000 in postage and printing charges.

Income Taxes Income taxes amounted to $3.0 million in 2010 compared to $2.7 million in 2009 and $3.5 million in 2008. The effective tax rates for those years were 27.0%, 27.0%, and 32.4%, respectively. The tax rate is lower than the statutory 35% tax rate for the Company mainly because of investments in tax-exempt securities. The earnings on tax-exempt securities are not subject to federal income tax. See Note 19 – Income Taxes in the Notes to the 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.

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 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 $407.7 million at December 31, 2010, which represents 27.0% 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 1.94% at December 31, 2010. There are no other industry concentrations that exceed 10% of the Company’s loan portfolio.

 

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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 $32.2 million, $23.5 million and $22.0 million in 2010, 2009 and 2008, 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 financing activities, as well as proceeds from payment on existing loans and proceeds from maturities of investment securities. On May 10, 2010, First Defiance completed the acquisition of a line of business from Andres O’Neil & Lowe for $1.5 million in cash. On March 14, 2008, First Defiance completed the acquisition of Pavilion, which was purchased with a combination of stock and cash and resulted in a decrease in cash of $23.9 million.

In considering the more typical investing activities, during 2010, $46.8 million and $448,000 was generated from the maturity, pay-downs, calls or sale of available-for-sale investment securities and $53.8 million was provided by a decline in loan growth while $76.4 million was used to purchase available-for-sale investment securities. During 2009, $25.8 million and $6.4 million was generated from the maturity or sale of available-for-sale investment securities, while $35.6 million was used to fund loan growth and $52.6 million was used to purchase available-for-sale investment securities. During 2008, $30.4 million was generated from the maturity of available-for-sale investment securities, while $114.8 million was used to fund loan growth and $31.8 million was used to purchase available-for-sale investment securities.

Principal financing activities include the gathering of deposits, the utilization of FHLB advances, and the sale of securities under agreements to repurchase such securities and borrowings from other banks. For 2010, total deposits decreased by $4.5 million. The amount of deposits acquired from out of market sources decreased in 2010 by $5.6 million. For 2009, total deposits increased by $110.6 million, including $101.4 million of growth in retail deposits. The amount of deposits acquired from out of market sources increased in 2009 by $8.9 million. For 2008, total deposits increased by $42.9 million excluding the deposits acquired in the Pavilion acquisition, including $4.6 million of growth in retail deposits. The amount of deposits acquired from out-of-market sources increased in 2008 by $38.1 million. Also in 2010, securities sold under repurchase arrangements increased by $7.8 million. Also in 2009, Short-term advances from the FHLB decreased by $9.1 million and there were no borrowings on lines of credit from other banks. Also securities sold under repurchase arrangements decreased by $1.1 million. Also in 2008, Short-term advances from the FHLB decreased by $2.2 million and there were no borrowings on lines of credit from other banks. Also securities sold under repurchase arrangements increased by $7.2 million. In 2008, First Defiance issued $37.0 million of preferred stock to the U.S. Treasury. For additional information about cash flows from First Defiance’s operating, investing and financing activities, see the Consolidated Statements of Cash Flows included in the Consolidated Financial Statements.

 

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At December 31, 2010, First Defiance had the following commitments to fund deposit, advance, borrowing obligations and post-retirement benefits:

Table 9 – Contractual Obligations

 

     Maturity Dates by Period at December 31, 2010  

Contractual Obligations

   Total      Less than
1 year
     1-3 years      4-5 years      After 5
years
 
     (In Thousands)  

Certificates of deposit

   $ 658,795       $ 414,520       $ 230,912       $ 12,349       $ 1,014   

FHLB fixed advances including interest (1)

     125,828         38,247         68,909         13,410         5,262   

Subordinated debentures

     36,083         —           —           —           36,083   

Securities sold under repurchase agreements

     56,247         56,247         —           —           —     

Unrecognized tax benefits

     282         141         141         —           —     

Lease obligations

     6,605         536         720         569         4,780   

Post-retirement benefits

     1,570         125         277         308         860   
                                            

Total contractual obligations

   $ 885,410       $ 509,816       $ 300,959       $ 26,636       $ 47,999   
                                            

 

(1)

Includes principal payments of $116,885 and interest payments of $8,943

At December 31, 2010, First Defiance had the following commitments to fund loan or line of credit obligations:

Table 10 – Commitments

 

     Total      Amount of Commitment Expiration by Period  

Commitments

   Amounts
Committed
     Less than
1 year
     1-3 years      4-5 years      After 5
years
 
     (In Thousands)  

Residential real estate loans in process

   $ 11,862       $ 2,548       $ 475       $ 570       $ 8,269   

Commercial loans in process

     6,877         296         1,020         5,560         1   

One-to-four family mortgage loan originations

     23,176         23,176         —           —           —     

Multifamily originations

     2,640         2,640         —           —           —     

Other real estate originations

     21,143         20,798         345         —           —     

Nonmortgage loan originations

     9,484         9,484         —           —           —     

Consumer lines of credit

     106,476         14,023         20,109         21,041         51,303   

Commercial lines of credit

     121,352         116,834         3,518         1,000         —     
                                            

Total loan commitments

     303,010         189,799         25,468         28,171         59,572   

Standby letters of credit

     21,533         16,938         4,211         384         —     
                                            

Total Commitments

   $ 324,543       $ 206,737       $ 29,679       $ 28,555       $ 59,572   
                                            

In addition to the above commitments, at December 31, 2010 First Defiance had commitments to sell $34.7 million of loans to Freddie Mac, Fannie Mae, FHLB of Cincinnati or BB&T Mortgage.

To meet its obligations management can adjust the rate of savings certificates to retain deposits in changing interest rate environments; it can sell or securitize mortgage and non-mortgage loans; and it can turn to other sources of financing including FHLB advances, the Federal Reserve Bank, and brokered certificates of deposit. At December 31, 2010, First Defiance had $29.5 million capacity under its agreements with the FHLB.

First Federal is subject to various capital requirements of the OTS. At December 31, 2010, First Federal had capital ratios that exceeded the standard to be considered “well capitalized.” For additional

 

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information about First Federal’s capital requirements, see Note 18 – Regulatory Matters to the Consolidated December 31, 2010 Financial Statements.

Critical Accounting Policies

First Defiance has established various accounting policies that govern the application of accounting principles generally accepted in the United States in the preparation of its financial statements. The significant accounting policies of First Defiance are described in the footnotes to the consolidated financial statements. Certain accounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of certain assets and liabilities; Management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and estimates, which could have a material impact on the carrying value of assets and liabilities and the results of operations of First Defiance.

Allowance for Loan Losses – First Defiance believes the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in preparation of its consolidated financial statements. In determining the appropriate estimate for the allowance for loan losses, management considers a number of factors relative to both specific credits in the loan portfolio and macro-economic factors relative to the economy of the United States as a whole and the economy of the northwest Ohio, northeast Indiana and southeast Michigan regions in which the Company does business.

Factors relative to specific credits that are considered include a customer’s payment history, a customer’s recent financial performance, an assessment of the value of collateral held, knowledge of the customer’s character, the financial strength and commitment of any guarantors, the existence of any customer or industry concentrations, changes in a customer’s competitive environment and any other issues that may impact a customer’s ability to meet his obligations.

Economic factors that are considered include levels of unemployment and inflation, specific plant or business closings in the Company’s market area, the impact of strikes or other work stoppages, the impact of weather or environmental conditions, especially relative to agricultural borrowers, and other matters that may have an impact on the economy as a whole.

In addition to the identification of specific customers who may be potential credit problems, management considers its historical losses, the results of independent loan reviews, an assessment of the adherence to underwriting standards, the loss experience being reported by other financial institutions operating in the Company’s market area, and other factors in providing for loan losses that have not been specifically classified. While management believes its allowance for loan losses is conservatively determined based on the above factors, it does not believe the allowances to be excessive or unnecessary. Refer to the section titled “Allowance for Loan Losses” and Note 2, Statement of Accounting Policies for a further description of the Company’s estimation process and methodology related to the allowance for loan losses.

Valuation of Mortgage Servicing Rights – First Defiance believes the valuation of mortgage servicing rights is a critical accounting policy that requires significant estimates in preparation of its consolidated financial statements. First Defiance recognizes as separate assets the value of mortgage servicing rights, which are acquired through loan origination activities. First Defiance does not purchase any mortgage servicing rights.

Key assumptions made by management relative to the valuation of mortgage servicing rights include the stratification policy used in valuing servicing, assumptions relative to future prepayments of mortgages, the potential value of any escrow deposits maintained or ancillary income received as a result of the servicing activity and discount rates used to value the present value of a future cash flow stream. In

 

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assessing the value of the mortgage servicing rights portfolio, management utilizes a third party that specializes in valuing servicing portfolios. That third party reviews key assumptions with management prior to completing the valuation. Prepayment speeds are determined based on projected median prepayment speeds for 15 and 30 year mortgage backed securities. Those speeds are then adjusted up or down based on the size of the loan. The discount rate used in this analysis is the pretax yield generally required by purchasers of bulk servicing rights as of the valuation date. The value of mortgage servicing rights is especially vulnerable in a falling interest rate environment. Refer also to the section entitled Mortgage Servicing Rights and Note 2—Statement of Accounting Policies, and Note 9—Mortgage Banking, for a further description of First Defiance’s valuation process, methodology and assumptions along with sensitivity analyses.

Valuation of Securities – First Defiance believes the valuation of certain securities is a critical accounting policy that requires significant estimates in preparation of its consolidated financial statements. This is pertaining to the Company’s investment in certain trust preferred debt obligations securities (“CDOs”). As required by FASB ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other-than-temporary, are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of other-than-temporary impairment that does not relate to the credit losses is recognized in other comprehensive income. The fair value of these CDOs, which are backed by trust preferred securities issued by banks, thrifts and insurance companies, have a fair value of $1.5 million. The market for these securities at December 31, 2010 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which CDOs trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive as no new CDOs have been issued since 2007. There are currently very few market participants who are willing and/or able to transact for these securities.

The market values for these securities (and any securities other than those issued or guaranteed by the U.S. Treasury) are very depressed relative to historical levels. Thus in today’s market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general versus being an indicator of credit problems with a particular issue.

Given the conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, management has determined: 1) The few observable transactions and market quotations that are available are not reliable for the purpose of determining fair value at December 31, 2010; 2) An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of observable inputs will be equally or more representative of fair value than the market approach valuation used at the prior measurement dates and 3) The Company’s CDOs will be classified within Level 3 of the fair value hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

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

 

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Item 7a. Quantitative and Qualitative Disclosures About Market Risk

Asset/Liability Management

A significant portion of the Company’s revenues and net income is derived from net interest income and, accordingly, the Company strives to manage its interest-earning assets and interest-bearing liabilities to generate an appropriate contribution from net interest income. Asset and liability management seeks to control the volatility of the Company’s performance due to changes in interest rates. The Company attempts to achieve an appropriate relationship between rate sensitive assets and rate sensitive liabilities. First Defiance does not presently use off balance sheet derivatives to enhance its risk management.

First Defiance monitors interest rate risk on a monthly basis through simulation analysis that measures the impact changes in interest rates can have on net interest income. The simulation technique analyzes the effect of a presumed 100 basis point shift in interest rates (which is consistent with management’s estimate of the range of potential interest rate fluctuations) and takes into account prepayment speeds on amortizing financial instruments, loan and deposit volumes and rates, non-maturity deposit assumptions and capital requirements. The results of the simulation indicate that in an environment where interest rates rise 100 basis points over a 24 month period, First Defiance’s net interest income would increase by just 2.46% over the base case scenario. It should be noted that other areas of First Defiance’s income statement, such as gains from sales of mortgage loans and amortization of mortgage servicing rights are also impacted by fluctuations in interest rates but are not considered in the simulation of net interest income.

The majority of First Defiance’s lending activities are in non-residential real estate and commercial loan areas. While such loans carry higher credit risk than residential mortgage lending, they tend to be more rate sensitive than residential mortgage loans. The balance of First Defiance’s non-residential and multi-family real estate loan portfolio was $767.0 million, which was split between $137.3 million of fixed-rate loans and $629.7 million of adjustable-rate loans at December 31, 2010. The commercial loan portfolio decreased to $370.0 million, which is split between $125.9 million of fixed-rate loans and $244.1 million of adjustable-rate loans at December 31, 2010. Certain loans classified as adjustable have fixed rates for an initial term that may be as long as five years. The maturities on fixed-rate loans are generally less than seven years. First Defiance also has significant balances of home equity and improvement loans ($133.6 million at December 31, 2010) of which $77.7 million fluctuate with changes in the prime lending rate. Approximately $55.9 million of home equity and improvement loans have fixed rates but the maturities on those loans range from three to five years. First Defiance also has consumer loans ($22.8 million at December 31, 2010) which tend to have a shorter duration than residential mortgage loans. Also, to limit its interest rate risk, as well as to provide liquidity, First Federal sells a majority of its fixed-rate mortgage originations into the secondary market.

In addition to the simulation analysis, First Federal also prepares an “economic value of equity” (“EVE”) analysis. For 2010, this analysis calculates the net present value of First Federal’s assets and liabilities in rate shock environments that range from –400 basis points to +400 basis points. The likelihood of a decrease in interest rates as of December 31, 2010 was considered to be remote given the current interest rate levels and therefore was not included in this analysis. The results of this analysis are reflected in the following table.

 

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Table 11 – Economic Value of Equity Analysis

 

December 31, 2010  
Economic Value of Equity     Economic Value of Equity as % of
Present Value of Assets
 

Change in Rates

    

$ Amount

    

$ Change

   

% Change

    Ratio     Change  
       (Dollars in Thousands)                    
  + 400 bp         264,330         (13,549)        (4.88 %)      13.76     6 bp 
  + 300 bp         269,417         (8,462)        (3.05 %)      13.83     13 bp 
  + 200 bp         272,867         (5,012)        (1.80 %)      13.82     12 bp 
  + 100 bp         276,234         (1,645     (0.59 %)      13.80     10 bp 
  0 bp         277,879         —          —          13.70     —     

 

December 31, 2009  
Economic Value of Equity     Economic Value of Equity as % of
Present Value of Assets
 

Change in Rates

    

$ Amount

    

$ Change

   

% Change

    Ratio     Change  
       (Dollars in Thousands)                    
  + 300 bp         263,012         (9,820     (3.60 %)      13.42     9 bp 
  + 200 bp         267,908         (4,924     (1.80 %)      13.47     14 bp 
  + 100 bp         270,927         (1,905     (0.70 %)      13.43     10 bp 
  0 bp         272,832         —          —          13.33     —     

Based on the above analysis, in the event of a 200 basis point increase in interest rates as of December 31, 2010, First Federal would experience a 1.80% decrease in its economic value of equity. During periods of rising rates, the value of monetary assets declines. Conversely, during periods of falling rates, the value of monetary assets increases. It should be noted that the amount of change in value of specific assets and liabilities due to changes in rates is not the same in a rising rate environment as in a falling rate environment. Based on the EVE analysis, the change in the economic value of equity in both rising and falling rate environments is relatively low because both its assets and liabilities have relatively short durations and the durations are fairly closely matched. The average duration of its assets at December 31, 2010 was 1.21 years while the average duration of its liabilities was 1.44 years.

In evaluating First Federal’s exposure to interest rate risk, certain shortcomings inherent in each of the methods of analysis presented must be considered. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market rates while interest rates on other types of financial instruments may lag behind current changes in market rates. Furthermore, in the event of changes in rates, prepayments and early withdrawal levels could differ significantly from the assumptions in calculating the table and the results therefore may differ from those presented.

 

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Item 8. Financial Statements and Supplementary Data

Management’s Report on Internal Control Over Financial Reporting

The management of First Defiance Financial Corp. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.

Based on our evaluation under the framework in Internal Control – Integrated Framework, management concluded that our internal control over financial reporting was effective as of December 31, 2010.

Crowe Horwath LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued a report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. The report, which expresses an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010, is included below.

 

LOGO   LOGO

William J. Small

 

Donald P. Hileman

Chairman, President and Chief Executive Officer

 

Executive Vice President and Chief Financial Officer

 

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Report of Independent Registered Public Accounting Firm

We have audited the accompanying consolidated statements of financial condition of First Defiance Financial Corp. (the Company) as of December 31, 2010 and 2009 and the related statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2010. We also have audited First Defiance Financial Corp.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Defiance Financial Corp. as of December 31, 2010 and 2009, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, First Defiance Financial Corp. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

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LOGO

Crowe Horwath LLP

South Bend, Indiana

March 1, 2011

 

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First Defiance Financial Corp.

