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EX-32 - FIRST FINANCIAL SERVICE CORPv223349_ex32.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended March 31, 2011

OR

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

Commission File Number 0-18832

First Financial Service Corporation
(Exact Name of Registrant as specified in its charter)

Kentucky
 
61-1168311
(State or other jurisdiction
 
(IRS Employer Identification No.)
of incorporation or organization)
   

2323 Ring Road
 
(270) 765-2131
Elizabethown, Kentucky 42701
 
(Registrant's telephone number,
(Address of principal executive offices)
 
including area code)
(Zip Code)
   
 
(270) 765-2131
(Registrant's telephone number, including area code)

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

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

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

Large Accelerated Filer ¨  Accelerated Filer ¨ Non-Accelerated Filer x   Smaller Reporting Company ¨

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class
 
Outstanding as of April 30, 2011
     
Common Stock
  
4,739,622 shares
 
 
 

 
 
FIRST FINANCIAL SERVICE CORPORATION
FORM 10-Q
TABLE OF CONTENTS

PART IFINANCIAL INFORMATION
 
   
Preliminary Note Regarding Forward-Looking Statements
  3
   
Item 1.
Consolidated Financial Statements and Notes to Consolidated Financial Statements
  4
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
31
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
46
     
Item 4.
Controls and Procedures
48
   
PART II – OTHER INFORMATION
 
   
Item 1.
Legal Proceedings
48
     
Item 1A.
Risk Factors
48
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
49
     
Item 3.
Defaults upon Senior Securities
49
     
Item 4.
[Removed and Reserved]
49
     
Item 5.
Other Information
49
     
Item 6.
Exhibits
49
     
SIGNATURES
50
 
 
2

 

PRELIMINARY NOTE REGARDING
FORWARD-LOOKING STATEMENTS

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

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

Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of the statement to reflect the occurrence of unanticipated events.
 
 
3

 
 
Item 1.
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Balance Sheets
(Unaudited)
 
   
March 31,
   
December 31,
 
(Dollars in thousands, except per share data)
 
2011
   
2010
 
             
ASSETS:
           
Cash and due from banks
  $ 9,759     $ 14,840  
Interest bearing deposits
    101,170       151,336  
Total cash and cash equivalents
    110,929       166,176  
                 
Securities available-for-sale
    243,395       196,029  
Securities held-to-maturity, fair value of $122 Mar (2011) and $126 Dec (2010)
    120       124  
Total securities
    243,515       196,153  
                 
Loans held for sale
    4,055       6,388  
Loans, net of unearned fees
    858,350       881,934  
Allowance for loan losses
    (24,591 )     (22,665 )
Net loans
    837,814       865,657  
                 
Federal Home Loan Bank stock
    4,909       4,909  
Cash surrender value of life insurance
    9,439       9,354  
Premises and equipment, net
    31,773       31,988  
Real estate owned:
               
Acquired through foreclosure
    24,908       25,807  
Held for development
    45       45  
Other repossessed assets
    39       40  
Core deposit intangible
    917       994  
Accrued interest receivable
    7,727       6,404  
Accrued income taxes
    3,005       2,161  
Deferred income taxes
    1,801       2,982  
Prepaid FDIC Insurance
    3,516       4,449  
Other assets
    5,844       2,388  
                 
TOTAL ASSETS
  $ 1,286,181     $ 1,319,507  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
LIABILITIES:
               
Deposits:
               
Non-interest bearing
  $ 71,869     $ 73,566  
Interest bearing
    1,094,919       1,100,342  
Total deposits
    1,166,788       1,173,908  
                 
Advances from Federal Home Loan Bank
    27,500       52,532  
Subordinated debentures
    18,000       18,000  
Accrued interest payable
    835       594  
Accounts payable and other liabilities
    2,930       3,162  
                 
TOTAL LIABILITIES
    1,216,053       1,248,196  
Commitments and contingent liabilities
    -       -  
                 
STOCKHOLDERS' EQUITY:
               
Serial preferred stock, $1 par value per share; authorized 5,000,000 shares; issued and outstanding, 20,000 shares with a liquidation preference of $20,000
    19,849       19,835  
Common stock, $1 par value per share; authorized 35,000,000 shares; issued and outstanding, 4,739,622 shares Mar (2011), and 4,726,329 shares Dec (2010)
    4,740       4,726  
Additional paid-in capital
    35,290       35,201  
Retained earnings
    13,930       16,264  
Accumulated other comprehensive loss
    (3,681 )     (4,715 )
                 
TOTAL STOCKHOLDERS' EQUITY
    70,128       71,311  
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 1,286,181     $ 1,319,507  
 
See notes to the unaudited consolidated financial statements.
 
 
4

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Income
(Unaudited)
 
   
Three Months Ended
 
(Dollars in thousands, except per share data)
 
March 31,
 
   
2011
   
2010
 
Interest and Dividend Income:
           
Loans, including fees
  $ 12,343     $ 14,047  
Taxable securities
    1,566       493  
Tax exempt securities
    257       171  
Total interest income
    14,166       14,711  
                 
Interest Expense:
               
Deposits
    4,914       4,869  
Short-term borrowings
    -       21  
Federal Home Loan Bank advances
    295       593  
Subordinated debentures
    341       327  
Total interest expense
    5,550       5,810  
                 
Net interest income
    8,616       8,901  
Provision for loan losses
    3,465       1,752  
Net interest income after provision for loan losses
    5,151       7,149  
                 
Non-interest Income:
               
Customer service fees on deposit accounts
    1,445       1,525  
Gain on sale of mortgage loans
    265       299  
Gain on sale of investments
    69       -  
Loss on sale of investments
    -       (23 )
Other than temporary impairment loss:
               
Total other-than-temporary impairment losses
    (37 )     (172 )
Portion of loss recognized in other comprehensive income/(loss) (before taxes)
    -       -  
Net impairment losses recognized in earnings
    (37 )     (172 )
Loss on sale and write downs on real estate acquired through foreclosure
    (235 )     (26 )
Brokerage commissions
    107       93  
Other income
    379       442  
Total non-interest income
    1,993       2,138  
                 
Non-interest Expense:
               
Employee compensation and benefits
    4,329       4,090  
Office occupancy expense and equipment
    811       804  
Marketing and advertising
    225       225  
Outside services and data processing
    797       730  
Bank franchise tax
    314       350  
FDIC insurance premiums
    970       660  
Amortization of core deposit intangible
    77       64  
Real estate acquired through foreclosure expense
    382       155  
Other expense
    1,501       1,196  
Total non-interest expense
    9,406       8,274  
                 
Income/(loss) before income taxes
    (2,262 )     1,013  
Income taxes/(benefits)
    (192 )     258  
Net Income/(Loss)
    (2,070 )     755  
Less:
               
Dividends on preferred stock
    (250 )     (250 )
Accretion on preferred stock
    (14 )     (14 )
Net income (loss) attributable to common shareholders
  $ (2,334 )   $ 491  
                 
Shares applicable to basic income per common share
    4,736,287       4,715,721  
Basic income (loss) per common share
  $ (0.49 )   $ 0.10  
                 
Shares applicable to diluted income per common share
    4,736,287       4,715,721  
Diluted income (loss) per common share
  $ (0.49 )   $ 0.10  
                 
Cash dividends declared per common share
  $ -     $ -  
 
See notes to the unaudited consolidated financial statements.
 
 
5

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Comprehensive Income
(Unaudited)

   
Three Months Ended
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Net Income/(Loss)
  $ (2,070 )   $ 755  
Other comprehensive income (loss):
               
Change in unrealized gain (loss) on securities available-for-sale
    1,207       67  
Change in unrealized gain (loss) on securities available-for-sale for which a portion of other-than-temporary impairment has been recognized into earnings
    393       (28 )
Reclassification of realized amount on securities available-for-sale losses (gains)
    (44 )     146  
Reclassification of unrealized loss on held-to-maturity security recognized in income
    12       29  
Accretion (amortization) of non-credit component of other-than-temporary impairment on held-to-maturity securities
    (1 )     -  
Net unrealized gain (loss) recognized in comprehensive income
    1,567       214  
Tax effect
    (533 )     (73 )
Total other comphrehensive income
    1,034       141  
                 
Comprehensive Income/(Loss)
  $ (1,036 )   $ 896  
 
The following is a summary of the accumulated other comprehensive income balances, net of tax:

 
   
Balance
   
Current
   
Balance
 
   
at
   
Period
   
at
 
   
12/31/2010
   
Change
   
3/31/2011
 
Unrealized gains (losses) on securities available-for-sale
  $ (5,691 )   $ 750     $ (4,941 )
Unrealized gains (losses) on available-for-sale  securities for which OTTI has been recorded,
     1,082        276        1,358  
Unrealized gains (losses) on held-to-maturity securities for which OTTI has been recorded, net of accretion
       (106 )        8          (98 )
                         
Total
  $ (4,715 )   $ 1,034     $ (3,681 )

See notes to the unaudited consolidated financial statements.
 
 
6

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Changes in Stockholders' Equity
Three Months Ended March 31, 2011
(Dollars In Thousands, Except Per Share Amounts)
(Unaudited)
 
   
Shares
   
Amount
   
Additional
Paid-in
   
Retained
   
Accumulated
Other
Comprehensive
(Loss), Net of
       
   
Preferred
   
Common
   
Preferred
   
Common
   
Capital
   
Earnings
   
Tax
   
Total
 
                                                                 
Balance, January 1, 2011
    20,000       4,726     $ 19,835     $ 4,726     $ 35,201     $ 16,264     $ (4,715 )   $ 71,311  
Net loss
                                            (2,070 )             (2,070 )
Shares issued under dividend reinvestment program
            1               1       1                       2  
Stock issued for employee benefit plans
            13               13       40                       53  
Stock-based compensation expense
                                    48                       48  
Net change in unrealized gains (losses) on securities available-for-sale,
                                                    750       750  
Change in unrealized gains (losses) on held-to-maturity securities for which an other-than-temporary impairment charge has been recorded,
                                                    8       8  
Change in unrealized gains (losses) on securities available-for-sale for which a portion of an other-than-temporary impairment charge has been recognized into earnings, net of reclassification
                                                    276       276  
Dividends on preferred stock
                                            (250 )             (250 )
Accretion of preferred stock discount
    -       -       14       -       -       (14 )     -       -  
Balance, March 31, 2011
    20,000       4,740     $ 19,849     $ 4,740     $ 35,290     $ 13,930     $ (3,681 )   $ 70,128  

See notes to the unaudited consolidated financial statements.
 