Consolidated Statements of Financial Condition

 

     December 31  
     2010      2009  
     (In Thousands, except share data)  

Assets

     

Cash and cash equivalents:

     

Cash and amounts due from depository institutions

   $ 24,977       $ 29,613   

Interest-bearing deposits

     144,187         91,503   
                 
     169,164         121,116   

Securities available-for-sale, carried at fair value

     165,252         137,458   

Securities held-to-maturity, carried at amortized cost (fair value $865 and $1,958 at December 31, 2010 and 2009 respectively)

     839         1,920   

Loans held for sale

     18,127         10,346   

Loans receivable, net of allowance of $41,080 and $36,547 at December 31, 2010 and 2009, respectively

     1,478,423         1,580,575   

Mortgage servicing rights

     9,477         8,958   

Accrued interest receivable

     6,374         6,851   

Federal Home Loan Bank (FHLB) stock

     21,012         21,376   

Bank owned life insurance

     34,979         30,804   

Premises and equipment

     41,743         43,597   

Real estate and other assets held for sale (REO)

     9,591         13,527   

Goodwill

     57,556         56,585   

Core deposit and other intangibles

     6,128         6,888   

Deferred taxes

     5,805         3,289   

Other assets

     11,047         14,233   
                 

Total assets

   $ 2,035,517       $ 2,057,523   
                 

 

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First Defiance Financial Corp

Consolidated Statements of Financial Condition (continued)

 

     December 31  
     2010     2009  
     (In Thousands, except share data)  

Liabilities and stockholders’ equity

    

Liabilities:

    

Deposits:

    

Noninterest-bearing

   $ 216,699      $ 189,132   

Interest-bearing

     1,358,720        1,391,094   
                

Total

     1,575,419        1,580,226   

Advances from the Federal Home Loan Bank

     116,885        146,927   

Securities sold under agreements to repurchase and other

     56,247        48,398   

Subordinated debentures

     36,083        36,083   

Advance payments by borrowers

     937        665   

Other liabilities

     9,615        11,138   
                

Total liabilities

     1,795,186        1,823,437   

Commitments and Contingent (Note 7)

    

Stockholders’ equity:

    

Preferred stock, $.01 par value per share: 37,000 shares authorized and issued with a liquidation preference of $37,231, net of discount

     36,463        36,293   

Preferred stock, $.01 par value per share:

    

4,963,000 shares authorized; no shares issued

     —          —     

Common stock, $.01 par value per share:

    

25,000,000 shares authorized; 12,739,496 and 12,739,496 shares issued and 8,117,770 and 8,117,520 shares outstanding, respectively

     127        127   

Common stock warrant

     878        878   

Additional paid-in capital

     140,845        140,677   

Accumulated other comprehensive income (loss), net of tax of $(184) and $(85), respectively

     (342     (158

Retained earnings

     134,988        128,900   

Treasury stock, at cost, 4,621,726 and 4,621,976 shares respectively

     (72,628     (72,631
                

Total stockholders’ equity

     240,331        234,086   
                

Total liabilities and stockholders’ equity

   $ 2,035,517      $ 2,057,523   
                

See accompanying notes.

 

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FIRST DEFIANCE FINANCIAL CORP.

Consolidated Statements of Income

(Amounts in Thousands, except per share data)

 

     Years Ended December 31  
     2010     2009     2008  

Interest Income

      

Loans

   $ 88,628      $ 93,702      $ 96,522   

Investment securities:

      

Taxable

     4,070        3,976        4,357   

Tax-exempt

     1,985        1,797        1,399   

Interest-bearing deposits

     303        149        123   

FHLB stock dividends

     879        955        1,062   
                        

Total interest income

     95,865        100,579        103,463   

Interest Expense

      

Deposits

     19,222        26,102        31,354   

Federal Home Loan Bank advances and other

     4,711        5,114        6,375   

Subordinated debentures

     1,314        1,471        1,907   

Securities sold under agreement to repurchase

     455        570        1,632   
                        

Total interest expense

     25,702        33,257        41,268   
                        

Net interest income

     70,163        67,322        62,195   

Provision for loan losses

     23,177        23,232        12,585   
                        

Net interest income after provision for loan losses

     46,986        44,090        49,610   

Noninterest Income

      

Service fees and other charges

     12,740        13,503        13,268   

Mortgage banking income

     7,847        9,747        2,990   

Insurance commissions

     5,140        5,021        5,496   

Gain on sale of non-mortgage loans

     516        264        180   

Gain (loss) on sale or call of securities

     (8     284        22   

Other-than-temporary impairment (OTTI) losses on investment securities

      

Total impairment losses on investment securities

     (367     (4,015     (3,182

Losses recognized in other comprehensive income

     36        75        —     
                        

Net impairment loss recognized in earnings

     (331     (3,940     (3,182

Trust income

     507        415        448   

Income from bank owned life insurance

     1,146        557        323   

Other noninterest income

     33        444        (476
                        

Total noninterest income

     27,590        26,295        19,069   

Noninterest Expense

      

Compensation and benefits

     27,403        27,898        28,829   

Occupancy

     7,048        7,852        7,484   

FDIC insurance

     3,766        3,350        1,082   

Data processing

     4,909        4,541        4,658   

Acquisition related charges

     63        —          1,117   

Other noninterest expense

     20,274        16,883        14,624   
                        

Total noninterest expense

     63,463        60,524        57,794   
                        

Income before income taxes

     11,113        9,861        10,885   

Federal income taxes

     3,005        2,667        3,528   
                        

Net Income

   $ 8,108      $ 7,194      $ 7,357   
                        

Dividends Accrued on Preferred Shares

   $ (1,850   $ (1,850   $ (134

Accretion on Preferred Shares

   $ (170   $ (160   $ (11
                        

Net Income Applicable to Common Shares

   $ 6,088      $ 5,184      $ 7,212   
                        

Earnings per common share:

      

Basic

   $ 0.75      $ 0.64      $ 0.91   

Diluted

   $ 0.75      $ 0.63      $ 0.91   

Dividends declared per common share

   $ —        $ 0.295      $ 0.95   

See accompanying notes

 

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FIRST DEFIANCE FINANCIAL CORP.

Consolidated Statement of Changes in Stockholders’ Equity

(In Thousands, except number of shares)

 

    Preferred
Stock
     Preferred
Stock
Discount
    Common
Stock
     Common
Stock
Warrant
     Treasury
Stock
    Additional
Paid-In
Capital
     Stock
Acquired
by ESOP
    Accumulated
Other
Comprehensive
Income (Loss)
    Retained
Earnings
    Total
Stockholder’s
Equity
 

Balance at December 31, 2007

  $ —         $ —        $ 117       $ —         $ (72,827   $ 112,651       $ (202   $ (415   $ 126,630      $ 165,954   

Comprehensive income:

                       

Net income

    —           —          —           —           —          —           —          —          7,357        7,357   

Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of ($790)

    —           —          —           —           —          —           —          (1,464     —          (1,464

Change in unrealized loss on postretirement benefit, net of tax of ($13)

    —           —          —           —           —          —           —          (25     —          (25
                             

Total comprehensive income

                          5,868   

ESOP shares released

    —           —          —           —           —          351         202        —          —          553   

Stock option expense

    —           —          —           —           —          266         —          —          —          266   

52,486 shares issued under stock option plan, including income tax benefit of $72

    —           —          —           —           824        63         —          —          (46     841   

1,036,861 shares issued in acquisition of Pavilion

    —           —          10         —           —          27,118               27,128   

31,429 common shares acquired for treasury

    —           —          —           —           (635     —           —          —          —          (635

37,000 shares issued to U.S. Treasury CPP

    37,000         (878        —                    —          36,122   

Preferred stock dividends accrued

    —           —          —           —           —          —           —          —          (134     (134

Issuance of common stock warrant

    —           —          —           878         —          —           —          —          —          878   

Accretion on preferred shares

    —           11           —                    (11     —     

Common stock dividends declared

    —           —          —           —           —          —           —          —          (7,682     (7,682
                                                                                   

Balance at December 31, 2008

    37,000         (867     127         878         (72,638     140,449         —          (1,904     126,114        229,159   

Comprehensive income:

                       

Net income

                        7,194        7,194   

Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of $844

                      1,568          1,568   

Change in unrealized gain on postretirement benefit, net of tax of $96

                      178          178   
                             

Total comprehensive income

                          8,940   

Stock option expense

                 228               228   

400 shares issued under stock option plan, with no income tax benefit

               7               (2     5   

Preferred stock dividends accrued

                        (1,850     (1,850

Accretion on preferred shares

       160                       (160     —     

Common stock dividends declared

                        (2,396     (2,396
                                                                                   

Balance at December 31, 2009

  $ 37,000       $ (707   $ 127       $ 878       $ (72,631   $ 140,677       $ —        $ (158   $ 128,900      $ 234,086   

Comprehensive income:

                       

Net income

                        8,108        8,108   

Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of ($235)

                      (436       (436

Change in unrealized gain on postretirement benefit, net of tax of $136

                      252          252   
                             

Total comprehensive income

                          7,924   

Stock option expense

                 168               168   

250 shares issued under stock option plan, with no income tax benefit

               3                 3   

Preferred stock dividends accrued

                        (1,850     (1,850

Accretion on preferred shares

       170                       (170     —     
                                                                                   

Balance at December 31, 2010

  $ 37,000       $ (537   $ 127       $ 878       $ (72,628   $ 140,845       $ —        $ (342   $ 134,988      $ 240,331   
                                                                                   

See accompanying notes

 

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FIRST DEFIANCE FINANCIAL CORP.

Consolidated Statements of Cash Flows

(Amounts in Thousands)

 

     Years Ended December 31  
     2010     2009     2008  

Operating Activities

      

Net income

   $ 8,108      $ 7,194      $ 7,357   

Adjustments to reconcile net income to net cash provided by operating activities:

      

Provision for loan losses

     23,177        23,232        12,585   

Provision for depreciation

     3,403        3,832        3,803   

Net amortization of premium and discounts on loans, securities, deposits and debt obligations

     1,503        170        752   

Amortization of mortgage servicing rights

     2,642        3,171        1,266   

Net impairment (recovery) of mortgage servicing rights

     (353     (1,314     2,676   

Amortization of intangibles

     1,495        1,456        1,458   

Gain on sale of loans

     (7,533     (9,008     (4,575

Loss on sale or disposals of property, plant and equipment

     12        563        —     

Loss on sale or write-down of REO

     4,050        1,627        434   

FHLB stock dividends

     —          —          (754

Release of ESOP shares

     —          —          553   

OTTI losses on investment securities

     331        3,940        3,182   

(Gain) loss on sale of securities

     8        (284     (22

Change in deferred taxes

     (2,417     (4,007     (4,672

Proceeds from sale of loans held for sale

     384,492        518,747        180,072   

Stock option expense

     168        228        266   

Origination of loans held for sale

     (388,064     (513,593     (182,336

Income from bank owned life insurance

     (1,146     (557     (323

Change in interest receivable and other assets

     3,664        (8,541     2,407   

Change in accrued interest and other liabilities

     (1,340     (3,384     (2,122
                        

Net cash provided by operating activities

     32,200        23,472        22,007   

Investing Activities

      

Proceeds from maturities calls and paydowns of held-to-maturity securities

     1,081        175        230   

Proceeds from maturities calls and paydowns of available-for-sale securities

     46,765        25,770        30,416   

Proceeds from sale of available-for-sale securities

     448        6,383        —     

Proceeds from sale of REO

     10,511        7,076        2,796   

Proceeds from sale of office properties and equipment

     1        1,227        27   

Purchases of available-for-sale securities

     (76,439     (52,645     (31,811

Purchases of held-to-maturity securities

     —          (1,210     —     

Purchases of office properties and equipment

     (1,562     (1,763     (4,589

Investment in bank owned life insurance

     (3,757     (1,500     —     

Proceed from insurance death benefit

     728        —          —     

Net cash paid in Andres O’Neil & Lowe acquisition

     (1,500     —          —     

Proceeds from FHLB stock redemption

     364        —          —     

Net cash paid in Pavilion acquisition

     —          —          (23,907

Proceeds from sale of non-mortgage loans

     13,949        8,714        10,707   

Net decrease (increase) in loans receivable

     53,767        (35,598     (114,816
                        

Net cash provided by (used) in investing activities

     44,356        (43,371     (130,947

 

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FIRST DEFIANCE FINANCIAL CORP.

Consolidated Statements of Cash Flows (continued)

(Amounts in Thousands)

 

     Years Ended December 31  
     2010     2009     2008  

Financing Activities

      

Net (decrease) increase in deposits

     (4,468     110,577        42,925   

Repayment of Federal Home Loan Bank long-term advances

     (30,042     (25,040     (16,408

Net decrease in Federal Home Loan Bank short-term advances

     —          (9,100     (2,200

Proceeds from Federal Home Loan Bank long-term advances

     —          25,000        29,000   

Increase (decrease) in securities sold under repurchase agreements

     7,849        (1,056     7,153   

Proceeds from issuance of subordinated debentures

     —          —          —     

Purchase of common stock for treasury

     —          —          (635

Cash dividends paid on common stock

     —          (3,776     (8,137

Cash dividends paid on preferred stock

     (1,850     (1,747     —     

Proceeds from issuance of preferred stock

     —          —          37,000   

Proceeds from exercise of stock options

     3        5        769   

Excess tax benefit from exercise of stock options

     —          —          72   
                        

Net cash (used) provided by financing activities

     (28,508     94,863        89,539   
                        

Increase (decrease) in cash and cash equivalents

     48,048        74,964        (19,401

Cash and cash equivalents at beginning of period

     121,116        46,152        65,553   
                        

Cash and cash equivalents at end of period

   $ 169,164      $ 121,116      $ 46,152   
                        

Supplemental cash flow information:

      

Interest paid

   $ 26,212      $ 34,038      $ 42,433   
                        

Income taxes paid

   $ 5,800      $ 8,800      $ 6,772   
                        

Stock option exercise price paid with common stock

   $ —        $ —        $ 33   
                        

Transfers from loans to other real estate owned and other assets held for sale

   $ 12,147      $ 14,930      $ 6,060   
                        

Transfers from premises and equipment to other real estate owned and other assets held for sale

   $ —        $ 300      $ —     
                        

First Defiance acquired all of the capital stock of Pavilion Bancorp, Inc. for $55.5 million in 2008.

In conjunction with the acquisition, liabilities were assumed as follows:

 

     Pavilion  

Fair value of assets acquired

   $ 287,994   

Purchase price

     55,548   
        

Liabilities assumed

   $ 232,446   
        

See accompanying notes.

 

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Notes to the Consolidated Financial Statements

1. Basis of Presentation

First Defiance Financial Corp. (First Defiance or the Company) is a unitary thrift holding company that conducts business through its two wholly owned subsidiaries, First Federal Bank of the Midwest (First Federal) and First Insurance and Investments, Inc. (First Insurance). All significant intercompany transactions and balances are eliminated in consolidation.

First Federal is primarily engaged in attracting deposits from the general public through its offices and using those and other available sources of funds to originate loans primarily in the counties in which its offices are located. First Federal’s traditional banking activities include originating and servicing residential, commercial and consumer loans and providing a broad range of depository, trust and wealth management services. First Insurance is an insurance agency that does business in the Defiance, Archbold, Bryan and Bowling Green, Ohio areas, offering property and casualty, and group health and life insurance products.

2. Statement of Accounting Policies

Use of Estimates

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

Earnings Per Common Share

Basic earnings per common share is net income applicable to common shares divided by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options, warrants and stock grants. Unreleased shares held by the Company’s Employee Stock Ownership Plan are not included in average shares for purposes of calculating earnings per share. As shares are released for allocation, they are included in the average shares outstanding. Also see Notes 5 and 20.

Comprehensive Income

Comprehensive income (loss) consists of net income and other comprehensive income (loss). Other comprehensive income includes unrealized gains and losses on available-for-sale securities and the net unrecognized actuarial losses and unrecognized prior service costs associated with the Company’s Defined Benefit Postretirement Medical Plan. All items included in other comprehensive income are reported net of tax. See also Notes 3, 6 and 17.

 

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Cash Flows

Cash and cash equivalents include amounts due from banks and overnight investments with the Federal Home Loan Bank (FHLB) and the Federal Reserve Bank (FRB). Cash and amounts due from depository institutions include required balances on hand or on deposit at the FHLB and Federal Reserve of approximately $1,187,000 and $2,130,000, respectively, at December 31, 2010 to meet regulatory reserve and clearing requirements. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions and repurchase agreements.

Investment Securities

Management determines the appropriate classification of debt securities at the time of purchase and evaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity when First Defiance has the positive intent and ability to hold the securities to maturity and are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity.

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, with the unrealized gains and losses, net of tax, reported in other comprehensive income (loss) until realized. Realized gains and losses are included in gains (losses) on securities or other-than-temporary impairment losses on securities. Realized gains and losses on securities sold are recognized on the trade date based on the specific identification method.

Interest income includes amortization of purchase premiums and discounts. Premiums and discounts are amortized on the level-yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are expected. Securities with unrealized losses are reviewed quarterly to determine if value impairment is other–than-temporary. In performing this review management considers the length of time and extent that fair value has been less than cost, the financial condition of the issuer, the impact of changes in market interest rates on market value and whether the Company intends to sell or it would be more than likely required to sell the securities prior to their anticipated recovery.

FHLB Stock

As a member of the FHLB System, First Federal is required to own stock of the FHLB of Cincinnati in an amount principally equal to 0.15% of total assets plus an amount of at least 2% but no more than 4% of its non-grandfathered mission asset activity (as defined in the FHLB’s regulations). First Federal is permitted to own stock in excess of the minimum requirement. FHLB stock is a restricted equity security that does not have a readily determinable fair value and is carried at cost. It is evaluated for impairment based upon the ultimate recovery of par value. Both cash and stock dividends are reported as income. At December 31, 2010, the balance at FHLB of Cincinnati was $19.3 million. First Federal acquired $2.0 of stock from the Pavilion acquisition which is held at the FHLB of Indianapolis and is required to be held for five years from the date of acquisition of March 14, 2008. The balance of this stock was $1.7 million at December 31, 2010.

Loans Receivable

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal amount outstanding, net of deferred loan fees and costs, purchase premiums and discounts and the allowance for loan losses. Deferred fees net of deferred incremental loan origination costs, are amortized to interest income generally over the contractual life of the loan using the interest method without anticipating prepayments. The recorded investment in loans includes accrued interest receivable and net deferred fees and costs.

 

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Mortgage loans originated and intended for sale in the secondary market are classified as loans held for sale and are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Mortgage loans held for sale are generally sold with servicing rights retained. The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right. Gains or losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.

During 2010 and 2009, the Company realized losses totaling $477,000 and $281,000 pertaining to loans sold to Fannie Mae and Freddie Mac but were returned due to underwriting issues. Repurchase losses are recognized when the Company determines they are probable and estimable. No amount was accrued at December 31, 2010 and 2009 for such losses.

Interest receivable is accrued on loans and credited to income as earned. The accrual of interest on loans 90 days delinquent or impaired is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. For these loans, interest accrual is only to the extent cash payments are received. The accrual of interest on these loans is generally resumed after a pattern of repayment has been established and the collection of principal and interest is reasonably assured.

Acquired Loans

Valuation allowances for all acquired loans subject to FASB ASC Topic 310 reflect only those losses incurred after acquisition—that is, the present value of cash flows expected at acquisition that are not expected to be collected.

The Company acquires loans individually and in groups or portfolios. At acquisition, the Company reviews each loan to determine whether there is evidence of deterioration of credit quality since origination and if it is probable that it will be unable to collect all amounts due according to the loan’s contractual terms. If both conditions exist, the Company determines whether each such loan is to be accounted for individually or whether such loans will be assembled into pools of loans based on common risk characteristics (credit score, loan type and date of origination). The Company considers expected prepayments, and estimates the amount and timing of undiscounted expected principal, interest, and other cash flows (expected at acquisition) for each loan and subsequently aggregated pool of loans.

The Company determines the excess of the loan’s or pool’s scheduled contractual principal and contractual interest payments over all cash flows expected at acquisition as an amount that should not be accreted (nonaccretable difference). The remaining amount—representing the excess of the loan’s cash flows expected to be collected over the amount paid—is accreted into interest income over the remaining life of the loan or pool (accretable yield).

Over the life of the loan or pool, the Company continues to estimate cash flows expected to be collected, and evaluates whether the present value of its loans determined using the effective interest rates has decreased and, if so, recognizes a loss. The present value of any subsequent increase in the loan’s or pool’s actual cash flows or cash flows expected to be collected is used first to reverse any existing valuation allowance for that loan or pool. For any remaining increases in cash flows expected to be collected, the Company adjusts the amount of accretable yield recognized on a prospective basis over the loan’s or pool’s remaining life.

 

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Allowance for Loan Losses

The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans, actual loss experience, current economic events in specific industries and geographical areas and other pertinent factors, including general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience and consideration of economic trends, all of which may be susceptible to significant change. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

Loan losses are charged off against the allowance when in management’s estimation it is unlikely that the loan will be collected, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan loss is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors in order to maintain the allowance for loan losses at the level deemed adequate by management. The determination of whether a loan is considered past due or delinquent is based on the contractual payment terms.

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.

A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loans agreement. Loans, for which terms have been modified and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.

The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent two years. Loss experience is adjusted for other economic factors based on the identified risks credit related or trends present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following portfolio segments have been identified: commercial real estate (consisting of multi-family residential and non-residential), commercial, consumer, residential real estate, construction, consumer, and home equity and improvement.

Servicing Rights

Servicing rights are recognized separately when they are acquired through sales of loans. Servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans.

 

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Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. The Company compares the valuation model inputs and results to published industry data in order to validate the model results and assumptions. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.

Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. Changes in valuation allowances are reported with mortgage banking income on the income statement. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.

Servicing fee income, which is reported on the income statement with mortgage banking income, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal, or a fixed amount per loan, and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. Servicing fees, net of amortization of mortgage servicing rights (excluding valuation adjustments) totaled $477,000, $(311,000) and $1.3 million for the years ended December 31, 2010, 2009 and 2008. Late fees and ancillary fees related to loan servicing are not material. See Note 9.

Bank Owned Life Insurance

The Company has purchased life insurance policies on certain key employees. Bank owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.

Premises and Equipment and Long Lived Assets

Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciation and amortization computed principally by the straight-line method over the following estimated useful lives:

 

Buildings and improvements

     20 to 50 years   

Furniture, fixtures and equipment

     3 to 15 years   

Long-lived assets to be held and those to be disposed of and certain intangibles are periodically evaluated for impairment. See Note 10.

Goodwill and Other Intangibles

Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair

 

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value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. The Company has selected November 30 as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on our balance sheet.

Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank, insurance and branch acquisitions. They are initially recorded at fair value and then amortized on an accelerated basis over their estimated lives, which range from five years for non-compete agreements to 10 to 20 years for core deposit and customer relationship intangibles. See Note 11.

Real Estate and Other Assets Held for Sale

Other assets held for sale are comprised of properties acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. These assets are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. Losses arising from the acquisition of such property are charged against the allowance for loan losses at the time of acquisition. These properties are carried at the lower of cost or fair value, less estimated costs to dispose. If fair value declines subsequent to foreclosure, the property is written down against expense. Costs after acquisition are expensed.

Stock Compensation Plans

Compensation cost is recognized for stock options issued to employees and directors, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award. See Note 21.

Fair Value of Financial Instruments

Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales, when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Mortgage Banking Derivatives

Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free standing

 

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derivatives. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest on the loan is locked. The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into, in order to hedge the change in interest rates resulting from its commitments to fund the loans. Changes in fair values of these derivatives are included in mortgage banking income.

Operating Segments

Management considers the following factors in determining the need to disclose separate operating segments: 1) The nature of products and services, which are all financial in nature; 2) The type and class of customer for the products and services; in First Defiance’s case retail customers for retail bank and insurance products and commercial customers for commercial loan, deposit, life, health and property and casualty insurance needs; 3) The methods used to distribute products or provide services; such services are delivered through banking and insurance offices and through bank and insurance customer contact representatives. Retail and commercial customers are frequently targets for both banking and insurance products; 4) The nature of the regulatory environment; both banking and insurance entities are subject to various regulatory bodies and a number of specific regulations.

Quantitative thresholds as stated in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 280, Segment Reporting are monitored. For the year ended December 31, 2010, the reported revenue for First Insurance was 5.1% of total revenue for First Defiance. Total revenue includes net interest income (before provision for loan losses) plus non-interest income. Net income for First Insurance for the year ended December 31, 2010 was 6.0% of consolidated net income. Total assets of First Insurance at December 31, 2010 were 0.4% of total assets. First Insurance does not meet any of the quantitative thresholds of FASB ASC Topic 280. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable segment.

Dividend Restriction

Banking regulations require maintaining certain capital levels and may limit the dividends paid by the savings bank to the holding company. See Note 18 for further details on restrictions.

Loan Commitments and Related Financial Instruments

Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

Loss Contingencies

Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are any such matters that will have a material effect on the financial statements.

Income Taxes

Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts

 

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for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. Realization of deferred tax assets is dependent upon the generation of a sufficient level of future taxable income and recoverable taxes paid in prior years. Although realization is not assured, management believes it is more likely than not that all of the deferred tax assets will be realized.

An effective tax rate of 35% is used to determine after-tax components of other comprehensive income (loss) included in the statements of stockholders’ equity. See Note 19.

A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.

The Company recognizes interest and/or penalties related to income tax matters in income tax expense.

Reclassifications

Some items in the prior year financial statements were reclassified to conform to the current presentation.

Adoption of New Accounting Standards

In July 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-20, Receivables (Topic 310) - Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU 2010-20 requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled debt restructurings will also be required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU became effective for the Company’s financial statements as of December 31, 2010, as it relates to disclosures required as of the end of a reporting period.

 

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3. Comprehensive Income

Comprehensive income consists of net income and other comprehensive income (loss) (“OCI”). Other comprehensive income (loss) includes unrealized gains and losses on securities available-for-sale and the net unrecognized actuarial losses and unrecognized prior services costs associated with the Company’s Defined Benefit Postretirement Medical Plan. All items reported in other comprehensive income (loss) are reported net of tax. Following is a summary of other comprehensive income (loss) for the years ended December 31, 2010, 2009 and 2008:

 

     For the Year Ended December 31  
     2010     2009     2008  
     (In Thousands)  

Net income

   $ 8,108      $ 7,194      $ 7,357   

Change in securities available-for-sale:

      

Other-than-temporary impairment on available-for-sale securities

     (233     (2,155     (3,182

Other-than-temporary impairment on available-for-sale securities associated with credit losses realized in income

     331        3,940        3,182   
                        

Other-than-temporary impairment on available-for-sale securities recorded in OCI

     98        1,785        —     

Unrealized holding gains (losses) on available-for-sale securities arising during the period

     (777     911        (2,232

Reclassification adjustment for (gains) losses realized in income

     8        (284     (22
                        

Net unrealized gains (losses)

     (769     627        (2,254

Income tax effect

     235        (844     (790
                        

Net of tax amount

     (436     1,568        (1,464
                        

Change in unrealized gain on postretirement benefit:

      

Net gain (loss) on defined benefit postretirement medical plan realized during the period

     349        218        (74

Prior service cost added during the period

     —          —          (25

Net amortization and deferral

     39        56        61   
                        

Net gain (loss) activity during the period

     388        274        (38

Income tax effect

     (136     (96     13   
                        

Net of tax amount

     252        178        (25
                        

Total other comprehensive income (loss)

     (184     1,746        (1,489
                        

Comprehensive income

   $ 7,924      $ 8,940      $ 5,868   
                        

 

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The following table summarizes the changes within each classification of accumulated other comprehensive income for the years ended December 31, 2010 and 2009:

 

     Unrealized gains
(losses) on available
for sale securities
    Postretirement
Benefit
    Accumulated
other
comprehensive
income (loss), net
 
     (In Thousands)  

Balance at December 31, 2009

   $ 468      $ (626   $ (158

Other comprehensive income (loss), net

     (436     252        (184
                        

Balance at December 31, 2010

   $ 32      $ (374   $ (342
                        
     Unrealized gains
(losses) on available
for sale securities
    Postretirement
Benefit
    Accumulated
other
comprehensive
income (loss), net
 
     (In Thousands)  

Balance at December 31, 2008

   $ (1,100   $ (804   $ (1,904

Other comprehensive income (loss), net

     1,568        178        1,746   
                        

Balance at December 31, 2009

   $ 468      $ (626   $ (158
                        

4. Acquisitions

On May 10, 2010, First Defiance acquired a group medical benefits line of business from Andres O’Neil & Lowe Insurance Agency (“AOL”) for a cash purchase price of $1.5 million and future consideration to be paid in cash in 2010, 2011 and 2012. As of December 31, 2010, management has determined goodwill of $971,200 and identifiable intangible assets of $735,800 consisting of customer relationship intangible of $597,800, non-compete intangible of $138,000 and a contingent payable of $207,000. Disclosure of pro forma results of this acquisition is not material to the Company’s consolidated financial statements.

 

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5. Earnings Per Common Share

The following table sets forth the computation of basic and diluted earnings per common share:

 

     2010      2009      2008  
     (In Thousands, Except Per Share Amounts)  

Numerator for basic and diluted earnings per common share-net income applicable to common shares

   $ 6,088       $ 5,184       $ 7,212   
                          

Denominator:

        

Denominator for basic earnings per common share-weighted-average common shares

     8,118         8,117         7,889   

Effect of dilutive securities:

        

Employee stock options

     1         1         22   

Warrants

     34         78         8   
                          

Dilutive potential common shares

     35         79         30   
                          

Denominator for diluted earnings per common share

     8,153         8,196         7,919   
                          

Basic earnings per common share

   $ .75       $ .64       $ .91   
                          

Diluted earnings per common share

   $ .75       $ .63       $ .91   
                          

Shares under option of 363,050 in 2010, 412,150 in 2009 and 327,300 in 2008 were excluded from the diluted earnings per common share calculation as they were anti-dilutive.

6. Investment Securities

The following tables summarize the amortized cost and fair value of available-for-sale securities and held-to-maturity investment securities portfolio at December 31, 2010 and 2009 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:

 

     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair Value  
     (In Thousands)  

2010

          

Available-for-sale

          

Obligations of U.S. government corporations and agencies

   $ 11,980       $ 80       $ (75   $ 11,985   

Mortgage-backed securities - residential

     39,561         1,244         (229     40,576   

REMICs

     3,378         163         —          3,541   

Collateralized mortgage obligations

     49,862         1,364         (169     51,057   

Trust preferred stock and preferred stock

     3,787         13         (2,254     1,546   

Corporate bonds

     3,782         15         —          3,797   

Obligations of state and political subdivisions

     52,853         779         (882)        52,750   
                                  

Total Available-for-Sale

   $ 165,203       $ 3,658       $ (3,609   $ 165,252   
                                  

Held-to-Maturity

          

FHLMC certificates

   $ 95       $ 7       $ —        $ 102   

FNMA certificates

     259         6         —          265   

GNMA certificates

     86         3         —          89   

Obligations of states and political subdivisions

     399         10         —          409   
                                  

Total Held-to-Maturity

   $ 839       $ 26       $ —        $ 865   
                                  

 

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     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair Value  
     (In Thousands)  

2009

          

Available-for-sale

          

Obligations of U.S. government corporations and agencies

   $ 14,038       $ 252       $ (39   $ 14,251   

Mortgage-backed securities - residential

     30,341         1,194         (31     31,504   

REMICs

     3,718         205         —          3,923   

Collateralized mortgage obligations

     40,878         824         (331     41,371   

Trust preferred stock and preferred stock

     4,122         —           (2,446     1,676   

Obligations of state and political subdivisions

     43,640         1,251         (158     44,733   
                                  

Total Available-for-Sale

   $ 136,737       $ 3,726       $ (3,005   $ 137,458   
                                  

Held-to-Maturity

          

FHLMC certificates

   $ 119       $ 7       $ —        $ 126   

FNMA certificates

     304         9         —          313   

GNMA certificates

     107         3         —          110   

Obligations of states and political subdivisions

     1,390         19         —          1,409   
                                  

Total Held-to-Maturity

     $1,920         $38         $—          $1,958   
                                  

The amortized cost and fair value of the investment securities portfolio at December 31, 2010 and 2009 are shown below by contractual maturity. Expected maturities will differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. For purpose of the maturity tables below, mortgage-backed securities, collateralized mortgage obligations and REMICs, which are not due at a single maturity date, have not been allocated over maturity groupings. These securities may mature earlier than their weighted-average contractual maturities because of principal prepayments.

 

     Available-for-Sale      Held-to-Maturity  
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
 
     (In Thousands)  

2010

  

Due in one year or less

   $ 2,937       $ 2,970       $ 60       $ 63   

Due after one year through five years

     5,116         5,204         60         67   

Due after five years through ten years

     18,714         19,008         279         279   

Due after ten years

     45,635         42,896         —           —     

MBS/CMO/REMIC

     92,801         95,174         440         456   
                                   
   $ 165,203       $ 165,252       $ 839       $ 865   
                                   

 

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     Available-for-Sale      Held-to-Maturity  
     Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
 
     (In Thousands)  

2009

  

Due in one year or less

   $ 3,079       $ 3,142       $ 960       $ 963   

Due after one year through five years

     11,321         11,584         120         136   

Due after five years through ten years

     8,102         8,319         310         310   

Due after ten years

     39,298         37,615         —           —     

MBS/CMO/REMIC

     74,937         76,798         530         549   
                                   
   $ 136,737       $ 137,458       $ 1,920       $ 1,958   
                                   

Securities pledged at year-end 2010 and 2009 had a carrying amount of $123.8 million and $122.8 million and were pledged to secure public deposits, securities sold under repurchase agreements and FHLB advances.

As of December 31, 2010, the Company’s investment portfolio consisted of 324 securities, 77 of which were in an unrealized loss position.