 
7

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Cash Flows
(Dollars In Thousands)
(Unaudited)

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Operating Activities:
           
Net income/(loss)
  $ (2,070 )   $ 755  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    3,465       1,752  
Depreciation on premises and equipment
    449       427  
Core deposit intangible amortization
    77       64  
Net amortization (accretion) available-for-sale
    439       (148 )
Impairment loss on securities available-for-sale
    25       123  
Impairment loss on securities held-to-maturity
    12       49  
Loss on sale of investments available-for-sale
    -       23  
Gain on sale of investments available-for-sale
    (69 )     -  
Gain on sale of mortgage loans
    (265 )     (299 )
Origination of loans held for sale
    (14,572 )     (24,629 )
Proceeds on sale of loans held for sale
    17,170       27,884  
Stock-based compensation expense
    48       24  
Prepaid FDIC premium
    933       614  
Changes in:
               
Cash surrender value of life insurance
    (85 )     (88 )
Interest receivable
    (1,323 )     (204 )
Other assets
    (2,803 )     (458 )
Interest payable
    241       (46 )
Accounts payable and other liabilities
    (232 )     746  
Net cash from operating activities
    1,440       6,589  
                 
Investing Activities:
               
Sales of securities available-for-sale
    16,271       500  
Purchases of securities available-for-sale
    (70,000 )     (34,614 )
Maturities of securities available-for-sale
    7,524       553  
Maturities of securities held-to-maturity
    3       785  
Net change in loans
    22,096       26,172  
Net purchases of premises and equipment
    (234 )     (774 )
Net cash from investing activities
    (24,340 )     (7,378 )
                 
Financing Activities
               
Net change in deposits
    (7,120 )     42,399  
Change in short-term borrowings
    -       (658 )
Maturity of Federal Home Loan Bank advance
    (25,000 )     -  
Repayments to Federal Home Loan Bank
    (32 )     (118 )
Issuance of common stock under dividend reinvestment program
    2       8  
Issuance of common stock for employee benefit plans
    53       63  
Dividends paid on preferred stock
    (250 )     (250 )
Net cash from financing activities
    (32,347 )     41,444  
                 
(Decrease) Increase in cash and cash equivalents
    (55,247 )     40,655  
Cash and cash equivalents, beginning of period
    166,176       98,533  
Cash and cash equivalents, end of period
  $ 110,929     $ 139,188  
                 
Supplemental noncash disclosures:
               
Transfers from loans to real estate owned
  $ 1,932     $ 2,337  

See notes to the unaudited consolidated financial statements.

 
8

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank.  First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, Heritage Properties, LLC and First Federal Office Park, LLC.  Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its direct and indirect wholly-owned subsidiaries.  All significant intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three-month period ending March 31, 2011 are not necessarily indicative of the results that may occur for the year ending December 31, 2011.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2010, as amended by Form 10-K/A filed May 13, 2011.

Adoption of New Accounting Standards – FASB ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, was issued in July 2010.  The new disclosure guidance significantly expands the existing requirements and leads to greater transparency into a company’s exposure to credit losses from lending arrangements.  The extensive new disclosures of information as of the end of a reporting period became effective for both interim and annual reporting periods ending after December 15, 2010.  Specific items regarding activity that occurred before the issuance of the ASU, such as the allowance roll-forward and modification disclosures were required for periods beginning after December 15, 2010.  The new standard did not have a material impact.

On April 5, 2011, the FASB issued ASU 2011-02 “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”, which clarifies when creditors should classify loan modifications as troubled debt restructurings. The guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the year. The guidance on measuring the impairment of a receivable restructured in a troubled debt restructuring, as clarified, is effective on a prospective basis. The adoption of this ASU is not expected to have a material impact.

2.
REGULATORY MATTERS

On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of 8.5% and a total risk-based capital ratio of 11.5% by March 31, 2011 and achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011.   At March 31, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements.  We notified the bank regulatory agencies that the increased capital levels would not be achieved and as we remain in regular contact with the FDIC and KDFI, we expect the agencies will reevaluate our progress toward the higher capital ratios at June 30, 2011.  On April 20, 2011, the Corporation entered into a Consent Order with the Federal Reserve Bank of St. Louis which requires the Corporation to obtain regulatory approval before declaring any dividends.  We also may not redeem shares or obtain additional borrowings without prior approval.

In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies including the following:

 
·
Raising capital by selling capital stock through a public offering or private placement.
 
 
9

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

2.
REGULATORY MATTERS – (Continued)

 
·
Continuing to operate the Company and the Bank in a safe and sound manner.  Until we can complete a capital raise, this will most likely require us to reduce lending concentrations, potentially sell loans, and take significant operating expense reductions and other cost cutting measures aimed at lowering expenses.  Additionally, we would adjust the mix of our assets to reduce the total risk weight of our assets, reduce total assets over time and potentially sell branches, deposits and loans.

 
·
Evaluating other strategic alternatives, such as a sale of assets, one or more branches, or the institution.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order.  The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances.

 
10

 
 
3. 
SECURITIES

The amortized cost basis and fair values of securities are as follows:
 
         
Gross
   
Gross
       
(Dollars in thousands)
 
Amortized
   
Unrealized
   
Unrealized
       
   
Cost
   
Gains
   
Losses
   
Fair Value
 
Securities available-for-sale:
                       
March 31, 2011:
                       
U.S. Treasury and agencies
  $ 174,347     $ 197     $ (3,792 )   $ 170,752  
Government-sponsored mortgage-backed residential
    48,679       464       (263 )     48,880  
Equity
    299       -       (5 )     294  
State and municipal
    22,555       531       (89 )     22,997  
Trust preferred securities
    1,073       -       (601 )     472  
                                 
Total
  $ 246,953     $ 1,192     $ (4,750 )   $ 243,395  
                                 
December 31, 2010:
                               
U.S. Treasury and agencies
  $ 117,886     $ 97     $ (4,090 )   $ 113,893  
Government-sponsored mortgage-backed residential
    59,320       448       (598 )     59,170  
Equity
    299       -       (6 )     293  
State and municipal
    22,564       264       (210 )     22,618  
Trust preferred securities
    1,074       -       (1,019 )     55  
                                 
Total
  $ 201,143     $ 809     $ (5,923 )   $ 196,029  
 
         
Gross
   
Gross
       
   
Amortized
   
Unrecognized
   
Unrecognized
       
   
Cost
   
Gains
   
Losses
   
Fair Value
 
Securities held-to-maturity:
                       
March 31, 2011:
                       
Government-sponsored mortgage-backed residential
  $ 97     $ 2     $ -     $ 99  
Trust preferred securities
    23       -       -       23  
                                 
Total
  $ 120     $ 2     $ -     $ 122  
                                 
December 31, 2010:
                               
Government-sponsored mortgage-backed residential
  $ 102     $ 2     $ -     $ 104  
Trust preferred securities
    22       -       -       22  
                                 
Total
  $ 124     $ 2     $ -     $ 126  
 
 
11

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3.
SECURITIES – (Continued)

The amortized cost and fair value of securities at March 31, 2011, by contractual maturity, are shown below.  Securities not due at a single maturity date, primarily mortgage-backed and equity securities, are shown separately.
 
   
Available for Sale
   
Held-to-Maturity
 
   
Amortized
   
Fair
   
Amortized
   
Fair
 
(Dollars in thousands)
 
Cost
   
Value
   
Cost
   
Value
 
                         
Due in one year or less
  $ 115     $ 116     $ -     $ -  
Due after one year through five years
    62,044       62,030       -       -  
Due after five years through ten years
    23,737       23,395       -       -  
Due after ten years
    112,079       108,680       23       23  
Government-sponsored mortgage-backed residential
    48,679       48,880       97       99  
Equity
    299       294       -       -  
    $ 246,953     $ 243,395     $ 120     $ 122  

For the March 31, 2011 quarter, proceeds from sales of available-for-sale debt securities were $16.3 million and for the 2010 quarter, proceeds from sales of available-for-sale equity securities were $500,000.  Gross realized gains recognized in income in 2011 were $69,000.  Gross realized losses recognized in income in 2010 were $23,000.

Investment securities pledged to secure public deposits and FHLB advances had an amortized cost of $62.7 million and fair value of $61.2 million at March 31, 2011 and a $66.8 million amortized cost and fair value of $65.1 million at December 31, 2010.

Securities with unrealized losses at March 31, 2011 and December 31, 2010 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

March 31, 2011
 
Less than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
Description of Securities
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
   
                                   
U.S. Treasury and agencies  
  $ 101,127     $ (3,792 )   $ -     $ -     $ 101,127     $ (3,792 )
Government-sponsored  mortgage-backed residential
    21,660       (263 )     -       -       21,660       (263 )
Equity  
    3       (5 )     -       -       3       (5 )
State and municipal  
    2,602       (58 )     548       (31 )     3,150       (89 )
Trust preferred securities
    -       -       472       (601 )     472       (601 )
                                                 
Total temporarily impaired
  $ 125,392     $ (4,118 )   $ 1,020     $ (632 )   $ 126,412     $ (4,750 )
 
December 31, 2010
 
Less than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
Description of Securities
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
   
                                   
U.S. Treasury and agencies
  $ 70,896     $ (4,090 )   $ -     $ -     $ 70,896     $ (4,090 )
Government-sponsored mortgage-backed residential
    22,084       (598 )     -       -       22,084       (598 )
Equity  
    3       (6 )     -       -       3       (6 )
State and municipal  
    11,095       (157 )     527       (53 )     11,622       (210 )
Trust preferred securities
    -       -       55       (1,019 )     55       (1,019 )
   
                                               
Total temporarily impaired
  $ 104,078     $ (4,851 )   $ 582     $ (1,072 )   $ 104,660     $ (5,923 )
 
 
12

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3. 
SECURITIES – (Continued)
 
We evaluate investment securities with significant declines in fair value on a quarterly basis to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary.

Accounting guidance requires entities to split other than temporary impairment charges between credit losses (i.e., the loss based on the entity’s estimate of the decrease in cash flows, including those that result from expected voluntary prepayments), which are charged to earnings, and the remainder of the impairment charge (non-credit component) to accumulated other comprehensive income. This requirement pertains to both securities held to maturity and securities available for sale.

The unrealized losses on our U. S. Treasury and agency securities and our government sponsored mortgage-backed residential securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2011.

The unrealized losses on the state and municipal securities were caused primarily by interest rate decreases.  The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment.  Because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these investments to be other-than-temporarily impaired at March 31, 2011.  We also considered the financial condition and near term prospects of the issuer and identified no matters that would indicate less than full recovery.

As discussed in Note 8 - Fair Value, the fair value of our portfolio of trust preferred securities, has decreased significantly as a result of the current credit crisis and lack of liquidity in the financial markets.  There are limited trades in trust preferred securities and the majority of holders of such instruments have elected not to participate in the market unless they are required to sell as a result of liquidation, bankruptcy, or other forced or distressed conditions.

To determine if the five trust preferred securities were other than temporarily impaired as of March 31, 2011, we used a discounted cash flow analysis.  The cash flow models were used to determine if the current present value of the cash flows expected on each security were still equivalent to the original cash flows projected on the security when purchased.   The cash flow analysis takes into consideration assumptions for prepayments, defaults and deferrals for the underlying pool of banks, insurance companies and REITs.

Management works with independent third parties to identify its best estimate of the cash flow expected to be collected. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed included the following general assumptions:

 
·
We assume default rates on individual entities behind the pools based on Fitch ratings for financial institutions and A.M. Best ratings for insurance companies.  These ratings are used to predict the default rates for the next several quarters.  Two of the trust preferred securities hold a limited number of real estate investment trusts (REITs) in their pools.  REITs are evaluated on an individual basis to predict future default rates.
 
·
We assume that annual defaults for the remaining life of each security will be 37.5 basis points.
 
·
We assume a recovery rate of 15% on deferrals after two years.

 
13

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3. 
SECURITIES – (Continued)

 
·
We assume 2% prepayments through the five year par call and then 2% per annum for the remaining life of the security.
 
·
Our securities have been modeled using the above assumptions by FTN Financial using the forward LIBOR curve plus original spread to discount projected cash flows to present values.

Additionally, in making our determination, we considered all available market information that could be obtained without undue cost and effort, and considered the unique characteristics of each trust preferred security individually by assessing the available market information and the various risks associated with that security including:

 
·
Valuation estimates provided by our investment broker;
 
·
The amount of fair value decline;
 
·
How long the decline in fair value has existed;
 
·
Significant rating agency changes on the issuer;
 
·
Level of interest rates and any movement in pricing for credit and other risks;
 
·
Information about the performance of the underlying institutions that issued the debt instruments, such as net income, return on equity, capital adequacy, non-performing assets, Texas ratios, etc;
 
·
Our intent to sell the security or whether it is more likely than not that we will be required to sell the security before its anticipated recovery; and
 
·
Other relevant observable inputs.

The following table details the five debt securities with other-than-temporary impairment at March 31, 2011 and the related credit losses recognized in earnings during the three months ended March 31, 2011:

        
Moody's
                             
% of Current
       
       
Credit
 
Current
                   
Current
   
Deferrals and
       
(Dollars in thousands)
     
Ratings
 
Moody's
             
Estimated
   
Deferrals
   
Defaults
   
Year to Date
 
       
When
 
Credit
 
Par
   
Amortized
   
Fair
   
and
   
to Current
   
OTTI
 
Security
 
Tranche
 
Purchased
 
Ratings
 
Value
   
Cost
   
Value
   
Defaults
   
Collateral
   
Recognized
 
                                                 
Preferred Term Securities IV
 
Mezzanine
  A3  
Ca
  $ 244     $ 180     $ 77     $ 18,000       27 %   $ 1  
Preferred Term Securities VI
 
Mezzanine
  A1  
Caa1
    259       23       23       33,000       81 %     12  
Preferred Term Securities XV B1
 
Mezzanine
  A2  
Ca
    1,004       420       187       156,050       26 %     -  
Preferred Term Securities XXI C2
 
Mezzanine
  A3  
Ca
    1,018       392       148       202,000       27 %     24  
Preferred Term Securities XXII C1
 
Mezzanine
  A3  
Ca
    503       81       60       367,500       27 %     -  
                                                             
Total
              $ 3,028     $ 1,096     $ 495                     $ 37  

The table below presents a roll-forward of the credit losses recognized in earnings for the periods ended March 31, 2011 and 2010:

(Dollars in thousands)
 
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
             
Beginning balance
  $ 1,910     $ 862  
Increases to the amount related to the credit loss for which other-than-temporary impairment was previously recognized
    37       172  
Ending balance
  $ 1,947     $ 1,034  

 
14

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS

Loans are summarized as follows:

   
March 31,
   
December 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Commercial
  $ 35,569     $ 42,265  
Commercial Real Estate:
               
Land Development
    55,487       56,086  
Building Lots
    11,237       11,333  
Other
    484,977       490,345  
Real estate construction
    7,964       11,034  
Residential mortgage
    160,610       163,975  
Consumer and home equity
    75,491       77,781  
Indirect consumer
    27,434       29,588  
Loans held for sale
    4,055       6,388  
      862,824       888,795  
Less:
               
Net deferred loan origination fees
    (419 )     (473 )
Allowance for loan losses
    (24,591 )     (22,665 )
      (25,010 )     (23,138 )
                 
Net Loans
  $ 837,814     $ 865,657  
 
The following table presents the activity in the allowance for loan losses by portfolio segment for the three months ending March 31, 2011:

March 31, 2011
       
Commercial
   
Real Estate
   
Residential
   
Consumer &
   
Indirect
       
   
Commercial
   
Real Estate
   
Construction
   
Mortgage
   
Home Equity
   
Consumer
   
Total
 
(Dollars in thousands)
                                         
Allowance for loan losses:
                                         
Beginning Balance
  $ 1,657     $ 18,595     $ 158     $ 751     $ 708     $ 796     $ 22,665  
Provision for loan losses
    22       3,351       -       43       84       (35 )     3,465  
Charge-offs
    (42 )     (1,616 )     (54 )     (19 )     (98 )     (31 )     (1,860 )
Recoveries
    42       206       -       1       48       24       321  
Total ending allowance balance
  $ 1,679     $ 20,536     $ 104     $ 776     $ 742     $ 754     $ 24,591  

The following table presents the activity in the allowance for loan losses for the three months ended March 31, 2010:

(Dollars in thousands)
     
       
Balance, beginning of period
  $ 17,719  
Provision for loan losses
    1,752  
Charge-offs
    (711 )
Recoveries
    50  
Balance, end of period
  $ 18,810  

We did not implement any changes to our accounting policies or methodology during the current period.
 
 
15

 
 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment excluding loans held for sale and based on the impairment method as of March 31, 2011 and December 31, 2010:

March 31, 2011
       
Commercial
   
Real Estate
   
Residential
   
Consumer &
   
Indirect
       
   
Commercial
   
Real Estate
   
Construction
   
Mortgage
   
Home Equity
   
Consumer
   
Total
 
(Dollars in thousands)
                                         
Allowance for loan losses:
                                         
Ending allowance balance attributable to loans:
                                         
Individually evaluated for impairment
  $ 827     $ 14,020       -     $ 385     $ 191     $ 37     $ 15,460  
Collectively evaluated for impairment
    852       6,516       104       391       551       717       9,131  
                                                         
Total ending allowance balance
  $ 1,679     $ 20,536       104     $ 776     $ 742     $ 754     $ 24,591  
                                                         
Loans:
                                                       
Loans individually evaluated for impairment
  $ 1,927     $ 97,370     $ 290     $ 1,871     $ 298     $ 137     $ 101,893  
Loans collectively evaluated for impairment
    33,642       454,331       7,674       158,739       75,193       27,297       756,876  
Loans acquired with deteriorated credit quality
    -       -       -       -       -       -       -  
                                                         
Total ending loans balance
  $ 35,569     $ 551,701     $ 7,964     $ 160,610     $ 75,491     $ 27,434     $ 858,769  
 
December 31, 2010
       
Commercial
   
Real Estate
   
Residential
   
Consumer &
   
Indirect
       
   
Commercial
   
Real Estate
   
Construction
   
Mortgage
   
Home Equity
   
Consumer
   
Total
 
(Dollars in thousands)
                                         
Allowance for loan losses:
                                         
Ending allowance balance attributable to loans:
                                         
Individually evaluated for impairment
  $ 691     $ 11,872       24     $ 334     $ 147     $ 29     $ 13,097  
Collectively evaluated for impairment
    966       6,723       134       417       561       767       9,568  
                                                         
Total ending allowance balance
  $ 1,657     $ 18,595       158     $ 751     $ 708     $ 796     $ 22,665  
                                                         
Loans:
                                                       
Loans individually evaluated for impairment
  $ 1,870     $ 86,250     $ 1,267     $ 1,609     $ 337     $ 91     $ 91,424  
Loans collectively evaluated for impairment
    40,395       471,514       9,767       162,366       77,444       29,497       790,983  
Loans acquired with deteriorated credit quality
    -       -       -       -       -       -       -  
                                                         
Total ending loans balance
  $ 42,265     $ 557,764     $ 11,034     $ 163,975     $ 77,781     $ 29,588     $ 882,407  
 
 
16

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)

The following table presents loans individually evaluated for impairment by class of loans as of March 31, 2011 and December 31, 2010.  The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits:
 
March 31,2011
 
Unpaid
         
Allowance for
   
Average
   
Interest
   
Cash Basis
 
   
Principal
   
Recorded
   
Loan Losses
   
Recorded
   
Income
   
Interest
 
(Dollars in thousands)
 
Balance
   
Investment
   
Allocated
   
Investment
   
Recognized
   
Recognized
 
                                     
With no related allowance recorded:
                                   
Commercial
  $ 262     $ 263     $ -     $ 288     $ 11     $ 11  
Commercial Real Estate:
                                               
Land Development
    -       -       -       -       -       -  
Building Lots
    -       -       -       -       -       -  
Other
    42,845       44,145       -       38,239       1,467       1,467  
Real Estate Construction
    290       290       -       238       7       7  
Residential Mortgage
    -       -       -       -       -       -  
Consumer and Home Equity
    -       -       -       -       -       -  
Indirect Consumer
    -       -       -       -       -       -  
                                                 