The following table summarizes First Defiance’s securities that were in an unrealized loss position at December 31, 2010 and December 31, 2009:

 

     Duration of Unrealized Loss Position     Total  
     Less than 12 Months     12 Months or Longer    
     Fair
Value
     Gross
Unrealized
Loss
    Fair
Value
     Gross
Unrealized
Loss
    Fair
Value
     Unrealized
Loses
 
     (In Thousands)  

At December 31, 2010

               

Available-for-sale securities:

               

Obligations of U.S. govt. corps. and agencies

   $ 3,925       $ (75   $ —         $ —        $ 3,925       $ (75

Mortgage-backed securities - residential

     11,876         (229        —           —          11,876         (229

Collateralized mortgage obligations and REMICs

     6,011         (169     —           —          6,011         (169

Obligations of state and political subdivisions

     21,431         (729     1,116         (153     22,547         (882

Trust preferred stock and preferred stock

     —           —          1,498         (2,254     1,498         (2,254
                                                   

Total temporarily impaired securities

   $ 43,243       $ (1,202   $ 2,614       $ (2,407   $ 45,857       $ (3,609
                                                   

At December 31, 2009

          

Available-for-sale securities:

          

Obligations of U.S. govt. corps. and agencies

   $ 1,961       $ (39   $ —         $ —        $ 1,961       $ (39

Mortgage-backed securities - residential

     1,921         (31     —           —          1,921         (31

Collateralized mortgage obligations and REMICs

     12,007         (287     604         (44     12,611         (331

Obligations of state and political subdivisions

     3,879         (55     1,182         (103     5,061         (158

Trust preferred stock and preferred stock

     —           —          1,651         (2,446     1,651         (2,446
                                                   

Total temporarily impaired securities

   $ 19,768       $ (412   $ 3,437       $ (2,593   $ 23,205       $ (3,005
                                                   

 

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

Realized losses from the sales and calls of investment securities totaled $8,000 ($5,000 after tax) in 2010 while there were realized gains of $284,000 and $22,000 ($185,000 and $14,000 after tax) in 2009 and 2008, respectively.

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

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

In 2010, management determined OTTI on three CDOs resulting in a write-down of $214,000 ($139,000 after tax). Also in 2010, management deemed it necessary based on the current economic conditions, to further write-down the perpetual preferred stock of Fannie Mae and Freddie Mac which resulted in a permanent write-down of $117,000 ($76,000 after tax). In 2009, management determined OTTI on nine CDOs resulting in a write-down of $3.9 million ($2.6 million after tax) on impaired investments.

The Company held nine collateralized debt obligations (“CDOs”) at December 31, 2010. Four of those CDOs were written down in full prior to January 1, 2010. The remaining five CDOs have a total amortized cost of $3.8 million at December 31, 2010. Of these, two, with a total amortized cost of $862,000, were identified as OTTI in prior periods and one with an amortized cost of $902,000 was identified as OTTI during 2010. The final two CDOs, with a total amortized cost of $2.0 million, continue to pay principal and interest payments in accordance with the contractual terms of the securities and no credit loss impairment has been identified in management’s analysis. Therefore, these two CDO investments have not been deemed by management to be OTTI. The Company held three additional CDOs at December 31, 2009 with a total amortized cost of $25,000. These CDOs were classified as held for sale at December 31, 2009 and were sold during the first quarter of 2010.

Given the conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, the Company’s CDOs will be classified within Level 3 of the fair

 

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value hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

As required under FASB ASC Topic 320, beginning January 1, 2009, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.

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

Trust Preferred CDOs Discount Rate Methodology

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

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

The Company uses the same methodology for all of its CDOs and believes its valuation methodology is appropriate for all of its CDOs in accordance with FASB ASC Topic 320 as well as other related guidance.

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

 

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The following table details the seven securities with other-than-temporary impairment, their lowest credit rating at December 31, 2010 and the related credit losses recognized in earnings for the four quarters ended March 31, 2010, June 30, 2010, September 30, 2010 and December 31, 2010 (In Thousands):

 

     Preferred
Term VI
Rated Ca
     TPREF
Funding
II

Rated
Caa3
     Alesco
VIII
Rated Ca
     Preferred
Term Sec
XXVII
Rated C
     Trapeza
CDO I
Rated Ca
     Alesco
Preferred
Funding
VIII

Not Rated
     Alesco
Preferred
Funding
IX

Not Rated
     Total  

Amount of OTTI related to credit loss at January 1, 2010

   $ 17       $ 243       $ 1,000       $ —         $ 857       $ 453       $ 465       $ 3,035   

Addition – Qtr 1

     48         —           —           22         —           —           —           70   
                                                                       

Amount of OTTI related to credit loss at March 31, 2010

   $ 65       $ 243       $ 1,000       $ 22       $ 857       $ 453       $ 465       $ 3,105   
                                                                       

Addition – Qtr 2

     —           17         —           54         —           —           —           71   
                                                                       

Amount of OTTI related to credit loss at June 30, 2010

   $ 65       $ 260       $ 1,000       $ 76       $ 857       $ 453       $ 465       $ 3,176   
                                                                       

Addition – Qtr 3

     15         58         —           —           —           —           —           73   
                                                                       

Amount of OTTI related to credit loss at September 30, 2010

   $ 80       $ 318       $ 1,000       $ 76       $ 857       $ 453       $ 465       $ 3,249   
                                                                       

Addition – Qtr 4

     —           —           —           —           —           —           —           —     
                                                                       

Amount of OTTI related to credit loss at December 31, 2010

   $ 80       $ 318       $ 1,000       $ 76       $ 857       $ 453       $ 465       $ 3,249   
                                                                       

In addition to the table above and below, $117,000 of OTTI was recognized relating to the write-down of the preferred stock issued by Fannie Mae and Freddie Mac in the third quarter of 2010.

The amount of OTTI recognized in accumulated other comprehensive income was $1.5 million for the above seven securities at December 31, 2010. There was $1.5 million recognized in accumulated other comprehensive income at December 31, 2009 on nine securities.

The following table provides additional information related to the five CDO investments for which a balance remains as of December 31, 2010 (dollars in thousands):

 

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CDO

   Class      Amortized
Cost
     Fair
Value
     Unrealized
Loss
    OTTI
Losses
2010
    Lowest
Rating
     Current
Number of
Banks and
Insurance
Companies
     Actual
Deferrals
and
Defaults
as a % of
Current
Collateral
    Expected
Deferrals
and Defaults
as a % of
Remaining
Performing
Collateral
    Excess
Sub-ordination
as a % of
Current
Performing
Collateral
 

Preferred Term VI

     Mezz       $ 184       $ 45       $ (139   $ (63     Ca         5         71.33     —       —  

TPREF Funding II

     B         677         283         (394     (75     Caa3         18         37.37     26.28     —     

I-Preferred Term Sec I

     B-1         1,000         512         (488     —          CCC         16         9.04     19.34     24.05

Dekania II CDO

     C-1         989         484         (505     —          CCC         36         —          14.88     30.07

Preferred Term Sec XXVII

     C-1         902         174         (728     (76     C         34         27.07     25.86     1.58
                                                 

Total

      $ 3,752       $ 1,498       $ (2,254   $ (214            
                                                 

The increase in OTTI in 2010 was the result of deterioration in the performance of the underlying collateral. Specifically, depreciation was driven by both realized credit events (i.e. defaults and deferrals) and weakening credit fundamentals in some of the performing collateral, which led to an increased probability of default going forward. Excluding the Preferred Term VI, the Company’s assumed average lifetime default rate declined from 36.1% at the end of 2009 to a rate of 29.7% at the end of 2010.

 

     2010     2009      2008  

Beginning balance, January 1

   $ 2,521      $ 1,281       $ —     

Additions for amounts related to credit loss for which an OTTI was not previously recognized

     76        3,521         1,281   

Reductions for amounts realized for securities sold during the period

     (2,261     —           —     

Reductions for amounts related to securities for which the Company intends to sell or that it will be more likely than not that the Company will be required to sell prior to recovery of amortized cost basis

     —          —           —     

Reductions for increase in cash flows expected to be collected that are

       

Recognized over the remaining life of the security

     —          —           —     

Increases to the amount related to the credit loss for which

       

Other-than-temporary was previously recognized

     138        419         —     
                         

Ending balance, December 31

   $ 474      $ 5,221       $ 1,281   
                         

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

 

     2010     2009     2008  
     (In Thousands)  

Proceeds

   $ 448      $ 6,383      $ —     

Gross realized gains on sales

     —          284        —     

Gross realized losses on sales

     (11     —          —     

Other-than-temporary impairment charges

     (331     (3,940     (3,182

The Company also recognized gross gains of $3,000, $0 and $22,000 on calls during 2010, 2009 and 2008, respectively.

 

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7. Commitments and Contingent Liabilities

Loan Commitments

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

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

The Company’s maximum obligation to extend credit for loan commitments (unfunded loans and unused lines of credit) and standby letters of credit outstanding on December 31 was as follows (in thousands):

 

     2010      2009  
     Fixed Rate      Variable Rate      Fixed Rate      Variable Rate  

Commitments to make loans

   $ 26,382       $ 48,801       $ 29,206       $ 64,243   

Unused lines of credit

     34,735         193,092         36,772         195,692   

Standby letters of credit

     —           21,533         263         21,036   
                                   

Total

   $ 61,117       $ 263,426       $ 66,241       $ 280,971   
                                   

Commitments to make loans are generally made for periods of 60 days or less. The fixed rate loan commitments have interest rates ranging from 3.38% to 13.00% and maturities ranging from less than 1 year to 30 years.

In addition to the above commitments, at December 31, 2010 First Defiance had commitments to sell $34.7 million of loans to Freddie Mac, Fannie Mae, Federal Home Loan Bank of Cincinnati or BB&T Mortgage.

Contingent Receivable

The Company recorded a receivable of approximately $800,000 in 2007 relating to claims from various insurance carriers from incurred losses associated with a former employee. In 2008, $73,000 of this receivable was recovered and $727,000 of this receivable was recorded as an expense due to the denial of the insurance claim under the Company’s fidelity bond. In 2009, an additional $190,000 was recovered through a settlement.

 

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8. Loans Receivable

Loans receivable consist of the following at December 31:

 

     December 31  
     2010     2009  
     (In Thousands)  

Real estate loans:

    

Secured by 1-4 family residential

   $ 205,938      $ 227,592   

Secured by multi-family residential

     120,534        103,169   

Secured by non-residential real estate

     646,478        703,721   

Construction

     30,340        48,625   
                
     1,003,290        1,083,107   

Other loans:

    

Commercial

     369,959        379,408   

Home equity and improvement

     133,593        147,977   

Consumer Finance

     22,848        34,105   
                
     526,400        561,490   
                

Total loans

     1,529,690        1,644,597   

Deduct:

    

Undisbursed loan funds

     (9,267     (26,494

Net deferred loan origination fees and costs

     (920     (981

Allowance for loan losses

     (41,080     (36,547
                

Totals

   $ 1,478,423      $ 1,580,575   
                

Changes in the allowance for loan losses were as follows:

 

     Years Ended December 31  
     2010     2009     2008  
     (In Thousands)  

Allowance at beginning of year

   $ 36,547      $ 24,592      $ 13,890   

Provision for credit losses

     23,177        23,232        12,585   

Acquired in acquisitions

     —          —          4,258   

Charge-offs

     (19,328     (11,826     (6,499

Recoveries

     684        549        358   
                        

Net charge-offs

     18,644        11,277        (6,141
                        

Ending allowance

   $ 41,080      $ 36,547      $ 24,592   
                        

 

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The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2010:

(In Thousands)

 

    1-4 Family
Residential
Real Estate
    Construction     Multi- Family
Residential
Real Estate
    Commercial
Real Estate
    Commercial     Home Equity
& Improvement
    Consumer     Total  

Allowance for loan losses:

               

Ending allowance balance attributable to loans:

               

Individually evaluated for impairment

  $ 1,741      $ 13      $ 230      $ 9,843      $ 4,252      $ 36      $ —        $ 16,115   

Collectively evaluated for impairment

    4,215        60        1,917        9,995        6,509        1,492        297        24,485   

Acquired with deteriorated credit quality

    —          —          —          370        110        —          —          480   
                                                               

Total ending allowance balance

  $ 5,956      $ 73      $ 2,147      $ 20,208      $ 10,871      $ 1,528      $ 297      $ 41,080   
                                                               

Loans:

               

Loans individually evaluated for impairment

  $ 8,994      $ 64      $ 1,333      $ 41,290      $ 17,189      $ 317      $ —        $ 69,187   

Loans collectively evaluated for impairment

    197,296        30,275        119,444        605,882        353,386        133,881        22,942        1,463,106   

Loans acquired with deteriorated credit quality 84

      —          —          1,388        729        —          —          2,201   
                                                               

Total ending loans balance

  $ 206,374      $ 30,339      $ 120,777      $ 648,560      $ 371,304      $ 134,198      $ 22,942      $ 1,534,494   
                                                               

 

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The unpaid principal balance of individually impaired loans were as follows:

 

     Years Ended December 31  
     2010      2009  
     (In Thousands)  

Year-end loans with no allocated allowance for loan losses

   $ 26,771       $ 18,239   

Year-end loans with allocated allowance for loan losses

     44,169         40,585   
                 

Total

   $ 70,940       $ 58,824   

Amount of the allowance for loan losses allocated

   $ 16,595       $ 12,249   

 

     Years Ended December 31  
     2010      2009      2008  
     (In Thousands)  

Average of individually impaired loans during the year

   $ 64,429       $ 38,860       $ 25,682   

Interest income recognized during impairment

     2,237         965         1,055   

Cash-basis interest income recognized

     2,017         913         1,067   

 

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The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2010: (In Thousands)

 

     Unpaid
Principal
Balance
     Recorded
Investment
     Allowance
for Loan
Losses
Allocated
 

With no allowance recorded:

        

Residential Owner Occupied

   $ 1,679       $ 1,685       $ —     

Residential Non Owner Occupied

     3,300         3,311         —     
                          

Total Residential Real Estate

     4,979         4,996         —     

Construction

     —           —           —     

Multi-Family Residential Real Estate

     137         139         —     

CRE Owner Occupied

     4,530         4,534         —     

CRE Non Owner Occupied

     6,909         6,921         —     

Agriculture Land

     2,394         2,401         —     

Other CRE

     1,639         1,645         —     
                          

Total Commercial Real Estate

     15,472         15,501         —     

Commercial Working Capital

     1,713         1,718         —     

Commercial Other

     4,435         4,454         —     
                          

Total Commercial

     6,148         6,172         —     

Consumer

     —           —           —     

Home Equity and Home Improvement

     35         35         —     
                          

Total loans with no allowance recorded

   $ 26,771       $ 26,843       $ —     
                          

With an allowance recorded:

        

Residential Owner Occupied

   $ 800       $ 803       $ 259   

Residential Non Owner Occupied

     3,185         3,195         1,482   
                          

Total Residential Real Estate

     3,985         3,998         1,741   

Construction

     64         64         13   

Multi-Family Residential Real Estate

     1,193         1,194         230   

CRE Owner Occupied

     6,436         6,451         2,860   

CRE Non Owner Occupied

     13,743         13,789         5,554   

Agriculture Land

     315         316         163   

Other CRE

     6,554         6,558         1,636   
                          

Total Commercial Real Estate

     27,048         27,114         10,213   

Commercial Working Capital

     3,658         3,660         1,763   

Commercial Other

     7,940         7,968         2,599   
                          

Total Commercial

     11,598         11,628         4,362   

Consumer

     —           —           —     

Home Equity and Home Improvement

     281         282         36   
                          

Total loans with an allowance recorded

   $ 44,169       $ 44,280       $ 16,595   
                          

Impaired loans have been recognized in conformity with FASB ASC Topic 310. Loans having carrying values of $12.1 million and $14.9 million were transferred to real estate and other assets held for sale in 2010 and 2009, respectively.

 

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The unpaid principal balance of nonaccrual loans and loans past due 90 days still on accrual were as follows:

 

     Years Ended December 31  
     2010      2009  
     (In Thousands)  

Non-accrual loans

   $ 41,040       $ 41,191   

Loans past due over 90 days still on accrual

     —           —     

Troubled Debt Restructurings

     6,001         6,715   
                 

Total Non Performing Loans

   $ 47,041       $ 47,906   

Real estate owned (REO)

     9,591         13,527   
                 

Total Non Performing Assets

   $ 56,632       $ 61,433   
                 

The following table presents the aging of the recorded investment in past due loans as of December 31, 2010 by class of loans: (In Thousands)

 

     Current      30-59
days
     60-89
days
     Non
Accrual
     TDR      Total
Past Due
& TDR
 

Residential Owner Occupied

   $ 106,249       $ 298       $ 1,420       $ 1,933       $ 1,775       $ 5,426   

Residential Non Owner Occupied

     86,680         842         393         5,295         1,489         8,019   
                                                     

Total residential real estate

     192,929         1,140         1,813         7,228         3,264         13,445   

Construction

     30,275         —           —           64         —           64   

Multi-Family

     119,606         257         228         686         —           1,171   

CRE Owner Occupied

     204,590         607         718         5,764         671         7,760   

CRE Non Owner Occupied

     308,278         247         518         7,519         142         8,426   

Agriculture Land

     73,650         108         176         1,971         166         2,421   

Other Commercial Real Estate

     36,378         —           85         5,793         1,179         7,057   
                                                     

Total Commercial Real Estate

     622,896         962         1,497         21,047         2,158         25,664   

Commercial Working Capital

     148,116         —           10         3,287         —           3,297   

Commercial Other

     209,328         413         1595         8,264         291         10,563   
                                                     

Total Commercial

     357,444         413         1,605         11,551         291         13,860   

Consumer

     22,642         233         53         14         —           300   

Home Equity / Home Improvement

     130,281         2,738         335         527         317         3,917   
                                                     

Total Loans

   $ 1,476,073       $ 5,743       $ 5,531       $ 41,117       $ 6,030       $ 58,421   
                                                     

 

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Specific reserves in the amount of $2.3 million and $3.5 million have been allocated to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2010 and 2009. First Defiance is not committed to lend additional funds to customers whose loans have been modified.

Credit Quality Indicators

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

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

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

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

 

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Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of December 31, 2010, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows: (In Thousands)

 

Category

   Pass      Special
Mention
     Substandard      Doubtful      Not
Graded
     Total  

Residential Owner Occupied

   $ 6,462       $ 1,055       $ 5,302       $ 794       $ 98,063       $ 111,676   

Residential Non Owner Occupied

     71,339         4,131         12,279         106         6,843         94,698   
                                                     

Total residential real estate

     77,801         5,186         17,581         900         104,906         206,374   

Construction

     22,794         363         64         —           7,118         30,339   

Multi Family

     111,042         7,089         787         661         1,198         120,777   

CRE Owner Occupied

     174,468         12,308         25,081         295         198         212,350   

CRE Non Owner Occupied

     270,243         12,603         33,663         —           195         316,704   

Agriculture Land

     68,842         2,536         4,693         —           —           76,071   

Other CRE

     26,685         2,654         12,903         —           1,193         43,435   
                                                     

Total Commercial Real Estate

     540,238         30,101         76,340         295         1,586         648,560   

Commercial Working Capital

     113,962         26,206         11,245         —           —           151,413   

Commercial Other

     181,506         14,138         24,247         —           —           219,891   
                                                     

Total Commercial

     295,468         40,344         35,492         —           —           371,304   

Consumer

     —           —           60         56         22,826         22,942   

Home Equity/Improvement

     —           —           852         546         132,800         134,198   
                                                     

Total

   $ 1,047,343       $ 83,083       $ 131,176       $ 2,458       $ 270,434       $ 1,534,494   
                                                     

Certain loans acquired in the Pavilion Bancorp, ComBanc and Genoa acquisitions had evidence that the credit quality of the loan had deteriorated since its origination and in management’s assessment at the acquisition date it was probable that the First Defiance would be unable to collect all contractually required payments due. In accordance with FASB ASC Topic 310 Subtopic 30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, these loans have been recorded based on management’s estimate of the fair value of the loans. Details of these loans are as follows:

 

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     Contractual
Amount
Receivable
    Impairment
Discount
    Recorded
Loan
Receivable
 
     (In Thousands)  

Balance at December 31, 2007

   $ 3,010      $ 1,353      $ 1,657   

Amount recorded for Pavilion Bancorp

     6,362        2,002        4,360   

Principal payments received

     (274     —          (274

Loans charged off

     (234     (234     —     

Loan accretion recorded

     —          (53     53   
                        

Balance at December 31, 2008

     8,864        3,068        5,796   

Principal payments received

     (2,633     —          (2,633

Loans charged off

     (1,110     (1,110     —     

Additional provision for loan loss

     (115     —          (115

Loan accretion recorded

     —          (340     340   
                        

Balance at December 31, 2009

     5,006        1,618        3,388   

Principal payments received

     (1,056     —          (1,056

Loans charged off

     (300     (300     —     

Additional provision for loan loss

     (168     —          (168

Loan accretion recorded

     —          (32     32   
                        

Balance at December 31, 2010

   $ 3,482      $ 1,286      $ 2,196   
                        

Interest income on loans is as follows:

 

     Years Ended December 31  
     2010      2009      2008  
     (In Thousands)  

Commercial and non-residential real-estate loans

   $ 71,547       $ 73,504       $ 73,973   

Residential loans

     7,679         9,446         10,115   

Other loans

     9,402         10,752         12,434   
                          

Totals

   $ 88,628       $ 93,702       $ 96,522   
                          

First Defiance’s loan portfolio is concentrated geographically in its northwest Ohio market area. Management has also identified lending for income-generating rental properties as an industry concentration. Total loans for income generating property totaled $407.7 million at December 31, 2010, which represents 27% of the Company’s loan portfolio. The Company’s loans receivable are primarily to borrowers in the Northwest Ohio, Northeast Indiana or Southeast Michigan areas.

Loans to executive officers, directors, and their affiliates are as follows (in thousands):

 

     Years Ended December 31  
     2010     2009  

Beginning balance

   $ 4,812      $ 5,041   

New loans

     4,599        3,405   

Effect of changes in composition of related parties

     (628     (216

Repayments

     (3,674     (3,418
                

Ending Balance

   $ 5,109      $ 4,812   
                

 

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9. Mortgage Banking

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

 

     Years Ended December 31  
     2010     2009     2008  
     (In Thousands)  

Gain from sale of mortgage loans

   $ 7,017      $ 8,744      $ 4,395   

Mortgage loan servicing revenue (expense):

      

Mortgage loan servicing revenue

     3,119        2,860        2,537   

Amortization of mortgage servicing rights

     (2,642     (3,171     (1,266

Mortgage servicing rights valuation adjustments

     353        1,314        (2,676
                        
     830        1,003        (1,405
                        

Net revenue from sale and servicing of mortgage loans

   $ 7,847      $ 9,747      $ 2,990   
                        

The unpaid principal balance of residential mortgage loans serviced for third parties was $1.3 billion at December 31, 2010 compared to $1.2 billion at December 31, 2009.

Activity for capitalized mortgage servicing rights and the related valuation allowance follows:

 

     Years Ended December 31  
     2010     2009     2008  
     (In Thousands)  

Mortgage servicing assets:

      

Balance at beginning of period

   $ 10,436      $ 9,403      $ 6,089   

Loans sold, servicing retained

     2,808        4,204        1,450   

Servicing assets acquired

     —          —          3,130   

Amortization

     (2,642     (3,171     (1,266
                        

Carrying value before valuation allowance at end of period

     10,602        10,436        9,403   

Valuation allowance:

      

Balance at beginning of period

     (1,478     (2,792     (116

Impairment recovery (charges)

     353        1,314        (2,676
                        

Balance at end of period

     (1,125     (1,478     (2,792
                        

Net carrying value of MSRs at end of period

   $ 9,477      $ 8,958      $ 6,611   
                        

Fair value of MSRs at end of period

   $ 9,477      $ 8,958      $ 6,611   
                        

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

The Company’s servicing portfolio is comprised of the following:

 

     December 31  
     2010      2009  
     Number of      Principal      Number of      Principal  

Investor

   Loans      Outstanding      Loans      Outstanding  
     (Dollars in Thousands)  

Fannie Mae

     5,053       $ 513,076         5,071       $ 520,959   

Freddie Mac

     8,195         722,000         7,760         656,680   

Federal Home Loan Bank

     303         38,529         310         41,903   

Other

     29         1,575         38         2,013   
                                   

Totals

     13,580       $ 1,275,180         13,179       $ 1,221,555   
                                   

 

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Custodial escrow balances maintained in connection with serviced loans were $8,509,000 and $7,524,000 at December 31, 2010 and 2009, respectively.

Significant assumptions at December 31, 2010 used in determining the value of MSRs include a weighted average prepayment rate of 283 PSA and a weighted average discount rate of 9.00%. Significant assumptions at December 31, 2009 used in determining the value of MSRs include a weighted average prepayment rate of 245 PSA and a weighted average discount rate of 9.00%.

A sensitivity analysis of the current fair value to immediate 10% and 20% adverse changes in those assumptions as of December 31, 2010 is presented below. These sensitivities are hypothetical. Changes in fair value based on 10% and 20% variation in assumptions generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the MSR is calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, changes in mortgage interest rates, which drive changes in prepayment rate estimates, could result in changes in the discount rates), which might magnify or counteract the sensitivities.

 

     10% Adverse
Change
     20% Adverse
Change
 
     (Dollars in Thousands)  

Assumption:

     

Decline in fair value from increase in prepayment rate

   $ 408       $ 786   

Declines in fair value from increase in discount rate

     282         534   

10. Premises and Equipment

Premises and equipment are summarized as follows:

 

     December 31  
     2010      2009  
     (In Thousands)  

Cost:

     

Land

   $ 6,836       $ 6,836   

Land improvements

     1,269         1,269   

Buildings

     38,529         38,529   

Leasehold improvements

     582         582   

Furniture, fixtures and equipment

     25,227         23,987   

Construction in process

     345         63   
                 
     72,788         71,266   

Less allowances for depreciation and amortization

     31,045         27,669   
                 
   $ 41,743       $ 43,597   
                 

Depreciation expense was $3.4 million, $3.8 million and $3.8 million for the years ended December 31, 2010, 2009 and 2008, respectively.

Lease Agreements

The Company has entered into lease agreements covering First Insurance’s main office and Bowling Green, Ohio office, three banking center locations, two land leases for which the Company owns the banking centers, one land lease which is primarily used for parking, one land lease for future branch

 

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development and numerous stand-alone Automated Teller Machine sites with varying terms and options to renew.

Future minimum commitments under non-cancelable operating leases are as follows (in thousands):

 

2011

   $ 536   

2012

     419   

2013

     301   

2014

     285   

2015

     284   

Thereafter

     4,780   
        

Total

   $ 6,605   
        

Rentals under operating leases amounted to $465,000, $504,000 and $444,000, in 2010, 2009, and 2008, respectively.

11. Goodwill and Intangible Assets

Goodwill

The change in the carrying amount of goodwill for the year is as follows:

 

     December 31  
     2010      2009      2008  
     (In Thousands)  

Beginning balance

   $ 56,585       $ 56,585       $ 36,820   

Goodwill acquired or adjusted during the year

     971         —           19,765   
                          

Ending balance

   $ 57,556       $ 56,585       $ 56,585   
                          

Acquired Intangible Assets

Activity in intangibles for the years ended December 31, 2010 and 2009 was as follows:

 

     Gross
Carrying
Amount
     Accumulated
Amortization
    Net
Value
 
     (In Thousands)  

Balance as of January 1, 2009

   $ 12,102       $ (3,758   $ 8,344   

Amortization of intangible assets

     —           (1,456     (1,456
                         

Balance as of December 31, 2009

     12,102         (5,214     6,888   

Intangible assets acquired

     735         —          735   

Amortization of intangible assets

     —           (1,495     (1,495
                         

Balance as of December 31, 2010

   $ 12,837       $ (6,709   $ 6,128   
                         

Aggregate amortization expense was $1,495,000, $1,456,000 and $1,458,000 for 2010, 2009 and 2008 respectively.

 

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Estimated amortization expense for each of the next five years and thereafter (in thousands) is as follows:

 

2011

   $ 1,295   

2012

     1,136   

2013

     983   

2014

     860   

2015

     481   

Thereafter

     1,373   
        

Total

   $ 6,128   
        

12. Deposits

The following schedule sets forth interest expense by type of deposit:

 

     Years Ended December 31  
     2010      2009      2008  
     (In Thousands)  

Checking and money market accounts

   $ 3,117       $ 3,439       $ 4,876   

Savings accounts

     362         460         1,376   

Certificates of deposit

     15,743         22,203         25,102   
                          

Totals

   $ 19,222       $ 26,102       $ 31,354   
                          

Accrued interest payable on deposit accounts amounted to $251,000 and $713,000 December 31, 2010 and 2009, respectively, which was comprised of $211,000 and $40,000 for certificates of deposit and checking and money market accounts, respectively, at December 31, 2010 and $665,000 and $48,000 for certificates of deposit and checking and money market accounts, respectively, at December 31, 2009.

A summary of deposit balances is as follows:

 

     December 31  
     2010      2009  
     (In Thousands)  

Non-interest bearing checking accounts

   $ 216,699       $ 189,132   

Interest bearing checking and money market accounts

     555,434         499,575   

Savings deposits

     144,491         130,156   

Retail certificates of deposit less than $100,000

     465,774         550,710   

Retail certificates of deposit greater than $100,000

     151,258         163,300   

Brokered or national certificates of deposit

     41,763         47,353   
                 
   $ 1,575,419       $ 1,580,226   
                 

Scheduled maturities of certificates of deposit at December 31, 2010 are as follows (in thousands):

 

2011

   $ 414,520   

2012

     142,228   

2013

     88,684   

2014

     10,981   

2015

     1,368   

2016 and thereafter

     1,014   
        

Total

   $ 658,795   
        

At December 31, 2010 and 2009, deposits of $604.6 million and $543.3 million, respectively, were in excess of $100,000. Of these same deposits at December 31, 2010 and 2009, deposits of $267.7 million and $229.5 million, respectively, were in excess of the $250,000 FDIC insurance limit. At December 31, 2010 and 2009, $51.3 million and $56.2 million, respectively, in investment securities were pledged as collateral against public deposits for certificates in excess of $100,000 and an additional $72.5 million

 

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and $66.6 million of securities were pledged at December 31, 2010 and December 31, 2009, respectively, as collateral against deposits from private entities in excess of $100,000.

13. Advances from Federal Home Loan Bank

First Federal has the ability to borrow funds from the FHLB. First Federal pledges its single-family residential mortgage loan portfolio, certain investment securities, certain first mortgage home equity loans, certain multi-family or non-residential real estate loans, and certain agriculture real estate loans as security for these advances. Advances secured by investment securities must have collateral of at least 105% of the borrowing. Advances secured by residential mortgages must have collateral of at least 125% of the borrowings. Advances secured by multi-family or non-residential real estate loans, and agriculture real estate loans must have 300% collateral coverage. The total level of borrowing is also limited to 50% of total assets and at least 50% of the borrowings must be secured by either one-to-four family residential mortgages or investment securities. Total loans pledged to the FHLB at December 31, 2010 and December 31, 2009 were $632.9 million and $662.9 million, respectively. First Federal may obtain advances of up to approximately $156.7 million from the FHLB at December 31, 2010.

At year-end, advances from the FHLB were as follows:

 

Principal Terms

   Advance
Amount
    

Range of Maturities

   Weighted
Average

Interest
Rate
 
(in Thousands)  

December 31, 2010

  

     

Short-term borrowings

   $ —        

Overnight

     0.00

Single maturity fixed rate advances

     35,000      

January 2011 to October 2013

     2.39

Putable advances

     54,000      

February 2011 to March 2018

     4.26

Strike-rate advances

     27,000      

March 2011 to February 2013

     4.18

Amortizable mortgage advances

     885      

December 2015

     4.10
              
   $ 116,885         
              

December 31, 2009

        

Short-term borrowings

   $ —        

Overnight

     0.00

Single maturity fixed rate advances

     35,000      

January 2011 to October 2013

     2.39

Single maturity LIBOR based advances

     20,000      

March 2011

     0.26

Putable advances

     64,000      

September 2010 to March 2018

     4.50

Strike-rate advances

     27,000      

March 2011 to February 2013

     4.18

Amortizable mortgage advances

     927      

December 2015

     4.10
              
   $ 146,927         
              

Putable advances are callable at the option of the FHLB on a quarterly basis. Strike rate advances are callable at the option of the FHLB only when three-month LIBOR rates exceed the agreed upon strike rate in the advance contract. Such strike rates range from 7.5% to 8.0%. When called, First Defiance has the option of paying off these advances or converting them to variable rate advances at the three month LIBOR rate.

 

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Estimated future minimum payments by fiscal year based on maturity date and current interest rates are as follows (in thousands):

 

2011

   $ 38,247   

2012

     15,023   

2013

     53,886   

2014

     553   

2015

     12,857   

Thereafter

     5,262   
        

Total minimum payments

     125,828   

Less amounts representing interest

     8,943   
        

Totals

   $ 116,885   
        

First Defiance also utilizes short-term advances from the FHLB to meet cash flow needs and for short-term investment purposes. First Defiance borrows short-term advances under a variety of programs at FHLB. At December 31, 2010 and December 31, 2009, there were no amounts outstanding under First Defiance’s Cash Management Advance line of credit. The total available under this line is $15.0 million. In addition, First Defiance has a $100.0 million REPO Advance line of credit available. There were no borrowings against this line at December 31, 2010 and December 31, 2009. Amounts are generally borrowed under the Cash Management and REPO lines on an overnight basis.

Amounts available under the various lines are also subject to the Company’s overall borrowing limitations. Information concerning short-term advances is summarized as follows:

 

     Years Ended December 31  
     2010     2009  
     (In Thousands, Except Percentages)  

Average daily balance during the year

   $ 0      $ 33   

Maximum month-end balance during the year

     0        0   

Average interest rate during the year

     0.00     0.84

14. Junior Subordinated Debentures Owed to Unconsolidated Subsidiary Trust

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

The Trust Preferred Securities issued by Trust Affiliate II are subject to mandatory redemption, in whole or part, upon repayment of the Subordinated Debentures. The Company has 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

 

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may be redeemed at the Company’s option at any time on or after June 15, 2012, or at any time upon certain events.

The Company also sponsors an affiliated trust, First Defiance Statutory Trust I (Trust Affiliate I), that issued $20 million of Trust Preferred Securities in 2005. In connection with this transaction, the Company issued $20.6 million of Subordinated Debentures to Trust Affiliate I. Trust Affiliate I was formed for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Junior Debentures held by Trust Affiliate I are the sole assets of the trust. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the Trust Preferred Securities issued by Trust Affiliate I are payable quarterly at a variable rate equal to the three-month LIBOR rate plus 1.38%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate I was 1.67% and 1.63% as of December 31, 2010 and 2009 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 has 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 Junior Debentures mature December 15, 2035 but may be redeemed by the issuer at par after October 28, 2010.