With an allowance recorded:
                                               
Commercial
    1,664       1,664       827       1,611       64       64  
Commercial Real Estate:
                                               
Land Development
    23,169       23,169       7,047       23,032       411       411  
Building Lots
    3,430       3,430       37       3,430       -       -  
Other
    26,626       26,626       6,936       27,110       1,040       1,040  
Real Estate Construction
    -       -       -       541       37       37  
Residential Mortgage
    1,871       1,871       385       1,740       2       2  
Consumer and Home Equity
    298       298       191       318       -       -  
Indirect Consumer
    137       137       37       114       -       -  
                                                 
Total
  $ 100,592     $ 101,893     $ 15,460     $ 96,661     $ 3,039     $ 3,039  
 
December 31, 2010
 
Unpaid
         
Allowance for
 
   
Principal
   
Recorded
   
Loan Losses
 
(Dollars in thousands)
 
Balance
   
Investment
   
Allocated
 
                   
With no related allowance recorded:
                 
Commercial
  $ 312     $ 312     $ -  
Commercial Real Estate:
                       
Land Development
    -       -       -  
Building Lots
    -       -       -  
Other
    30,337       32,332       -  
Real Estate Construction
    185       185       -  
Residential Mortgage
    -       -       -  
Consumer and Home Equity
    -       -       -  
Indirect Consumer
    -       -       -  
                         
With an allowance recorded:
                       
Commercial
    1,558       1,558       691  
Commercial Real Estate:
                       
Land Development
    22,895       22,895       4,562  
Building Lots
    3,430       3,430       39  
Other
    27,593       27,593       7,271  
Real Estate Construction
    1,082       1,082       24  
Residential Mortgage
    1,609       1,609       334  
Consumer and Home Equity
    337       337       147  
Indirect Consumer
    91       91       29  
                         
Total
  $ 89,429     $ 91,424     $ 13,097  
 
 
17

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)

The following table presents information for loans individually evaluated for impairment as of March 31, 2010:

   
March 31,
 
(Dollars in thousands)
 
2010
 
       
Average of individually impaired loans during period
    59,655  
Interest income recognized during impairment
    1,938  
Cash-basis interest income recognized
    1,938  

The following table presents the recorded investment in restructured, nonaccrual and loans past due over 90 days still on accrual by class of loans as of March 31, 2011 and December 31, 2010.

     
Loans Past Due
       
March 31, 2011
       
Over 90 Days
       
         
Still
       
(Dollars in thousands)
 
Restructured
   
Accruing
   
Nonaccrual
 
                   
Commercial
  $ 388       -     $ 579  
Commercial Real Estate:
                       
Land Development
    -       -       16,299  
Building Lots
    -               3,430  
Other
    17,543       -       22,939  
Real Estate Construction
    -               -  
Residential Mortgage
    750       -       1,120  
Consumer and Home Equity
    70               387  
Indirect Consumer
    -       -       145  
                         
Total
  $ 18,751       -     $ 44,899  

     
Loans Past Due
       
December 31, 2010
       
Over 90 Days
       
         
Still
       
(Dollars in thousands)
 
Restructured
   
Accruing
   
Nonaccrual
 
                   
Commercial
  $ 179       -     $ 597  
Commercial Real Estate:
                       
Land Development
    -       -       15,356  
Building Lots
    -               3,430  
Other
    3,394       -       19,939  
Real Estate Construction
    -               -  
Residential Mortgage
    306       -       2,294  
Consumer and Home Equity
    27               365  
Indirect Consumer
    -       -       188  
                         
Total
  $ 3,906       -     $ 42,169  
 
 
18

 
 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)
 
The following table presents the aging of the unpaid principal in past due loans as of March 31, 2011 and December 31, 2010 by class of loans:
 
March 31, 2011
 
30-59
   
60-89
   
Greater than
                   
   
Days
   
Days
   
90 Days
   
Total
   
Loans Not
       
(Dollars in thousands)
 
Past Due
   
Past Due
   
Past Due
   
Past Due
   
Past Due
   
Total
 
                                     
Commercial
  $ 552     $ -     $ 1,187     $ 1,739     $ 33,830     $ 35,569  
Commercial Real Estate:
                                               
Land Development
    150       4,506       8,624       13,280       42,189       55,469  
Building Lots
    206       135       3,430       3,771       7,466       11,237  
Other
    7,465       16,930       37,866       62,261       422,734       484,995  
Real Estate Construction
    -       -       -       -       7,964       7,964  
Residential Mortgage
    781       598       3,707       5,086       155,524       160,610  
Consumer and Home Equity
    550       48       641       1,239       74,252       75,491  
Indirect Consumer
    172       72       145       389       27,045       27,434  
                                                 
Total
  $ 9,876     $ 22,289     $ 55,600     $ 87,765     $ 771,004     $ 858,769  
 
December 31, 2010
 
30-59
   
60-89
   
Greater than
                   
   
Days
   
Days
   
90 Days
   
Total
   
Loans Not
       
(Dollars in thousands)
 
Past Due
   
Past Due
   
Past Due
   
Past Due
   
Past Due
   
Total
 
                                     
Commercial
  $ 719     $ 683     $ 574     $ 1,976     $ 40,289     $ 42,265  
Commercial Real Estate:
                                               
Land Development
    -       -       7,682       7,682       48,404       56,086  
Building Lots
    -       -       3,430       3,430       7,903       11,333  
Other
    2,824       10,110       16,294       29,228       461,117       490,345  
Real Estate Construction
    1,082       -       -       1,082       9,952       11,034  
Residential Mortgage
    313       962       4,386       5,661       158,314       163,975  
Consumer and Home Equity
    527       70       680       1,277       76,504       77,781  
Indirect Consumer
    386       51       188       625       28,963       29,588  
                                                 
Total
  $ 5,851     $ 11,876     $ 33,234     $ 50,961     $ 831,446     $ 882,407  
 
Troubled Debt Restructurings:
 
We have allocated $3.6 million and $151,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of March 31, 2011 and December 31, 2010.  We are not committed to lend additional funds to debtors whose loans have been modified in a troubled debt restructuring.

Credit Quality Indicators:
 
We categorize loans 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.  We analyze loans individually by classifying the loans as to credit risk.  This analysis includes commercial and commercial real estate loans.  We also evaluate credit quality on residential mortgage, consumer and home equity and indirect consumer loans based on the aging status and payment activity of the loan.  This analysis is performed on a monthly basis.  We use the following definitions for risk ratings:

Criticized:  Loans classified as criticized 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 in our credit position at some future date.

 
19

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)

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.

Loss:  Loans classified as loss are considered non-collectible and their continuance as bankable assets is not warranted.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.  Loans listed as not rated are included in groups of homogeneous loans.

As of March 31, 2011 and December 31, 2010, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
 
March 31, 2011
                                         
(Dollars in thousands)
 
Not Rated
   
Pass
   
Criticized
   
Substandard
   
Doubtful
   
Loss
   
Total
 
                                           
Commercial
  $ -     $ 31,402     $ 2,240     $ 1,414     $ 513     $ -     $ 35,569  
Commercial Real Estate:
                                                       
Land Development
    -       24,921       7,379       23,169       -       -       55,469  
Building Lots
    -       6,990       817       3,430       -       -       11,237  
Other
    -       391,030       23,021       70,646       125       173       484,995  
Real Estate Construction
    -       7,673       -       291       -       -       7,964  
Residential Mortgage
    154,403       -       1,179       5,025       -       3       160,610  
Consumer and Home Equity
    73,706       -       664       1,119       -       2       75,491  
Indirect Consumer
    27,120       -       38       276       -       -       27,434  
                                                         
Total
  $ 255,229     $ 462,016     $ 35,338     $ 105,370     $ 638     $ 178     $ 858,769  
 
December 31, 2010
                                         
(Dollars in thousands)
 
Not Rated
   
Pass
   
Criticized
   
Substandard
   
Doubtful
   
Loss
   
Total
 
                                           
Commercial
  $ -     $ 38,036     $ 2,359     $ 1,412     $ 458     $ -     $ 42,265  
Commercial Real Estate:
                                                       
Land Development
    -       29,769       3,422       22,895       -       -       56,086  
Building Lots
    -       7,903       -       3,430       -       -       11,333  
Other
    -       409,387       21,012       59,800       125       21       490,345  
Real Estate Construction
    -       9,767       -       1,267       -       -       11,034  
Residential Mortgage
    157,498       -       917       5,560       -       -       163,975  
Consumer and Home Equity
    76,086       -       599       1,072       -       24       77,781  
Indirect Consumer
    29,342       -       -       227       -       19       29,588  
                                                         
Total
  $ 262,926     $ 494,862     $ 28,309     $ 95,663     $ 583     $ 64     $ 882,407  
 
 
20

 
 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)

The following table presents the unpaid principal balance in residential mortgage, consumer and home equity and indirect consumer loans based on payment activity as of March 31, 2011 and December 31, 2010:

March 31, 2011
 
Residential
   
Consumer &
   
Indirect
 
(Dollars in thousands)
 
Mortgage
   
Home Equity
   
Consumer
 
                   
Performing
  $ 158,740     $ 75,034     $ 27,289  
Restructured & Non-accrual
    1,870       457       145  
                         
Total
  $ 160,610     $ 75,491     $ 27,434  

December 31, 2010
 
Residential
   
Consumer &
   
Indirect
 
(Dollars in thousands)
 
Mortgage
   
Home Equity
   
Consumer
 
                   
Performing
  $ 161,375     $ 77,389     $ 29,400  
Restructured & Non-accrual
    2,600       392       188  
                         
Total
  $ 163,975     $ 77,781     $ 29,588  
 
5. 
REAL ESTATE ACQUIRED THROUGH FORECLOSURE

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

   
March 31,
   
December 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Beginning balance
  $ 25,807     $ 8,428  
Additions
    1,932       24,622  
Sales
    (2,629 )     (4,928 )
Writedowns
    (202 )     (2,315 )
Ending balance
  $ 24,908     $ 25,807  

6. 
INCOME TAXES

The calculation for the income tax provision or benefit generally does not consider the tax effects of changes in other comprehensive income, or OCI, which is a component of shareholders’ equity on the balance sheet.  However, an exception is provided in certain circumstances, such as when there is a full valuation allowance against net deferred tax assets, there is a loss from continuing operations and income in other components of the financial statements.  In such a case, pre-tax income from other categories, such as changes in OCI, must be considered in determining a tax benefit to be allocated to the loss from continuing operations.  For the quarter ended March 31, 2011, this resulted in $192,000 of income tax benefit allocated to continuing operations.