Due to the Company’s participation in the U.S. Treasury’s CPP, permission must be obtained from the U.S. Treasury in order to call these securities.

A summary of all junior subordinated debentures issued by the Company to affiliates follows. These amounts represent the par value of the obligations owed to these affiliates, including the Company’s equity interest in the trusts. Junior subordinated debentures owed to the following affiliates were as follows:

 

     December 31  
     2010      2009  

First Defiance Statutory Trust I due December 2035

   $ 20,619       $ 20,619   

First Defiance Statutory Trust II due June 2037

     15,464         15,464   
                 

Total junior subordinated debentures owed to unconsolidated subsidiary Trusts

   $ 36,083       $ 36,083   
                 

Interest on both issues of Trust Preferred Securities may be deferred for a period of up to five years at the option of the issuer.

 

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15. Notes Payable and Other Short-term Borrowings

Total short-term borrowings, revolving and term debt is summarized as follows:

 

     Years Ended December 31  
     2010     2009  
     (In Thousands, Except Percentages)  

Securities sold under agreement to repurchase

    

Amounts outstanding at year-end

   $ 56,247      $ 48,398   

Year-end interest rate

     0.98     1.05

Average daily balance during year

     47,088        44,287   

Maximum month-end balance during the year

     56,247        50,920   

Average interest rate during the year

     0.97     1.29

Revolving line of credit facilities to financial institutions

    

Average daily balance during year

   $ —        $ —     

Maximum month-end balance during the year

     —          —     

Average interest rate during the year

     —       —  

As of December 31, 2010, First Defiance had no line of credit facilities available for short-term borrowing purposes; all previous lines of credit have expired.

During 2009, First Defiance had the following line of credit facilities expire:

A $20 million fed funds line of credit with a financial institution. The line was unsecured and had an interest rate of the institution’s fed funds rate. The line of credit had no activity in 2009 and expired on January 31, 2009

Further, the Company has agreed with its primary regulator not to incur, issue, renew or roll-over any debt, increase any current lines of credit, or guarantee the debt of any entity without the OTS’s prior approval.

16. Other Non-Interest Expense

The following is a summary of other non-interest expense:

 

     Years Ended December 31  
     2010      2009      2008  
     (In Thousands)  

Legal and other professional fees

   $ 3,045       $ 2,486       $ 1,933   

Marketing

     1,191         1,293         1,896   

State franchise taxes

     2,088         1,994         1,951   

REO expenses and write-downs

     4,324         2,245         583   

Printing and office supplies

     529         569         776   

Amortization of intangibles

     1,495         1,456         1,459   

Postage

     668         650         768   

Check charge-offs and fraud losses

     407         128         1,120   

Overdraft protection expense

     15         15         123   

Credit and collection expense

     1,149         1,117         676   

Other

     5,363         4,930         3,339   
                          

Total other non-interest expense

   $ 20,274       $ 16,883       $ 14,624   
                          

 

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17. Postretirement Benefits

First Defiance sponsors a defined benefit postretirement plan that is intended to supplement Medicare coverage for certain retirees who meet minimum age requirements. First Federal employees who retired prior to April 1, 1997 who completed 20 years of service after age 40 receive full medical coverage at no cost. Such coverage continues for surviving spouses of those participants for one year, after which coverage may be continued provided the spouse pays 50% of the average cost. First Federal employees retiring after April 1, 1997 are provided medical benefits at a cost based on their combined age and years of service at retirement. Surviving spouses are also eligible for continued coverage after the retiree is deceased at a subsidy level that is 10% less than what the retiree is eligible for. First Federal employees retiring before July 1, 1997 receive dental and vision care in addition to medical coverage. First Federal employees who retire after July 1, 1997 are not eligible for dental or vision care, but those retirees and their spouses each receive up to $200 annually in a medical spending account. Funds in that account may be used for payment of uninsured medical expenses.

First Federal employees who were born after December 31, 1950 are not eligible for the medical coverage described above at retirement. Rather, a medical spending account of up to $10,000 (based on the participant’s age and years of service) will be established to reimburse medical expenses for those individuals. First Insurance employees who were born before December 31, 1950 can continue coverage until they reach age 65, or in lieu of continuing coverage, can elect the medical spending account option, subject to eligibility requirements. Employees hired or acquired after January 1, 2003 are eligible only for the medical spending account option.

Included in accumulated other comprehensive income at December 31, 2010 and 2009 are the following amounts that have not yet been recognized in net periodic benefit cost:

 

     December 31  
     2010     2009  
     (In Thousands)  

Unrecognized prior service cost

   $ 56      $ 66   

Unrecognized actuarial losses

     519        898   
                

Total recognized in Accumulated Other Comprehensive Income

     575        964   

Income tax effect

     (201     (337
                

Net amount recognized in Accumulated Other Comprehensive Income

   $ 374      $ 627   
                

The prior service cost and actuarial loss included in other comprehensive income and expected to be recognized in net postretirement benefit cost during the fiscal year-ended December 31, 2011 is $15,000 ($9,750 net of tax) and $10,000 ($6,500 net of tax), respectively.

 

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Reconciliation of Funded Status and Accumulated Benefit Obligation

The plan is not currently funded. The following table summarizes benefit obligation and plan asset activity for the plan measured as of December 31 each year:

 

     December 31  
     2010     2009  
     (In Thousands)  

Change in benefit obligation:

    

Benefit obligation at beginning of year

   $ 2,734      $ 2,853   

Service cost

     73        60   

Interest cost

     146        166   

Participant contribution

     14        27   

Plan amendments

     —          —     

Actuarial (gains) / losses

     (349     (218

Acquisition

     —          —     

Benefits paid

     (121     (154
                

Benefit obligation at end of year

     2,497        2,734   

Change in fair value of plan assets:

    

Balance at beginning of year

     —          —     

Employer contribution

     107        127   

Participant contribution

     14        27   

Benefits paid

     (121     (154
                

Balance at end of year

     —          —     
                

Funded status at end of year

   $ (2,497   $ (2,734
                

Net periodic postretirement benefit cost includes the following components:

 

     Years Ended December 31  
     2010     2009     2008  
     (In Thousands)  

Service cost-benefits attributable to service during the period

   $ 73      $ 60      $ 57   

Interest cost on accumulated postretirement benefit obligation

     146        166        159   

Net amortization and deferral

     39        56        61   
                        

Net periodic postretirement benefit cost

     258        282        277   

Net (gain) / loss during the year

     (349     (218     74   

Prior service cost added during the year

     —          —          25   

Amortization of prior service cost and actuarial losses

     (39     (56     (61
                        

Total recognized in comprehensive income

     (388     (274     38   
                        

Total recognized in net periodic postretirement benefit cost and other comprehensive income

   $ (130   $ 8      $ 315   
                        

The following assumptions were used in determining the components of the postretirement benefit obligation:

 

     2010     2009  

Weighted average discount rates:

    

Used to determine benefit obligations at December 31

     5.25     5.70

Used to determine net periodic postretirement benefit cost for years ended December 31

     5.70     6.00

Assumed health care cost trend rates at December 31:

    

Health care cost trend rate assumed for next year

     8.00     8.50

Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)

     4.00     4.00

Year that rate reaches ultimate trend rate

     2019        2019   

 

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The following benefits are expected to be paid over the next five years and in aggregate for the next five years thereafter. Because the plan is unfunded, the expected net benefits to be paid and the estimated Company contributions are the same amount.

 

     Expected to be Paid  
     (In Thousands)  

2011

   $ 125   

2012

     138   

2013

     139   

2014

     154   

2015

     154   

2016 through 2020

     860   

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effect:

 

     One-Percentage-Point
Increase
     One-Percentage-Point
Decrease
 
     Year Ended December 31      Year Ended December 31  
     2010      2009      2010     2009  
     (In Thousands)  

Effect on total of service and interest cost

   $ 28       $ 34       $ (24   $ (29

Effect on postretirement benefit obligation

     288         351         (247     (299

The Company expects to contribute $125,000 before reflecting expected Medicare retiree drug subsidy payments in 2011.

18. Regulatory Matters

First Federal is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, First Federal must meet specific capital guidelines that involve quantitative measures of First Federal’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. First Federal’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require First Federal to maintain minimum amounts and ratios of Tier I and total capital to risk-weighted assets and of Tier I capital to average assets. As of December 31, 2010 and 2009, First Federal meets all capital adequacy requirements to which it is subject and the most recent notification from the OTS categorized First Federal as well-capitalized under the regulatory framework. There are no conditions or events since these notifications that management believes have changed any of the well-capitalized categorizations of First Federal. The following schedule presents First Federal’s regulatory capital ratios:

 

     Actual     Required for Capital
Adequacy Purposes
    Required to be
Well Capitalized
 
     Amount      Ratio     Amount      Ratio     Amount      Ratio  

As of December 31, 2010

               

Tangible Capital

   $ 213,625         10.81   $ 29,646         1.50     N/A         N/A   

Tier 1 (Core) Capital

     213,625         10.81     79,055         4.00   $ 98,819         5.00

Tier 1 Capital to risk-weighted assets

     213,625         12.84     66,571         4.00     99,856         6.00

Risk-Based Capital

     234,576         14.09     133,141         8.00     166,426         10.00

As of December 31, 2009

               

Tangible Capital

   $ 207,554         10.40   $ 29,937         1.50     N/A         N/A   

 

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Tier 1 (Core) Capital

     207,554         10.40     79,831         4.00   $ 99,789         5.00

Tier 1 Capital to risk-weighted assets

     207,554         11.78     70,455         4.00     105,683         6.00

Risk-Based Capital

     229,649         13.04     140,910         8.00     176,138         10.00

First Defiance is a unitary thrift holding company and is regulated by the OTS. The OTS does not have defined capital requirements for unitary thrift holding companies.

Dividend Restrictions – Dividends paid by First Federal to First Defiance are subject to various regulatory restrictions. First Federal paid $4.8 million in dividends in 2010 and $5.4 million in dividends in 2009. First Federal can initiate dividend payments equal to its net profits (as defined by statute) for 2009 and 2010 plus 2011 net profits. During 2011, First Federal could declare dividends of approximately $7.3 million plus 2011 net profits to First Defiance. First Federal must receive approval from the OTS prior to the payment of any such dividend, and it may apply to the OTS to pay total dividends that exceed an amount equal to its 2009 to 2011 net profits. First Insurance paid dividends of $1.0 million to First Defiance in 2010 and $700,000 in dividends in 2009.

As a result of its participation in the CPP, First Defiance is prohibited without prior approval of the U.S. Treasury, from paying a quarterly cash dividend of more than $0.26 per share until the earlier of December 5, 2011 or the date the U.S. Treasury’s preferred stock is redeemed or transferred to an unaffiliated third party. Further, First Defiance has agreed to obtain OTS approval prior to the declaration of dividends.

19. Income Taxes

The components of income tax expense are as follows:

 

     Years Ended December 31  
     2010     2009     2008  
     (In Thousands)  

Current:

      

Federal

   $ 5,372      $ 6,590      $ 7,534   

State and local

     50        84        45   

Deferred

     (2,417     (4,007     (4,051
                        
   $ 3,005      $ 2,667      $ 3,528   
                        

The provision for income taxes differs from that computed at the statutory corporate tax rate as follows:

 

     Years Ended December 31  
     2010     2009     2008  
     (In Thousands)  

Tax expense at statutory rate (35%)

   $ 3,889      $ 3,451      $ 3,810   

Increases (decreases) in taxes from:

      

State income tax – net of federal tax benefit

     32        55        29   

ESOP adjustments

     —          —          (30

Tax exempt interest income, net of TEFRA

     (745     (673     (530

Bank owned life insurance

     (278     (311     130   

Stock option expense

     54        76        90   

Other

     53        69        29   
                        

Totals

   $ 3,005      $ 2,667      $ 3,528   
                        

Deferred federal income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

 

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Significant components of First Defiance’s deferred federal income tax assets and liabilities are as follows:

 

     December 31  
     2010      2009  
     (In Thousands)  

Deferred federal income tax assets:

     

Allowance for loan losses

   $ 14,296       $ 12,648   

Postretirement benefit costs

     874         952   

Deferred compensation

     900         810   

Impaired loans

     1,310         1,227   

Capital loss carry-forward

     621         621   

Impaired investments

     804         756   

Accrued vacation

     476         432   

Allowance for real estate held for sale losses

     748         200   

Deferred loan origination fees and costs

     309         326   

Other

     347         311   
                 

Total deferred federal income tax assets

     20,685         18,283   

Deferred federal income tax liabilities:

     

FHLB stock dividends

     3,284         3,284   

Goodwill

     3,172         2,684   

Mortgage servicing rights

     3,291         3,000   

Fixed assets

     1,524         1,432   

Other intangible assets

     1,871         2,329   

Loan mark to market

     1,405         1,800   

Net unrealized gains on available-for-sale securities

     17         252   

Other

     316         213   
                 

Total deferred federal income tax liabilities

     14,880         14,994   
                 

Net deferred federal income tax asset (liability)

   $ 5,805       $ 3,289   
                 

The realization of the Company’s deferred tax assets is dependent upon the Company’s ability to generate taxable income in future periods and the reversal of deferred tax liabilities during the same period. The Company has evaluated the available evidence supporting the realization of its deferred tax assets and determined it is more likely than not that the assets will be realized and thus no valuation allowance was required at December 31, 2010.

At December 31, 2010, the Company had capital loss carry-forwards of $1.8 million which will expire on December 31, 2014. No valuation allowance has been recorded as management has evaluated evidence supporting the realization of this asset and determined it is more likely than not that the asset will be realized.

Retained earnings at December 31, 2010 include approximately $11.0 million for which no tax provision for federal income taxes has been made. This amount represents the tax bad debt reserve at December 31, 1987, which is the end of the Company’s base year for purposes of calculating the bad debt deduction for tax purposes. If this portion of retained earnings is used in the future for any purpose other than to absorb bad debts, the amount used will be added to future taxable income. The unrecorded deferred tax liability on the above amount at December 31, 2010 was approximately $3.85 million.

 

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A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands):

 

Balance at January 1, 2008

   $ 498   

Additions based on tax positions related to the current year

     86   

Additions for tax positions of prior years

     —     

Reductions for tax positions of prior years

     —     

Reductions due to the statute of limitations

     (140

Settlements

     —     
        

Balance at December 31, 2008

   $ 444   
        

Balance at January 1, 2009

   $ 444   

Additions based on tax positions related to the current year

     —     

Additions for tax positions of prior years

     —     

Reductions for tax positions of prior years

     —     

Reductions due to the statute of limitations

     (98

Settlements

     —     
        

Balance at December 31, 2009

   $ 346   
        

Balance at January 1, 2010

   $ 346   

Additions based on tax positions related to the current year

     —     

Additions for tax positions of prior years

     —     

Reductions for tax positions of prior years

     —     

Reductions due to the statute of limitations

     (65

Settlements

     —     
        

Balance at December 31, 2010

   $ 281   
        

The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months.

The total amount of interest and penalties recorded in the income statement, net of the related federal tax benefit, for the year ended December 31, 2010 was $23,000, and the amount accrued for interest and penalties (net of the related federal tax benefit) at December 31, 2010 was $105,000.

The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax in the state of Indiana. The Company is no longer subject to examination by taxing authorities for years before 2006. The Company currently operates primarily in the states of Ohio and Michigan, which tax financial institutions based on their equity rather than their income.

20. Employee Benefit Plans

ESOP Plan

First Defiance has established an Employee Stock Ownership Plan (ESOP) covering all employees of First Defiance age 21 or older who have at least one year of credited service. Contributions to the ESOP are made by First Defiance and are determined by First Defiance’s Board of Directors at their discretion. The contributions may be made in the form of cash or First Defiance common stock. The annual contributions may not be greater than the amount deductible for federal income tax purposes and cannot cause First Federal to violate regulatory capital requirements.

To fund the plan, the ESOP borrowed funds from First Defiance for the purpose of purchasing shares of First Defiance common stock. The ESOP acquired a total of 863,596 shares in 1993 and 1995. The loan outstanding was paid off in June 2008. Principal and interest payments on the loan were due in equal

 

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quarterly installments. The loan was collateralized by the shares of First Defiance’s common stock and was repaid by the ESOP with funds from the Company’s contributions to the ESOP, dividends on allocated and unallocated shares and earnings on ESOP assets.

As principal and interest payments on the loan were paid, shares were released from collateral and committed for allocation to active employees, based on the proportion of debt service paid in the year. Shares held by the ESOP which had not been released for allocation were reported as stock acquired by the ESOP plan in the statement of financial condition. As shares were released, First Defiance recorded compensation expense equal to the average fair value of the shares over the period in which the shares were earned. Also, the shares released for allocation were included in the average shares outstanding for earnings per share computations. Dividends on allocated shares were recorded as a reduction of retained earnings and dividends on unallocated shares reduce debt and accrued interest. ESOP compensation expense was $0, $0, and $116,000, for 2010, 2009 and 2008, respectively.

Shares held by the ESOP at December 31 were as follows:

 

     Year Ended December 31, 2010     Year Ended December 31, 2009  
     Allocated     Unallocated      Total     Allocated     Unallocated      Total  

Beginning Balance

     522,946        —           522,946        527,723        —           527,723   

Allocation of shares to participants

     —          —           —          —          —           —     

Distribution of shares to former participants

     (51,959     —           (51,959     (4,777     —           (4,777
                                                  

Ending Balance

     470,987        —           470,987        522,946        —           522,946   
                                                  

There were no unallocated shares at December 31, 2010 and December 31, 2009.

401(k) Plan

Employees of First Defiance are eligible to participate in the First Defiance Financial Corp. 401(k) Employee Savings Plan (First Defiance 401(k)) if they meet certain age and service requirements. Beginning in 2009, under the First Defiance 401(k), First Defiance matches 100% of the participants’ contributions up to 3% of compensation and then 50% of the participants’ contributions for the next 2% of compensation. Previously, matching contributions were 50% of the first 3% of participants contributions. The First Defiance 401(k) also provides for a discretionary First Defiance contribution in addition to the First Defiance matching contribution. First Defiance matching contributions totaled $660,000, $719,000 and $474,000 for the years ended December 31, 2010, 2009 and 2008, respectively. There were no discretionary contributions in any of those years.

Group Life Plan

On June 30, 2010, First Federal adopted the First Federal Bank of the Midwest Executive Group Life Plan – Post Separation (the “Group Life Plan”) in which various employees, including the Company’s named executive officers, may participate. Under the terms of the Group Life Plan, First Federal will purchase and own life insurance policies covering the lives of employees selected by the board of directors of First Federal as participants. There was $547,000 of expense recorded for the year ended December 31, 2010 with a liability of $547,000 for future benefits recorded at December 31, 2010.

21. Stock Option Plans

First Defiance has established incentive stock option plans for its directors and its employees. On March 15, 2010, the Board adopted, and the shareholders approved at the 2010 Annual Shareholders Meeting, the First Defiance Financial Corp. 2010 Equity Incentive Plan (the “2010 Equity Plan”). The 2010 Equity Plan replaces all existing plans. All awards currently outstanding under the prior plans will remain in effect in accordance with their respective terms. Any new awards will be made under the 2010 Equity

 

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Plan. The 2010 Equity Plan allows for issuance of up to 350,000 share awards. As of December 31, 2010, 5,000 options have been granted under the 2010 Equity Plan to employees and 410,000 options (388,000 for employees and 22,000 for directors) have been granted under prior option plans and remain outstanding at option prices based on the market value of the underlying shares on the date the options were granted. Options granted under all plans vest 20% per year except for the options granted in 2009 to the Company’s then five most-highly compensated employees, which options vest 40% in 2011 and then 20% annually, subject to certain other limitations. All options expire ten years from date of grant. Vested options of retirees expire on the earlier of the scheduled expiration date or three months after the retirement date.

The fair value of each option award is estimated on the date of grant using the Black-Scholes model using the assumptions noted in the table below. Expected volatilities are based on historical volatilities of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

The fair value of options granted was determined using the following weighted-average assumptions as of grant date.

 

     Year Ended December 31  
     2010     2009     2008  

Risk-free interest rate

     1.57     3.38     4.26

Expected term

     7.2 years        6.4 years        6.5 years   

Expected stock price volatility

     44.6     26.1     22.5

Dividend yield

     0.00     3.62     6.08

The following table summarizes stock option activity for 2010:

 

     Options
Outstanding
    Weighted
Average
Exercise

Price
     Weighted
Average
Remaining
Contractual
Term

(in years)
     Aggregate
Intrinsic

Value
(in $000s)
 

Outstanding at January 1, 2010

     467,500      $ 19.41         

Granted

     5,000        9.96         

Exercised

     (250     9.22         

Forfeited/Expired

     (57,250     20.39         
                                  

Outstanding at December 31, 2010

     415,000      $ 19.17         4.84       $ 155   
                                  

Vested or expected to vest at December 31, 2010

     415,000      $ 19.17         4.84       $ 155   
                                  

Exercisable at December 31, 2010

     288,620      $ 20.60         3.65       $ 28   
                                  

Information related to the stock option plans follows:

 

     Year Ended December 31.  
     2010      2009      2008  
     (in thousands, except per share amounts)  

Intrinsic value of options exercised

   $ 1       $ 1       $ 290   

Cash received from option exercises*

     3         5         768   

Tax benefit realized from option exercises

     —           —           72   

Weighted average fair value of options granted

   $ 4.05       $ 1.88       $ 1.98   

 

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* - Includes $33,000 of option exercises paid by optionees in First Defiance common stock in 2008. There were no amounts for 2010 or 2009.

As of December 31, 2010, there was $246,000 of total unrecognized compensation cost related to non-vested stock options granted under the Company Stock Option Plans. The cost is expected to be recognized over a weighted-average period of 2.4 years.

As of December 31, 2010 and 2009, 345,000 and 98,750 shares, respectively, were available for grant under the Company’s stock option plans. Options forfeited or cancelled under all plans except the 2010 plan are no longer available for grant to other participants

22. Parent Company Statements

Condensed parent company financial statements, which include transactions with subsidiaries, follow:

 

     December 31  

Statements of Financial Condition

   2010      2009  
     (In Thousands)  

Assets

     

Cash and cash equivalents

   $ 1,868       $ 1,891   

Investment in banking subsidiary

     266,752         266,519   

Investment in non-bank subsidiary

     6,976         5,986   

Other assets

     1,744         1,900   
                 

Total assets

   $ 277,340       $ 272,296   
                 

Liabilities and stockholders’ equity:

     

Subordinated debentures

   $ 36,083       $ 36,083   

Accrued liabilities

     926         2,127   

Stockholders’ equity

     240,331         234,086   
                 

Total liabilities and stockholders’ equity

   $ 277,340       $ 272,296   
                 

 

     Years Ended December 31  

Statements of Income

   2010     2009     2008  
     (In Thousands)  

Dividends from subsidiaries

   $ 5,802      $ 6,050      $ 11,750   

Interest on loan to ESOP

     —          —          10   

Interest expense

     (1,315     (1,471     (2,545

Other-than-temporary impairment on investment securities

     —          (419     (1,281

Other income

     —          (3     35   

Noninterest expense

     (857     (881     (785
                        

Income (loss) before income taxes and equity in earnings of subsidiaries

     3,630        3,276        7,184   

Income tax credit

     (739     (950     (1,650
                        

Income (loss) before equity in earnings of subsidiaries

     4,369        4,226        8,834   

Undistributed equity in (distributions in excess of)

earnings of subsidiaries

     3,739        2,968        (1,477
                        

Net income

   $ 8,108      $ 7,194      $ 7,357   
                        

Comprehensive income

   $ 7,924      $ 8,940      $ 5,868   
                        

 

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     Years Ended December 31  

Statements of Cash Flows

   2010     2009     2008  
     (In Thousands)  

Operating activities:

      

Net income

   $ 8,108      $ 7,194      $ 7,357   

Adjustments to reconcile net income to net cash (used in) provided by operating activities:

      

Distribution in excess of (undistributed equity in) earnings of subsidiaries

     (3,739     (2,968     1,477   

OTTI on investment securities

     —          419        1,281   

Change in other assets and liabilities

     (1,045     741        115   
                        

Net cash provided by (used in) operating activities

     3,324        5,386        10,230   

Investing activities:

      

Cash paid for Pavilion Bancorp

     —          —          (27,964

Investment in non-bank subsidiary

     (1,500     —          —     

Principal payments received on ESOP loan

     —          —          493   

Maturities of available-for-sale securities

     —          —          29   
                        

Net cash (used in) provided by investing activities

     (1,500     —          (27,442

Financing activities:

      

Capital contribution to subsidiary

     —          —          (13,000

Stock options exercised

     3        5        768   

Excess tax benefit from exercise of stock options

     —          —          72   

Purchase of common stock for treasury

     —          —          (635

Cash dividends paid

     (1,850     (5,523     (8,137

Proceeds from issuance of preferred stock

     —          —          37,000   
                        

Net cash used in financing activities

     (1,847     (5,518     16,068   
                        

Net increase (decrease) in cash and cash equivalents

     (23     (132     (1,144

Cash and cash equivalents at beginning of year

     1,891        2,023        3,167   
                        

Cash and cash equivalents at end of year

   $ 1,868      $ 1,891      $ 2,023   
                        

23. Fair Value

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

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

 

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hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

   

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

 

   

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

 

   

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

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

Available for sale securities - Securities classified as available for sale are generally reported at fair value utilizing Level 2 inputs where the Company obtains fair value measurements from an independent pricing service which uses matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows and the bonds’ terms and conditions, among other things. Securities in Level 1 include preferred stock securities. Securities in Level 2 include U.S. Government agencies, mortgage-backed securities, corporate bonds and municipal securities. The Company classifies its pooled trust preferred collateralized debt obligations as Level 3. The portfolio consists of collateralized debt obligations backed by pools of trust preferred securities issued by financial institutions and insurance companies. Based on the lack of observable market data, the Company estimated fair values based on the observable data available and reasonable unobservable market data. The Company estimated fair value based on a discounted cash flow model which used appropriately adjusted discount rates reflecting credit and liquidity risks. The Company used an independent third party which is described further in Note 6.

Impaired loans - The fair value of impaired loans with specific allocations of the allowance for loan loss is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in impaired loans being valued using Level 3 inputs.

Mortgage servicing rights - Mortgage servicing rights are reported at fair value utilizing Level 2 inputs. MSRs are valued by a third party consultant using a proprietary cash flow valuation model.

 

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Mortgage banking derivative - The fair value of mortgage banking derivatives are based on derivative valuation models using market data inputs as of the valuation date (Level 2).

Real estate held for sale - Real estate held for sale is determined using Level 3 inputs which include current and prior appraisals and estimated costs to sell.

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

Assets and Liabilities Measured on a Recurring Basis

 

December 31, 2010    Level 1 Inputs      Level 2 Inputs      Level 3 Inputs      Total Fair
Value
 
     (In Thousands)  

Available for sale securities:

           

Obligations of U.S. Government corporations and agencies

   $ —         $ 11,985       $ —         $ 11,985   

Mortgage-backed securities - residential

     —           40,576         —           40,576   

REMICs

     —           3,541         —           3,541   

Collateralized mortgage obligations

     —           51,057         —           51,057   

Trust preferred stock

     —           —           1,498         1,498   

Preferred stock

     48         —           —           48   

Corporate bonds

     —           3,797         —           3,797   

Obligations of state and political subdivisions

     —           52,750         —           52,750   

Mortgage banking derivative - asset

     —           265         —           265   

 

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December 31, 2009    Level 1 Inputs      Level 2 Inputs      Level 3 Inputs      Total  Fair
Value
 
     (In Thousands)  

Available for sale securities:

           

Obligations of U.S. Government corporations and agencies

   $ —         $ 14,251       $ —         $ 14,251   

Mortgage-backed securities - residential

     —           31,504         —           31,504   

REMICs

     —           3,923         —           3,923   

Collateralized mortgage obligations

     —           41,371         —           41,371   

Trust preferred stock

     —           —           1,589         1,589   

Preferred stock

     87         —           —           87   

Obligations of state and political subdivisions

     —           44,733         —           44,733   

Mortgage banking derivative - asset

     —           380         —           380   

The table below presents a reconciliation and income classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2010 and December 31, 2009:

 

     Fair Value Measurements
Using Significant
Unobservable Inputs

(Level 3)
(In Thousands)
 

Beginning balance, January 1, 2010

   $ 1,589   

Total gains or losses (realized/unrealized) Included in earnings

     (214

Included in other comprehensive income (presented gross of taxes)

     128   

Purchases, issuances, and settlements

     20   

Sales

     (25

Transfers in and/or out of Level 3

     —     
        

Ending balance, December 31, 2010

   $ 1,498   
        

 

     Fair Value Measurements
Using Significant
Unobservable Inputs

(Level 3)
(In Thousands)
 

Beginning balance, January 1, 2009

   $ 3,873   

Total gains or losses (realized/unrealized) Included in earnings

     (3,940

Included in other comprehensive income (presented gross of taxes)

     1,785   

Purchases, issuances, and settlements

     (129

Transfers in and/or out of Level 3

     —     
        

Ending balance, December 31, 2009

   $ 1,589   
        

 

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

Assets and Liabilities Measured on a Non-Recurring Basis

 

December 31, 2010    Level 1 Inputs      Level 2 Inputs      Level 3 Inputs      Total Fair
Value
 
     (In Thousands)  

Impaired Loans

           

Residential Loans

   $ —         $ —         $ 2,541       $ 2,541   

Commercial Loans

           7,236         7,236   

Multi Family Loans

           962         962   

CRE loans

           16,835         16,835   
                       

Total Impaired loans

           27,574         27,574   

Mortgage servicing rights

     —           9,477         —           9,477   

Real estate held for sale

     —           —           3,449         3,449   
December 31, 2009    Level 1 Inputs      Level 2 Inputs      Level 3 Inputs      Total Fair
Value
 
     (In Thousands)  

Impaired loans

   $ —         $ —         $ 28,336       $ 28,336   

Mortgage servicing rights

     —           8,958         —           8,958   

Real estate held for sale

     —           —           935         935   

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a fair value of $27.6 million, with a valuation allowance of $16.6 million at December 31, 2010. A provision expense of $18.0 million for year ended December 31, 2010 was included in earnings.

Mortgage servicing rights which are carried at lower of cost or fair value had a fair value of $9,477,000 at December 31, 2010, resulting in a valuation allowance of $1,125,000. A recovery of $353,000 was included in the earnings for the year ended December 31, 2010.

Real estate held for sale is determined using Level 3 inputs which include current and prior appraisals and estimated costs to sell. The change in fair value of real estate held for sale was $3,196,000 for the year ended December 31, 2010 was recorded directly as an adjustment to current earnings through non-interest expense.

Impaired loans had a fair value of $28,336,000, with a valuation allowance of $12,249,000 at December 31, 2009. A provision expense of $11,985,000 for year ended December 31, 2009 was included in earnings.

Mortgage servicing rights had a fair value of $8,958,000 at December 31, 2009, resulting in a valuation allowance of $1,478,000. A recovery of $1,314,000 was included in the earnings for the year ended December 31, 2009.

Real estate held for sale is determined using Level 3 inputs which include current and prior appraisals and estimated costs to sell. The change in fair value of real estate held for sale was $1,295,000 for the

 

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year ended December 31, 2009 was recorded directly as an adjustment to current earnings through non-interest expense.

In accordance with FASB ASC Topic 825, the following table is a comparative condensed consolidated statement of financial condition based on carrying amount and estimated fair values of financial instruments as of December 31, 2010 and December 31, 2009. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of First Defiance.

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

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

As disclosed in more detail in Note 6, investment securities fair value has been based on current market quotations. If market prices are not available, fair value has been estimated based upon the quoted price of similar instruments or based on observable and unobservable data. It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.

The fair value of loans which reprice within 90 days is equal to their carrying amount. For other loans, the estimated fair value is calculated based on discounted cash flow analysis, using interest rates currently being offered for loans with similar terms. The allowance for loan losses is considered to be a reasonable adjustment for credit risk.

FASB ASC Topic 825 requires that the fair value of demand, savings, NOW and certain money market accounts be equal to their carrying amount. The Company believes that the fair value of these deposits may be greater or less than that prescribed by FASB ASC Topic 825.

The carrying value of Subordinated Debentures and deposits with fixed maturities is estimated based on interest rates currently being offered on instruments with similar characteristics and maturities. FHLB advances with maturities greater than 90 days are valued based on discounted cash flow analysis, using interest rates currently being quoted for similar characteristics and maturities. The cost or value of any call or put options is based on the estimated cost to settle the option at December 31, 2010.

 

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     December 31, 2010      December 31, 2009  
     Carrying
Value
     Estimated
Fair Values
     Carrying
Value
     Estimated
Fair Values
 
     (In Thousands)  

Assets:

           

Cash and cash equivalents

   $ 169,164       $ 169,164       $ 121,116       $ 121,116   

Investment securities

     166,091         166,117         139,378         139,416   

Federal Home Loan Bank Stock

     21,012         N/A         21,376         N/A   

Loans, net, including loans

held for sale

     1,496,550         1,498,990         1,590,921         1,586,101   

Mortgage banking derivative asset

     265         265         380         380   

Accrued interest receivable

     6,374         6,374         6,851         6,851   
                                   
     1,859,456       $ 1,840,910         1,880,022       $ 1,853,864   
                       

Other assets

     176,061            177,501      
                       

Total assets

   $ 2,035,517          $ 2,057,523      
                       

Liabilities and stockholders’ equity:

           

Deposits

   $ 1,575,419       $ 1,582,539       $ 1,580,226       $ 1,586,466   

Advances from Federal Home Loan Bank

     116,885         121,504         146,927         152,643   

Securities sold under repurchase agreements

     56,247         55,443         48,398         48,398   

Subordinated debentures

     36,083         32,258         36,083         32,057   

Accrued interest payable

     724         724         1,234         1,234   

Advance payments by borrowers for taxes and insurance

     937         937         665         665   
                                   
     1,786,295       $ 1,793,405         1,813,533       $ 1,821,463   
                       

Other liabilities

     8,891            9,904      
                       

Total liabilities

     1,795,186            1,823,437      

Stockholders’ equity

     240,331            234,086      
                       

Total liabilities and stockholders’ equity

   $ 2,035,517          $ 2,057,523      
                       

 

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24. Derivative Financial Instruments

Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated in hedge relationships. First Federal had approximately $24.9 million and $18.7 million of interest rate lock commitments at December 31, 2010 and 2009, respectively. There were $34.7 million and $23.8 million of forward commitments for the future delivery of residential mortgage loans at December 31, 2010 and 2009, respectively.