A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized.  In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 and 2011.  These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at March 31, 2011 and December 31, 2010.  The remaining deferred tax asset of $1.8 million is considered more likely than not to be realizable due to the availability of taxable income in open years.
 
 
21

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
7. 
EARNINGS (LOSS) PER SHARE

 
The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:

   
Three Months Ended
 
(Dollars in thousands,
 
March 31,
 
except per share data)
 
2011
   
2010
 
             
Basic:
           
Net income/(loss)
  $ (2,070 )   $ 755  
Less:
               
Preferred stock dividends
    (250 )     (250 )
Accretion on preferred stock discount
    (14 )     (14 )
Net income (loss) available to common shareholders
  $ (2,334 )   $ 491  
Weighted average common shares
    4,736       4,716  
                 
Diluted:
               
Weighted average common shares
    4,736       4,716  
Dilutive effect of stock options and warrants
    -       -  
Weighted average common and incremental shares
    4,736       4,716  
                 
Earnings (Loss) Per Common Share:
               
Basic
  $ (0.49 )   $ 0.10  
Diluted
  $ (0.49 )   $ 0.10  

Stock options for 266,521 and 239,706 shares of common stock were not included in the March 31, 2011 and 2010 computation of diluted earnings per share because their impact was anti-dilutive.  Warrants to purchase 215,983 shares at March 31, 2011 and 2010 were not included in the computation because their impact was also anti-dilutive.

8. 
STOCK BASED COMPENSATION PLAN

Our 2006 Stock Option and Incentive Compensation Plan, which is shareholder approved, succeeded our 1998 Stock Option and Incentive Compensation Plan. Under the 2006 Plan, we may grant restricted stock and incentive or non-qualified stock options to key employees and directors for a total of 647,350 shares of our common stock. Options available for future grant under the 1998 Plan totaled 38,500 shares and were rolled into the 2006 Plan. We believe that the ability to award stock options and other forms of stock-based incentive compensation can assist us in attracting and retaining key employees. Stock-based incentive compensation is also a means to align the interests of key employees with those of our shareholders by providing awards intended to reward recipients for our long-term growth. The option to purchase shares vest over periods of one to five years and expire ten years after the date of grant. We issue new shares of common stock upon the exercise of stock options. If options or awards granted under the 2006 Plan expire or terminate for any reason without having been exercised in full or released from restriction, the corresponding shares shall again be available for option or award for the purposes of the Plan. At March 31, 2011, options and restricted stock available for future grant under the 2006 Plan totaled 430,559.

Compensation cost related to options and restricted stock granted under the 1998 and 2006 Plans that was charged against earnings for the periods ended March 31, 2011 and 2010 was $48,000 and $24,000.  As of March 31, 2011 there was $374,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 1998 and 2006 Plans. That cost is expected to be recognized over a weighted-average period of 2.8 years.

Stock Options – The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various weighted-average assumptions.  The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant.  The expected volatility is based on the fluctuation in the price of a share of stock over the period for which the option is being valued and the expected life of the options granted represents the period of time the options are expected to be outstanding.  There were no stock option grants for the March 31, 2011 period.

 
22

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
8. 
STOCK OPTION PLAN - (Continued)
 
A summary of option activity under the 1998 and 2006 Plans as of March 31, 2011 is presented below:

               
Weighted
       
         
Weighted
   
Average
       
   
Number
   
Average
   
Remaining
   
Aggregate
 
   
of
   
Exercise
   
Contractual
   
Intrinsic
 
   
Options
   
Price
   
Term
   
Value
 
                   
(Dollars In Thousands)
                         
Outstanding, beginning of period
    296,521     $ 13.70              
Granted during period
    -       -              
Forfeited during period
    (30,000 )     14.03              
Exercised during period
    -       -              
Outstanding, end of period
    266,521     $ 13.67       6.9     $ -  
                                 
Eligible for exercise at period end
    125,455     $ 19.32       4.7     $ -  

There were no options exercised, modified or settled in cash for the periods ended March 31, 2011 and 2010. Management expects all outstanding unvested options will vest.

Restricted Stock – In addition to the stock options reflected above, on December 31, 2010, we granted 36,855 shares of restricted common stock at the weighted average current market price of $4.07.  No restricted stock had been granted prior to December 31, 2010.  Restricted stock provides the grantee with voting, dividend and anti-dilution rights equivalent to common shareholders.  The restricted stock vests on December 31, 2012, provided that the recipient has continued to perform substantial services for the Company through that date.  The restricted stock will become 100% vested before the vesting date upon the recipient’s death or disability or a change of control event as defined by federal regulations. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date of vesting. The recipient may not transfer, pledge or dispose of the restricted stock before the date of vesting, and thereafter only in proportion to percentage of the preferred shares originally issued to the U.S. Treasury that have been redeemed.  As of March 31, 2011 there was $131,000 of total unrecognized compensation cost related to the restricted stock. That cost is expected to be recognized over the remaining vesting period of 1.75 years.
 
9. 
FAIR VALUE

U.S. GAAP 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 at the measurement date and establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

We used the following methods and significant assumptions to estimate the fair value of available-for-sale-securities.

 
23

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9. 
FAIR VALUE - (Continued)

Securities: The fair values of some equity securities are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs).  The fair values of most debt securities are determined by a 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).  In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within (Level 3) of the valuation hierarchy.  For trust preferred securities, discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality.  Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.  For other equity securities, discounted cash flows are calculated with available market information through processes using benchmark yields, market spreads sourced from new issues, dealer quotes and trade prices among other sources.  Equity securities are carried at cost which approximates fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets measured at fair value on a recurring basis are summarized below:  There were no significant transfers between Level 1 and Level 2 during the periods presented.
 
     
Quoted Prices in
             
         
Active Markets for
   
Significant Other
   
Significant
 
   
March 31,
   
Identical Assets
   
Observable Inputs
   
Unobservable Inputs
 
(Dollars in thousands)
 
2011
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Assets:
                       
U.S. Treasury and agencies
  $ 170,752     $ -     $ 170,752     $ -  
Government-sponsored mortgage-backed residential
    48,880       -       48,880       -  
Equity
    294       3       -       291  
State and municipal
    22,997       -       22,997       -  
Trust preferred securities
    472       -       -       472  
                                 
Total
  $ 243,395     $ 3     $ 242,629     $ 763  
 
     
Quoted Prices in
             
         
Active Markets for
   
Significant Other
   
Significant
 
   
December 31,
   
Identical Assets
   
Observable Inputs
   
Unobservable Inputs
 
(Dollars in thousands)
 
2010
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Assets:
                       
U.S. Treasury and agencies
  $ 113,893     $ -     $ 113,893     $ -  
Government-sponsored mortgage-backed residential
    59,170       -       59,170       -  
Equity
    293       2       -       291  
State and municipal
    22,618       -       22,618       -  
Trust preferred securities
    55       -       -       55  
                                 
Total
  $ 196,029     $ 2     $ 195,681     $ 346  
 
Between June 2002 and July 2006, we invested in four AFS and one HTM investment grade tranches of trust preferred collateralized debt obligation (“CDO”) securities.  The securities were issued and are referred to as Preferred Term Securities Limited (“PreTSL”).  The underlying collateral for the PreTSL is unguaranteed pooled trust preferred securities issued by banks, insurance companies and REITs geographically dispersed across the United States.  We hold five PreTSL securities, none of which are currently investment grade.  Prior to September 30, 2008, we determined the fair value of the trust preferred securities using a valuation technique based on Level 2 inputs.  The Level 2 inputs included estimates of the market value for each security provided through our investment broker.
 
 
24

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9. 
FAIR VALUE - (Continued)

Since late 2007, the markets for collateralized debt obligations and trust preferred securities have become increasingly inactive.  The inactivity began in late 2007 when new issues of similar securities were discounted in order to complete the offering.  Beginning in the second quarter of 2008, the purchase and sale activity of these securities substantially decreased as investors elected to hold the securities instead of selling them at substantially depressed prices.  Our brokers have indicated that little if any activity is occurring in this sector and that the PreTSL securities trades that are taking place are primarily distressed sales where the seller must liquidate as a result of insolvency, redemptions or closure of a fund holding the security, or other distressed conditions.  As a result, the bid-ask spreads have widened significantly and the volume of trades decreased significantly compared to historical volumes.

During 2008, we determined that the market for the trust preferred securities that we hold and for similar CDO securities (such as higher-rated tranches within the same CDO security) are also not active.  That determination was made considering that there are few observable transactions for the trust preferred securities or similar CDO securities and the observable prices for those transactions have varied substantially over time.  Consequently, we have considered those observable inputs and determined that our trust preferred securities are classified within Level 3 of the fair value hierarchy.

We have determined that an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs is equally or more representative of fair value than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.  

We received valuation estimates on our trust preferred securities for March 31, 2011.  Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.  In accordance with current accounting guidance, we determined that a risk-adjusted discount rate appropriately reflects the reporting entity’s estimate of the assumptions that market participants would use in an active market to estimate the selling price of the asset at the measurement date.  

We conduct a thorough review of fair value hierarchy classifications on a quarterly basis.  Reclassification of certain financial instruments may occur when input observability changes.

The table below presents reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended March 31, 2011 and 2010:

   
Fair Value Measurements
 
   
Using Significant
 
   
Unobservable Inputs
 
   
(Level 3)
 
   
Three Months Ended
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Beginning balance
  $ 346     $ 340  
Total gains or losses:
               
Impairment charges on securities
    (25 )     (123 )
Included in other comprehensive income
    442       118  
Transfers in and/or out of Level 3
    -       -  
Ending balance
  $ 763     $ 335  
 
 
25

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9. 
FAIR VALUE - (Continued)

The table below summarizes changes in unrealized gains and losses recorded in earnings for the quarter ended March 31 for Level 3 assets and liabilities that are still held at March 31.