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

 

     December 31, 2010      December 31, 2009  
     Assets      (Liabilities)      Derivative
Net Carrying
Value
     Assets      (Liabilities)      Derivative
Net Carrying
Value
 
     Carrying
Value
     Carrying
Value
        Carrying
Value
     Carrying
Value
    
                   (In Thousands)                

Derivatives not designated as hedging instruments

                 

Mortgage Banking Derivatives

   $ 265       $ —         $ 265       $ 380       $ —         $ 380   
                                                     

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

 

     Twelve Months  Ended
December 31,
 
     2010     2009  

Derivatives not designated as hedging instruments

    

Mortgage Banking Derivatives – Gain (Loss)

   $ (115   $ (718
                

The above amounts are included in mortgage banking income.

 

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25. Quarterly Consolidated Results of Operations (Unaudited)

The following is a summary of the quarterly consolidated results of operations:

 

     Three Months Ended  
     March 31     June 30     September 30     December 31  
     (In Thousands, Except Per Share Amounts)  

2010

        

Interest income

   $ 24,129      $ 24,349      $ 24,057      $ 23,329   

Interest expense

     7,044        6,788        6,295        5,574   
                                

Net interest income

     17,085        17,561        17,762        17,755   

Provision for loan losses

     6,889        5,440        5,196        5,652   
                                

Net interest income after provision for loan losses

     10,196        12,121        12,566        12,103   

Gain (loss) on sale, call or write-down

of securities

     (64     1,238        1,231        (14

Noninterest income

     6,830        4,553        6,248        7,568   

Noninterest expense

     14,832        15,045        17,102        16,485   
                                

Income before income taxes

     2,130        2,867        2,943        3,172   

Income taxes

     624        808        668        904   
                                

Net income

   $ 1,506      $ 2,059      $ 2,275      $ 2,268   
                                

Dividends declared on Preferred Shares

     (463     (462     (463     (463

Accretion on Preferred Shares

     (40     (42     (43     (43
                                

Net income applicable to common shares

   $ 1,003      $ 1,555      $ 1,769      $ 1,762   
                                

Earnings per common share:

        

Basic

   $ 0.12      $ 0.19      $ 0.22      $ 0.22   

Diluted

   $ 0.12      $ 0.19      $ 0.22      $ 0.22   

Average shares outstanding:

        

Basic

     8,117        8,118        8,118        8,118   

Diluted

     8,142        8,193        8,118        8,178   

 

     Three Months Ended  
     March 31     June 30     September 30     December 31  
     (In Thousands, Except Per Share Amounts)  

2009

        

Interest income

   $ 25,122      $ 24,822      $ 25,487      $ 25,148   

Interest expense

     9,085        8,643        7,914        7,615   
                                

Net interest income

     16,037        16,179        17,573        17,533   

Provision for loan losses

     2,746        3,965        8,051        8,470   
                                

Net interest income after provision for loan losses

     13,291        12,214        9,522        9,063   

Gain (loss) on sale, call or write-down

of securities

     (672     (750     (840     (1,394

Noninterest income

     7,476        9,109        6,396        6,970   

Noninterest expense

     14,996        16,133        14,786        14,609   
                                

Income before income taxes

     5,099        4,440        292        30   

Income taxes

     1,691        1,539        (37     (526
                                

Net income

   $ 3,408      $ 2,901      $ 329      $ 556   
                                

Dividends declared on Preferred Shares

     (463     (468     (473     (446

Accretion on Preferred Shares

     (38     (40     (40     (42
                                

Net income applicable to common shares

   $ 2,907      $ 2,393      $ (184   $ 68   
                                

Earnings per common share:

        

Basic

   $ 0.36      $ 0.29      $ (0.02   $ 0.01   

Diluted

   $ 0.36      $ 0.29      $ (0.02   $ 0.01   

Average shares outstanding:

        

Basic

     8,117        8,117        8,117        8,117   

Diluted

     8,117        8,182        8,117        8,265   

 

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26. Preferred Stock

On December 5, 2008, as part of the CPP, the Company entered into a Letter Agreement and Securities Purchase Agreement (collectively, the “Purchase Agreement”) with the U.S. Treasury, pursuant to which the Company sold $37.0 million shares of newly authorized Fixed Rate Cumulative Perpetual Preferred Stock, par value $0.01 per share and liquidation value $1,000 per share (“Senior Preferred Shares”) and also issued warrants (the “Warrants”) to the U.S. Treasury to acquire an additional 550,595 of common shares having an exercise price of $10.08 per share. The Warrants have a term of 10 years.

The Senior Preferred Shares qualify as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The Senior Preferred Shares may be redeemed by the Company after three years. The Senior Preferred Shares are not subject to any contractual restrictions on transfer, except that the U.S. Treasury or any its transferees may affect any transfer that, as a result of such transfer, would require the Company to become subject to the periodic reporting requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934.

Pursuant to the terms of the Purchase Agreement, the ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, its common shares will be subject to restrictions, including a restriction against increasing dividends from the last quarterly cash dividend per share of $0.26 declared on the common stock prior to October 14, 2008. The redemption, purchase or other acquisition of trust preferred securities of the Company or its affiliates also will be restricted. These restrictions will terminate on the earlier of (a) the third anniversary of the date of issuance of the Senior Preferred Shares and (b) the date on which the Senior Preferred Shares have been redeemed in whole or the U.S. Treasury has transferred all of the Senior Preferred Shares to third parties, except that, after the third anniversary of the date of issuance of the Senior Preferred Shares, if the Senior Preferred Shares remain outstanding at such time, the Company may not increase its common dividends per share without obtaining consent of the U.S. Treasury.

The Purchase Agreement also subjects the Company to certain of the executive compensation limitations included in the Emergency Economic Stabilization Act of 2008 (the “EESA”). As a condition to the closing of the transaction, the Company’s Senior Executive Officers (as defined in the Purchase Agreement) (the “Senior Executive Officers”), (i) voluntarily waived any claim against the U.S. Treasury or the Company for any changes to such officer’s compensation or benefits that are required to comply with the regulation issued by the U.S. Treasury under the CPP and acknowledged that the regulation may require modification of the compensation, bonus, incentive and other benefit plans, arrangements and policies and agreements as they relate to the period the U.S. Treasury owns the Senior Preferred Shares of the Company; and (ii) entered into a letter agreement with the Company amending the Benefit Plans with respect to such Senior Executive Officers as may be necessary, during the period that the U.S. Treasury owns the Senior Preferred Shares, as necessary to comply with Section 111(b) of the EESA.

 

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Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure

None.

 

Item 9a. Controls and Procedures

First Defiance’s management carried out an evaluation, under the supervision and with the participation of the chief executive officer and the chief financial officer, of the effectiveness of First Defiance’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2010. Based upon that evaluation, the chief executive officer along with the interim chief financial officer concluded that First Defiance’s disclosure controls and procedures as of December 31, 2010, are effective.

The information set forth under “Management’s Report on Internal Control Over Financial Reporting” and “Report of Independent Registered Public Accounting Firm” included in Item 8 above is incorporated herein by reference.

Changes in Internal Control Over Financial Reporting

There were no changes in First Defiance’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the last fiscal quarter ended December 31, 2010 that have materially affected, or are reasonably likely to materially affect First Defiance’s internal control over financial reporting.

 

Item 9b. Other Information

None

PART III

 

Item 10. Directors, Executive Officers and Corporate Governance

The information required herein is incorporated by reference from the sections captioned: “Proposal 1 - Election of Directors”, “Executive Officers”, and “Section 16(a) Beneficial Ownership Reporting Compliance” of the definitive proxy statement to be filed on or about March 25, 2011 (the “Proxy Statement”).

First Defiance has adopted a Code of Ethics applicable to all officers, directors and employees that complies with SEC requirements, and is available on its Internet site at www.fdef.com under the Investor Relations tab.

 

Item 11. Executive Compensation

Information required by this item is set forth under the captions “Executive Compensation,” “Director Compensation,” “Compensation Committee Report” and “Compensation Committee Interlocks and Insider Participation” of the Proxy Statement.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information set forth under the caption “Beneficial Ownership” of the Proxy Statement is incorporated herein by reference.

Equity Compensation Plans

 

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The following table provides information as of December 31, 2010 with respect to the shares of First Defiance common stock that may be issued under First Defiance’s existing equity compensation plans.

 

Plan Category

   Number of securities to
be Issued Upon
Exercise of Outstanding
Options, Warrants and
Rights
     Weighted Average
Exercise Price of
Outstanding Options,
Warrants and Rights
     Number of Securities
Remaining Available
for Future Issuance
Under Equity
Compensation Plans
(Excluding Securities
Reflected in Column
(a))
 
     (a)      (b)      (c)  

Equity Compensation Plans Approved by Security Holders

     415,000       $ 19.17         345,000   

 

Item 13. Certain Relationships and Related Transactions, and Director Independence

The information set forth under the captions “Composition of the Board” and “Related Person Transactions” of the Proxy Statement is incorporated herein by reference.

 

Item 14. Principal Accountant Fees and Services

The information set forth under the caption “Independent Registered Public Accounting Firm” of the Proxy Statement is incorporated herein by reference.

 

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PART IV

 

Item 15. Exhibits, Financial Statement Schedules

 

(a)

Financial Statements

The following documents are filed as Item 8 of this Form 10-K.

 

(A)    Report of Independent Registered Public Accounting Firm (Crowe Horwath LLP)

(B)    Consolidated Statements of Financial Condition as of December 31, 2010 and 2009

(C)     Consolidated Statements of Income for the years ended December 31, 2010, 2009 and 2008

(D)     Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2010, 2009 and 2008

(E)     Consolidated Statements of Cash Flows for the years ended December 31, 2010, 2009 and 2008

(F)    Notes to Consolidated Financial Statements

 

(1)

We are not filing separate financial statement schedules because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements or the related notes.

 

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SIGNATURES

Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

FIRST DEFIANCE FINANCIAL CORP.

March 1, 2011

 

By:

 

/s/ Donald P. Hileman

   

Donald P. Hileman, Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 1, 2011.

 

Signature

       

Title

    

/s/ William J. Small

    

Chairman of the Board, President and

  

William J. Small

    

Chief Executive Officer

  
       

/s/ Donald P. Hileman

    

Executive Vice President and Chief

  

Donald P. Hileman

    

Financial Officer (principal accounting officer)

  
       

/s/ James L. Rohrs

    

Director, Executive Vice President

  

James L. Rohrs

       
       

/s/ Stephen L. Boomer

    

Director, Vice Chairman

  

Stephen L. Boomer

       
       

/s/ John L. Bookmyer

    

Director

  

John L. Bookmyer

       
       

/s/ Dr. Douglas A. Burgei

    

Director

  

Dr. Douglas A. Burgei

       
       

/s/ Peter A. Diehl

    

Director

  

Peter A. Diehl

       
       

/s/ Barb A. Mitzel

    

Director

  

Barb A. Mitzel

       
       

/s/ Dwain I. Metzger

    

Director

  

Dwain I. Metzger

       
       

/s/ Jean A. Hubbard

    

Director

  

Jean A. Hubbard

       
       

/s/ Samuel S. Strausbaugh

    

Director

  

Samuel S. Strausbaugh

       
       

/s/ Thomas A. Voigt

    

Director

  

Thomas A. Voigt

       

 

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Exhibit Index

This report incorporates by reference the documents listed below that we have previously filed with the SEC. The SEC allows us to incorporate by reference information in this document. The information incorporated by reference is considered to be part of this document.

This information may be read and copied at the Public Reference Room of the SEC at 100 F Street, N.E., Washington D.C. 20549. The SEC also maintains an internet web site that contains reports, proxy statements, and other information about issuers, like First Defiance, who file electronically with the SEC. The address of the site is http://www.sec.gov. The reports and other information filed by First Defiance with the SEC are also available at the First Defiance Financial Corp. web site. The address of the site is http://www.fdef.com. Except as specifically incorporated by reference into this Annual Report on Form 10-K, information on those web sites is not part of this report.

 

Exhibit
Number

  

Description

    
  3.1    Articles of Incorporation    (1)
  3.2    Code of Regulations    (1)
  3.3    Bylaws    (1)
  3.4    Amendment to Articles of Incorporation    (11)
  4.1   

Agreement to furnish instruments and agreements defining

rights of holders of long-term debt

   (17)
  4.2    Form of Warrant for Purchase of Shares of Common Stock    (15)
10.1    1996 Stock Option Plan    (2)
10.2    Form of Incentive Stock Option Award Agreement under 2001 Plan    (3)
10.3    Form of Nonqualified Stock Option Award Agreement under 1996 Plan    (3)
10.4    1996 Management Recognition Plan and Trust    (8)
10.5    2001 Stock Option and Incentive Plan    (5)
10.7    Employment Agreement with William J. Small    (6)
10.8    Employment Agreement with James L. Rohrs    (7)
10.9    Employment Agreement with Donald P. Hileman    (18)
10.10    Employment Agreement with Gregory R. Allen    (9)
10.11    Description of Annual Cash Bonus Plan    (17)
10.12    2005 Stock Option and Incentive Plan    (10)
10.13    Letter Agreement, dated December 5, 2008, between First Defiance and the U.S. Treasury    (12)
10.14    2008 Long Term Incentive Compensation Plan (LTIP)    (13)
10.15    Form of Contingent Award Agreement under LTIP    (14)
10.16    Form of Stock Option Award Agreement under 2005 Plan    (4)
10.17    Amendment to all Employment Agreements for CPP    (4)
10.18    Form of Agreement for CPP Compensation Standards    (21)
10.19    Form of Option Award Agreement with EESA restriction under 2005 Plan    (21)
10.20    First Federal Executive Group Life Plan – Post Separation    (19)
10.21    2010 Equity Incentive Plan    (20)
21    List of Subsidiaries of the Company    (17)
23.1    Consent of Crowe Horwath LLP    (17)
31.1    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002    (17)
31.2    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002    (17)
32.1    Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002    (17)
32.2    Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002    (17)
99.1    PEO TARP Capital Purchase Program Certification    (17)

 

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99.2    PFO TARP Capital Purchase Program Certification    (17)

 

(1)

Incorporated herein by reference to the like numbered exhibit in the Registrant’s Form S-1 (File No. 33-93354)

 

(2)

Incorporated herein by reference to like numbered exhibit in Registrant’s 2001 Form 10-K (Film No. 02580719)

 

(3)

Incorporated herein by reference to like numbered exhibit in Registrant’s 2004 Form 10-K (Film No. 0568550)

 

(4)

Incorporated herein by reference to like numbered exhibit in Registrant’s 2008 Form 10-K (Film No. 09683948)

 

(5)

Incorporated herein by reference to Appendix B to the 2001 Proxy Statement (Film No. 1577137)

 

(6)

Incorporated herein by reference to exhibit 10.1 in Form 8-K filed October 1, 2007 (Film No. 071144951)

 

(7)

Incorporated herein by reference to exhibit 10.2 in Form 8-K filed October 1, 2007 (Film No. 071144951)

 

(8)

Incorporated herein by reference to exhibit 10.2 in Registrant’s 2001 Form 10-K (Film No. 02580719)

 

(9)

Incorporated herein by reference to exhibit 10.4 in Form 8-K filed October 1, 2007 (Film No. 071144951)

 

(10)

Incorporated herein by reference to Appendix A to the 2005 Proxy Statement (Film No. 05692264)

 

(11)

Incorporated herein by reference to exhibit 3 in Form 8-K filed December 8, 2008 (Film No. 081236105)

 

(12)

Incorporated herein by reference to exhibit 10 in Form 8-K filed December 8, 2008 (Film No. 081236105)

 

(13)

Incorporated herein by reference to exhibit 10.1 in Form 8-K filed December 12, 2008 (Film No. 081245224)

 

(14)

Incorporated herein by reference to exhibit 10.2 in Form 8-K filed December 12, 2008 (Film No. 081245224)

 

(15)

Incorporated herein by reference to exhibit 4 in Form 8-K filed December 8, 2008 (Film No. 081236105)

 

(17)

Included herein

 

(18)

Incorporated herein by reference to exhibit 10.1 in Form 8-K filed December 16, 2009 (Film No. 091245196)

 

(19)

Incorporated herein by reference to exhibit 10.1 in Form 10-Q filed November 2, 2010 (Film No. 101158262)

 

(20)

Incorporated herein by reference to Annex A to 2010 Proxy Statement (Film No. 10693151)

 

(21)

Incorporated herein by reference to like numbered exhibit in Registrant’s 2010 Form 10-K (Film No. 10652528)

 

 

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