   
Changes in Unrealized Gains/Losses
 
   
Relating to Assets Still Held at Reporting
 
   
Date for the Three Months Ended
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Interest income on securities
  $ -     $ -  
Other changes in fair value
    25       123  
Total
  $ 25     $ 123  

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Assets measured at fair value on a nonrecurring basis are summarized below:

         
Quoted Prices in
             
         
Active Markets for
   
Significant Other
   
Significant
 
   
March 31,
   
Identical Assets
   
Observable Inputs
   
Unobservable Inputs
 
(Dollars in thousands)
 
2011
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Assets:
                       
Impaired loans:
                       
Commercial
  $ 948     $ -     $ -     $ 948  
Commercial Real Estate:
                               
Land Development
    16,122       -       -       16,122  
Building Lots
    3,393       -       -       3,393  
Other
    49,600       -       -       49,600  
Real Estate Contruction
    291       -       -       291  
Residential Mortgage
    3,908       -       -       3,908  
Consumer and Home Equity
    777       -       -       777  
Indirect Consumer
    211       -       -       211  
Real estate acquired through foreclosure
    8,618       -       -       8,618  
Trust preferred security held-to-maturity
    23       -       -       23  

         
Quoted Prices in
             
         
Active Markets for
   
Significant Other
   
Significant
 
   
December 31,
   
Identical Assets
   
Observable Inputs
   
Unobservable Inputs
 
(Dollars in thousands)
 
2010
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Assets:
                       
Impaired loans:
                       
Commercial
  $ 1,092     $ -     $ -     $ 1,092  
Commercial Real Estate:
                               
Land Development
    18,333       -       -       18,333  
Building Lots
    3,391       -       -       3,391  
Other
    49,505       -       -       49,505  
Real Estate Contruction
    1,057       -       -       1,057  
Residential Mortgage
    4,821       -       -       4,821  
Consumer and Home Equity
    824       -       -       824  
Indirect Consumer
    171       -       -       171  
Real estate acquired through foreclosure
    8,578       -       -       8,578  
Trust preferred security held-to-maturity
    22       -       -       22  

 
26

 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
9. 
FAIR VALUE - (Continued)

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $87.3 million, with a valuation allowance of $12.0 million, resulting in an additional provision for loan losses of $2.7 million for the 2011 period.  Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisals and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure.  Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach.  The cost method bases value on the estimated cost to replace the current property after considering adjustments for depreciation.  Values of the market comparison approach evaluate the sales price of similar properties in the same market area.  The income approach considers net operating income generated by the property and an investors required return.  The final value is a reconciliation of these three approaches and takes into consideration any other factors management deems relevant to arrive at a representative fair value.

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure.  Fair value is based on the appraised market value of the property based on sales of similar assets.  The fair value may be subsequently reduced if the estimated fair valuedeclines below the original appraised value. Fair value adjustments of $202,000 were made to real estate owned during the quarter ended March 31, 2011.

Trust preferred securities which are held-to-maturity are valued using an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The income approach is equally or more representative of fair value than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.  

We received valuation estimates on our trust preferred security for March 31, 2011.  Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.  

Fair Value of Financial Instruments

The estimated fair value of financial instruments not previously presented is as follows:
 
(Dollars in thousands)
 
March 31, 2011
   
December 31, 2010
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
   
Value
   
Value
   
Value
   
Value
 
Financial assets:
                       
Cash and due from banks
  $ 110,929     $ 110,929     $ 166,176     $ 166,176  
Securities held-to-maturity
    97       99       102       104  
Loans held for sale
    4,055       4,119       6,388       6,472  
Loans, net
    758,509       768,032       780,075       789,889  
Accrued interest receivable
    7,727       7,727       6,404       6,404  
FHLB stock
    4,909       N/A       4,909       N/A  
                                 
Financial liabilities:
                               
Deposits
    1,166,788       1,156,002       1,173,908    
1,163,654
 
Advances from Federal Home Loan Bank
    27,500       29,830       52,532       55,190  
Subordinated debentures
    18,000       12,743       18,000       12,743  
Accrued interest payable
    835       835       594       594  
 
 
27

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.
FAIR VALUE - (Continued)

The methods and assumptions used in estimating fair value disclosures for financial instruments are presented below:

Carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, accrued interest receivable and payable, demand deposits, short-term debt and variable rate loans or deposits that re-price frequently and fully.  Held-to-maturity securities fair values are based on market prices or dealer quotes and if no such information is available, on the rate and term of the security and information about the issuer.  The value of loans held for sale is based on the underlying sale commitments.  For fixed rate loans or deposits and for variable rate loans or deposits with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life.  Fair values of advances from Federal Home Loan Bank and subordinated debentures are based on current rates for similar financing.  The fair value of off-balance-sheet items is based on the current fees or cost that would be charged to enter into or terminate such arrangements and is not material.  It is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.

10.
PREFERRED STOCK

On January 9, 2009, we issued $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the United States Treasury under its Capital Purchase Program (“CPP”). The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares pay cumulative dividends quarterly at a rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after five years. The Senior Preferred Shares may be redeemed at any time, at our option. We also have the ability to defer dividend payments at any time, at our option.

We also issued a warrant to purchase 215,983 common shares to the U.S. Treasury at a purchase price of $13.89 per share. The aggregate purchase price equals 15% of the aggregate amount of the Senior Preferred Shares purchased by the U.S. Treasury or $3 million. The initial purchase price per share for the warrant and the number of common shares subject to the warrant were determined by reference to the market price of the common shares (calculated on a 20-day trailing average) on December 8, 2008, the date the U.S. Treasury approved our TARP application. The warrant has a term of 10 years and is potentially dilutive to earnings per share.

On October 29, 2010, we gave written notice to the U.S. Treasury that we were suspending the payment of regular quarterly cash dividends on our fixed rate cumulative perpetual preferred stock, Series A (“Series A Preferred Stock”).  Under the CPP provisions, failure to pay dividends for six quarters would trigger board appointment rights for the holder of the Series A Preferred Stock.  The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes.  As of March 31, 2011, these accrued but unpaid dividends totaled $630,000.

Participation in the CPP requires a participating institution to comply with a number of restrictions and provisions, including standards for executive compensation and corporate governance and limitations on share repurchases and the declaration and payment of dividends on common shares. The standard terms of the CPP require that a participating financial institution limit the payment of dividends to the most recent quarterly amount prior to October 14, 2008, which is $0.19 per share in our case. This dividend limitation will remain in effect until the earlier of three years or such time that the preferred shares are redeemed.

On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted. As required by ARRA, the U.S. Treasury has issued additional compensation standards on companies receiving financial assistance from the U.S. government. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on each CPP recipient, until the recipient has repaid the Treasury.  ARRA also permits CPP participants to redeem the preferred shares held by the Treasury Department without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency.

 
28

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

11. 
STOCKHOLDERS’ EQUITY

Regulatory Capital Requirements – The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies.  Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices.  Capital amounts and classifications are also subject to qualitative judgments by regulators.  Failure to meet capital requirements can initiate regulatory action.

Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition.  If adequately capitalized, regulatory approval is required to accept brokered deposits.  If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined).

Although the Corporation and the Bank remain above the regulatory capital levels for “well-capitalized” standards, because of the losses we have incurred in recent quarters, our elevated levels of non-performing loans and other real estate, and the ongoing economic stress in Jefferson and Oldham Counties, Kentucky, the FDIC, KDFI and the Bank entered into the Consent Order referred to in Note 2.  The Consent Order resulted in the Bank being categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized" despite its current capital levels.

 
29

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

11.
STOCKHOLDERS’ EQUITY - (Continued)

Our actual and required capital amounts and ratios are presented below.

(Dollars in thousands)
             
For Capital
 
   
Actual
   
Adequacy Purposes
 
As of March 31, 2011:
 
Amount
   
Ratio
   
Amount
   
Ratio
 
Total risk-based capital (to risk-weighted assets)
                       
Consolidated
  $ 102,363       11.32 %   $ 72,362       8.00 %
Bank
    103,317       11.43       72,344       8.00  
Tier I capital (to risk-weighted assets)
                               
Consolidated
    90,892       10.05       36,181       4.00  
Bank
    91,843       10.16       36,172       4.00  
Tier I capital (to average assets)
                               
Consolidated
    90,892       7.01       51,891       4.00  
Bank
    91,843       7.08       51,880       4.00  

                            
To Be Considered
 
                           
Well Capitalized
 
                           
Under Prompt
 
(Dollars in thousands)
             
For Capital
   
Correction
 
   
Actual
   
Adequacy Purposes
   
Action Provisions
 
As of December 31, 2010:
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
Total risk-based capital (to risk-weighted assets)
                                   
Consolidated
  $ 104,717       11.34 %   $ 73,890       8.00 %     N/A       N/A  
Bank
    105,116       11.38       73,880       8.00       92,350       10.00  
Tier I capital (to risk-weighted assets)
                                               
Consolidated
    93,034       10.07       36,945       4.00       N/A       N/A  
Bank
    93,423       10.12       36,940       4.00       55,410       6.00  
Tier I capital (to average assets)Consolidated
    93,034       7.16       52,003       4.00       N/A       N/A  
Bank
    93,423       7.18       52,082       4.00       65,103       5.00  
 
On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of 8.5% and a total risk-based capital ratio of 11.5% by March 31, 2011 and achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011.   At March 31, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements.

The Consent Order requires the Bank to achieve the minimum capital ratios set forth below
 
         
Ratio Required
   
Ratio Required
 
   
Actual as of
   
by the Order
   
by the Order
 
   
3/31/2011
   
at 3/31/2011
   
at 6/30/2011
 
Total capital to risk-weighted assets
    11.43 %     11.50 %     12.00 %
Tier 1 capital to average total assets
    7.08 %     8.50 %     9.00 %
 
 
30

 

Item 2.
 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

GENERAL

We operate 22 full-service banking centers and a commercial private banking center in eight contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area, including southern Indiana.  Our markets range from Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown to Harrison County, Indiana approximately 60 miles northwest of our headquarters.  Our markets are supported by a diversified industry base and have a regional population of over 1 million.  We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky and in Harrison and Floyd counties in southern Indiana.

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

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

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

The discussion and analysis section covers material changes in the financial condition since December 31, 2010 and material changes in the results of operations for the three month period ending March 31, 2011 as compared to 2010.  It should be read in conjunction with "Management’s Discussion and Analysis of Financial Condition and Results of Operations" included in our Annual Report on Form 10-K for the period ended December 31, 2010, as amended by Form 10-K/A filed May 13, 2011.

OVERVIEW

The unfavorable economic conditions that have persisted since 2007 continued to significantly impact the banking industry and our performance during the first quarter of 2011.  During 2011 we continued to experience an increase in our non-performing assets.  Our decline in credit quality impacted our operations during 2011 in the areas of net interest income, provision for loan losses, non-interest income, non-interest expense, and reversals of tax benefits.

Our net loss attributable to common shareholders for 2011 was $(2.3) million, or $(.49) per diluted common share compared to net income attributable to common shareholders of $491,000 or $.10 per diluted common share in 2010.  The 2011 results include provision for loans losses of $3.5 million, other than temporary securities impairment of $37,000, write downs and losses on other real estate owned of $235,000 and an increase in FDIC insurance expense of $310,000.

Our non-performing assets are largely comprised of residential housing development loans and other real estate acquired through foreclosure in Jefferson and Oldham Counties.  Six loan relationships totaling $42.9 million make up 48% of our non-performing assets.  These high-end subdivisions, while showing initial progress, have stalled due to the recession.  At March 31, 2011, substantially all of the residential housing development loan portfolio concentration in these counties had been classified as impaired

The allowance to total loans was 2.86% at March 31, 2011 while net charge-offs totaled 71 basis points, annualized, for the first quarter of 2011, compared to 27 basis points, annualized, for the first quarter in 2010.  Non-performing loans were $63.7 million, or 7.42% of total loans at March 31, 2011 compared to $46.1 million, or 5.22% of total loans for December 31, 2010.  The allowance for loan losses to non-performing loans was 39% at March 31, 2011 compared to 49% at December 31, 2010.  Non-performing assets increased to $88.6 million or 6.89% of total assets compared to $71.9million or 5.45% of total assets at December 31, 2010.
 
 
31

 

Net interest income was $8.6 million for 2011 compared to $8.9 million for 2010, while the net interest margin was 2.91% for 2011 compared to 3.12% in 2010.  The net interest margin was negatively impacted by a higher level of non-performing assets and due to our efforts to increase liquidity by placing assets into lower yielding investments other than loans.  Non-interest income decreased $145,000 primarily driven by an increase of $209,000 in the loss on sale and write downs on real estate acquired through foreclosure.  Offsetting this increase was a decrease in other than temporary securities impairment of $135,000. Non-interest expense increased $1.1 million to $9.4 million for the 2011 quarter compared to 2010.  Employee compensation and benefits expense increased $239,000 for the period due to higher insurance claims under our self funded insurance plan.  FDIC insurance premiums increased $310,000 due to the higher FDIC insurance rate from the Bank’s regulatory rating.  Expense related to real estate acquired through foreclosure increased $227,000 due to the higher level of properties in this portfolio at March 31, 2011.

Although the Corporation and the Bank remain above the regulatory capital levels for “well-capitalized” standards, the Consent Order entered into between the FDIC, KDFI and the Bank has resulted in the Bank being categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized" despite its current capital levels.  On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of 8.5% and a total risk-based capital ratio of 11.5% by March 31, 2011 and achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011.   At March 31, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements.  We notified the bank regulatory agencies that the increased capital levels would not be achieved and as we remain in regular contact with the FDIC and KDFI, we expect the agencies will reevaluate our progress toward the higher capital ratios at June 30, 2011.  On April 20, 2011, the Corporation entered into a Consent Order with the Federal Reserve Bank of St. Louis which requires the Corporation to obtain regulatory approval before declaring any dividends.  We also may not redeem shares or obtain additional borrowings without prior approval.
 
In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies including the following:

 
·
Raising capital by selling capital stock through a public offering or private placement.

 
·
Continuing to operate the Company and the Bank in a safe and sound manner.  Until we can complete a capital raise, this will most likely require us to reduce lending concentrations, potentially sell loans, and take significant operating expense reductions and other cost cutting measures aimed at lowering expenses.  Additionally, we would adjust the mix of our assets to reduce the total risk weight of our assets, reduce total assets over time and potentially sell branches, deposits and loans.

 
·
Evaluating other strategic alternatives, such as a sale of assets, one or more branches, or the institution.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order.  The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances.

Positive signs of economic growth in our home markets, which is fueled by the Ft. Knox base realignment, will provide a sound basis for us as the local economy recovers.  While our concerns about economic conditions in our market continue, opportunities for deposit growth helps us progress towards our long-range financial objectives, including building additional core customer relationships, maintaining sufficient liquidity and capital levels, improving shareholder value, improving our operational efficiency and remediating our problem assets.

CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry.  The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.  We consider our critical accounting policies to include the following:
 
 
32

 

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

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

Based on our calculation, an allowance of $24.6 million or 2.86% of total loans was our estimate of probable incurred losses within the loan portfolio as of March 31, 2011.  This estimate required a provision for loan losses on the income statement of $3.5 million for the 2011 period.  If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could materially increase.

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

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

Real Estate OwnedThe estimation of fair value is significant to real estate owned acquired through foreclosure.  These assets are recorded at fair value less estimated selling costs at the date of foreclosure.  Fair value is based on the appraised market value of the property based on sales of similar assets when available.  The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value.

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

In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 and 2011.  These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at March 31, 2011 and December 31, 2010.

 
33

 

RESULTS OF OPERATIONS

Net loss attributable to common shareholders for the quarter ended March 31, 2011 was $(2.3) million or $(.49) per diluted common share compared to net income attributable to common shareholders of $491,000 or $.10 per diluted common share for the same period in 2010.  Contributing to the net loss for 2011 was a decrease in our net interest margin, a valuation allowance against deferred tax assets of $1.2 million, write downs taken on real estate acquired through foreclosure, and higher FDIC insurance premiums.  Net loss attributable to common shareholders was also impacted by dividends paid on preferred shares.  Our book value per common share decreased from $14.01 at March 31, 2010 to $10.72 at March 31, 2011.

Net Interest Income The principal source of our revenue is net interest income.  Net interest income is the difference between interest income on interest-earning assets, such as loans and securities and the interest expense on liabilities used to fund those assets, such as interest-bearing deposits and borrowings. Net interest income is affected by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities as well as changes in market interest rates.

The increase in the volume of interest earning assets was offset by the change in the mix of interest earning assets, causing a negative impact on net interest income, which decreased $285,000 for 2011 compared to a year ago.  Average interest earning assets increased $50.6 million for 2011 compared to 2010.  The increase was primarily attributed to our efforts to increase liquidity which resulted in an increase of lower yielding investments, interest bearing deposits and cash.  The result was a shift in the mix of assets with the addition of lower yielding assets lowering our net interest margin.  Net interest margin was also negatively impacted by the increase in the amount of non-performing assets.  The yield on earning assets averaged 4.76% for 2011 compared to an average yield on earning assets of 5.14% for 2010.  This decrease was offset somewhat by a decrease in our cost of funds.  Net interest margin as a percent of average earning assets decreased 21 basis points to 2.91% for 2011 compared to 3.12% for the 2010 period.
 
Our cost of funds averaged 1.98% for the 2011 period compared to an average cost of funds of 2.19% for the same period in 2010. Competition for deposits combined with continued re-pricing of variable rate loans and our efforts to increase liquidity by placing assets into lower yielding investments other than loans is likely to compress our net interest margin in future quarters.
 
 
34

 

AVERAGE BALANCE SHEET

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

   
Quarter Ended March 31,
 
         
2011
               
2010
       
(Dollars in thousands)
 
Average
         
Average
   
Average
         
Average
 
   
Balance
   
Interest
   
Yield/Cost (5)
   
Balance
   
Interest
   
Yield/Cost (5)
 
                                     
ASSETS
                                   
Interest earning assets:
                                   
U.S. Treasury and agencies
  $ 137,355     $ 897       2.65 %   $ 28,443     $ 175       2.50 %
Mortgage-backed securities
    53,965       507       3.81       14,304       149       4.22  
Equity securities
    294       10       13.81       830       25       12.22  
State and political subdivision securities (1)
    22,616       389       6.98       16,367       257       6.37  
Corporate bonds
    1,106       24       8.80       2,045       26       5.16  
Loans (2) (3) (4)
    877,140       12,343       5.71       988,646       14,047       5.76  
FHLB stock
    4,909       54       4.46       8,515       93       4.43  
Interest bearing deposits
    120,460       74       0.25       108,060       26       0.10  
Total interest earning assets
    1,217,845       14,298       4.76       1,167,210       14,798       5.14  
Less:  Allowance for loan losses
    (21,879 )                     (17,421 )                
Non-interest earning assets
    102,234                       83,567                  
Total assets
  $ 1,298,200                     $ 1,233,356                  
                                                 
LIABILITIES AND STOCKHOLDERS' EQUITY
                                               
Interest bearing liabilities:
                                               
Savings accounts
  $ 115,951     $ 178       0.62 %   $ 126,561     $ 239       0.77 %
NOW and money market accounts
    281,673       694       1.00       253,426       774       1.24  
Certificates of deposit and other time deposits
    695,244       4,042       2.36       625,566       3,856       2.50  
Short term borrowings
    -       -       -       920       21       9.26  
FHLB advances
    28,586       295       4.19       52,689       593       4.56  
Subordinated debentures
    18,000       341       7.68       18,000       327       7.37  
Total interest bearing liabilities
    1,139,454       5,550       1.98       1,077,162       5,810       2.19  
Non-interest bearing liabilities:
                                               
Non-interest bearing deposits
    76,785                       66,078                  
Other liabilities
    4,476                       3,977                  
Total liabilities
    1,220,715                       1,147,217                  
                                                 
Stockholders' equity
    77,485                       86,139                  
Total liabilities and stockholders' equity
  $ 1,298,200                     $ 1,233,356                  
                                                 
Net interest income
          $ 8,748                     $ 8,988          
Net interest spread
                    2.78 %                     2.95 %
Net interest margin
                    2.91 %                     3.12 %

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.
(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.
(3) Calculations include non-accruing loans in the average loan amounts outstanding.
(4) Includes loans held for sale.
(5) Annualized
 
 
35

 

RATE/VOLUME ANALYSIS

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

   
Three Months Ended
 
   
March 31,
 
   
2011 vs. 2010
 
   
Increase (decrease)
 
   
Due to change in
 
(Dollars in thousands)
             
Net
 
   
Rate
   
Volume
   
Change
 
Interest income:
                 
U.S. Treasury and agencies
  $ 11     $ 711     $ 722  
Mortgage-backed securities
    (16 )     374       358  
Equity securities
    3       (18 )     (15 )
State and political subdivision securities
    26       106       132  
Corporate bonds
    13       (15 )     (2 )
Loans
    (134 )     (1,570 )     (1,704 )
FHLB stock
    1       (40 )     (39 )
Interest bearing deposits
    45       3       48  
                         
Total interest earning assets
    (51 )     (449 )     (500 )
                         
Interest expense:
                       
Savings accounts
    (42 )     (19 )     (61 )
NOW and money market accounts
    (160 )     80       (80 )
Certificates of deposit and other time deposits
    (227 )     413       186  
Short term borrowings
    (16 )     (5 )     (21 )
FHLB advances
    (46 )     (252 )     (298 )
Subordinated debentures
    14       -       14  
                         
Total interest bearing liabilities
    (477 )     217       (260 )
                         
Net change in net interest income
  $ 426     $ (666 )   $ (240 )
 
Non-Interest Income and Non-Interest Expense

The following tables compare the components of non-interest income and expenses for the periods ended March 31, 2011 and 2010.  The tables show the dollar and percentage change from 2010 to 2011.  Below each table is a discussion of significant changes and trends.
 
   
Three Months Ended
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
   
Change
   
%
 
Non-interest income
                       
Customer service fees on deposit accounts
  $ 1,445     $ 1,525     $ (80 )     -5.2 %
Gain on sale of mortgage loans
    265       299       (34 )     -11.4 %
Gain on sale of investments
    69       -       69       100.0 %
Loss on sale of investments
    -       (23 )     23       -100.0 %
Net impairment losses recognized in earnings
    (37 )     (172 )     135       -78.5 %
Loss on sale and write downs of real estate acquired through foreclosure
    (235 )     (26 )     (209 )     803.8 %
Brokerage commissions
    107       93       14       15.1 %
Other income
    379       442       (63 )     -14.3 %
    $ 1,993     $ 2,138     $ (145 )     -6.8 %


 
36

 

We originate qualified VA, KHC, RHC and conventional secondary market loans and sell them into the secondary market with servicing rights released.  Gain on sale of mortgage loans decreased for 2011 due to a decrease in the volume of loans refinanced, originated and sold due to the stabilizing interest rate environment.

We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others.  During 2011 we recorded a gain on the sale of debt investment securities of $69,000. During 2010 we recorded a loss on the sale of an equity investment security of $23,000.  Gains on investment securities are infrequent and are not a consistent recurring core source of income.

We recognized other-than-temporary impairment charges of $37,000 for the expected credit loss during the 2011 period on three of our trust preferred securities compared to $172,000 of impairment charges for 2010. Management believes this impairment was primarily attributable to the current economic environment which caused the financial conditions of some of the issuers to deteriorate.

Further reducing non-interest income for 2011 was an increase of $209,000 in losses on the sale and write down of real estate owned properties due to the decline in market value of properties held in this portfolio.

The decrease in other income for the 2011 period was the result of a reduction in loan fee income due to a decline in loan activity.
 
   
Three Months Ended
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
   
Change
   
%
 
Non-interest expenses
                       
Employee compensation and benefits
  $ 4,329     $ 4,090     $ 239       5.8 %
Office occupancy expense and equipment
    811       804       7       0.9 %
Marketing and advertising
    225       225       -       0.0 %
Outside services and data processing
    797       730       67       9.2 %
Bank franchise tax
    314       350       (36 )     -10.3 %
FDIC insurance premiums
    970       660       310       47.0 %
Amortization of core deposit intangible
    77       64       13       20.3 %
Real estate acquired through foreclosure expense
    382       155       227       146.5 %
Other expense
    1,501       1,196       305       25.5 %
    $ 9,406     $ 8,274     $ 1,132       13.7 %
 
Employee compensation and benefits is the largest component of non-interest expense.  Increases for 2011 were due to higher insurance claims under our self funded insurance plan.

During the fourth quarter of 2009, the FDIC adopted a requirement that all banks prepay three and a quarter years worth of FDIC assessments on December 31, 2009.   The prepaid amount will be amortized over the prepayment period.  Our prepayment was $7.5 million of which $970,000 was reflected in our 2011 income statement.  Because the Bank entered into the Consent Order and is designated a “troubled institution” it is in a higher risk category and now pays one of the highest deposit assessment rates.

The increase in real estate acquired through foreclosure expense was primarily due to increases in expense relating to repair, maintenance, attorney fees and taxes due to a higher level of properties in this portfolio at March 31, 2011.

Other expense increased due to increases in interchange expense, professional fees and losses on NOW accounts.

Income Taxes

The provision for income taxes includes federal and state income taxes and in 2011 reflects a valuation allowance against our deferred tax assets.  The effective tax rates for the quarter ended March 31, 2011 and 2010 were 8% and 25%, respectively.  Historically, the fluctuations in effective tax rates reflect the effect of the differences in the inclusion or deductibility of certain income and expenses, respectively, for income tax purposes.  A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized.  In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 and 2011.  These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at March 31, 2011 and December 31, 2010.  Our future effective income tax rate will fluctuate based on the mix of taxable and tax free investments we make and, to a greater extent, the impact of changes in the required amount of valuation allowance recorded against our net deferred tax assets and our overall level of taxable income.

 
37

 

ANALYSIS OF FINANCIAL CONDITION

Total assets decreased $33.3 million to $1.3 billion at March 31, 2011 compared to December 31, 2010.  The decrease was due to a decline in gross loans, excluding loans held for sale, of $23.6 million and the maturity of a $25.0 million FHLB fixed rate advance. This decrease was mainly off-set by an increase in cash and cash equivalents and building our investment portfolio to $243.5 million, an increase of $47.4 million since December 31, 2010.  This shift in the balance sheet reflects a conscious effort by management to add on-balance sheet liquidity to protect us against any adverse changes to our current wholesale funding position.

Loans

Net loans decreased $27.8 million to $837.8 million at March 31, 2011 compared to $865.7 million at December 31, 2010.  Our commercial real estate and commercial portfolios decreased $12.8 million to $587.3 million at March 31, 2011.  Our residential mortgage loan, real estate construction, consumer and home equity and indirect consumer portfolios all decreased for the 2011 period.  The decline in our commercial real estate and commercial loan portfolios is a result of pay-offs and charge-offs on large commercial real estate relationships.  Although there remains a high demand for loans from quality borrowers, we have elected to shift our focus to preserve capital.  We believe, however, we will still be well positioned to benefit from growth in our local markets as the economy rebounds.

   
March 31,
   
December 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Commercial
  $ 35,569     $ 42,265  
Commercial Real Estate:
               
Land Development
    55,487       56,086  
Building Lots
    11,237       11,333  
Other
    484,977       490,345  
Real estate construction
    7,964       11,034  
Residential mortgage
    160,610       163,975  
Consumer and home equity
    75,491       77,781  
Indirect consumer
    27,434       29,588  
Loans held for sale
    4,055       6,388  
      862,824       888,795  
Less:
               
Net deferred loan origination fees
    (419 )     (473 )
Allowance for loan losses
    (24,591 )     (22,665 )
      (25,010 )     (23,138 )
                 
Net Loans
  $ 837,814     $ 865,657  
 
Allowance and Provision for Loan Losses

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

The Allowance for Loan Loss Review Committee evaluates the allowance for loan losses monthly to maintain a level sufficient to absorb probable incurred credit losses existing in the loan portfolio.  Periodic provisions to the allowance are made as needed.  The Committee determines the allowance by applying loss estimates to graded loans by categories, as described below.  In addition, the Committee analyzes such factors as changes in lending policies and procedures; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.

 
38

 

Further declines in collateral values, including commercial real estate, may impact our ability to collect on certain loans when borrowers are dependent on the values of the real estate as a source of cash flow.  During the second half of 2008, 2009, 2010 and continuing into 2011, we substantially increased our provision for loan losses for our general and specific reserves as we identified adverse conditions.  The foreseeable future will continue to be a challenging time for our financial institution as we manage the overall level of our credit quality.  It is likely that provision for loan losses will remain elevated in the near term.

As discussed in Note 2 to the consolidated financial statements, we entered into a Consent Order with bank regulatory agencies.  In addition to increasing capital ratios, we agreed to maintain adequate reserves for loan losses, develop and implement a plan to reduce the level of non-performing assets through collection, disposition, charge-off or improvement in the credit quality of the loans, develop and implement a plan to reduce concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures and to report our progress to the regulators.

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

   
Three Months Ended
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Balance at beginning of period
  $ 22,665     $ 17,719  
                 
Loans charged-off:
               
Residential mortgage
    19       543  
Consumer & home equity
    129       168  
Commercial & commercial real estate
    1,712       -  
Total charge-offs
    1,860       711  
Recoveries:
               
Residential mortgage
    -       1  
Consumer & home equity
    73       43  
Commercial & commercial real estate
    248       6  
Total recoveries
    321       50  
                 
Net loans charged-off
    1,539       661  
                 
Provision for loan losses
    3,465       1,752  
                 
Balance at end of period
  $ 24,591     $ 18,810  
                 
Allowance for loan losses to total loans
               
(excluding loans held for sale)
    2.86 %     1.95 %
Annualized net charge-offs to average loans outstanding
    0.71 %     0.27 %
Allowance for loan losses to total non-performing loans
    39 %     57 %
 
The provision for loan losses increased $1.7 million in 2011 compared to 2010.  The increase was related to residential housing development loans in Jefferson and Oldham Counties and our continued efforts to ensure the adequacy of the allowance by adding specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. We require appraisals on real estate at the time of initial application and subsequently assess the transaction and market conditions to determine if updated appraisals are periodically needed.  Additionally, we evaluate the collateral condition and value upon classification as an impaired loan and upon foreclosure.  The higher provision was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the increase in classified loans for the 2011 period.  The allowance for loan losses increased $5.8 million to $24.6 million from March 31, 2010 to March 31, 2011.  The increase was due to specific reserves placed on loans due to updated appraisal information obtained as part of our on-going monitoring of the loan portfolio, as well as the provision recorded to reflect an increase in classified loans for the 2011 period.  Specific reserves as allocated to substandard loans made up 62% of the total allowance for loan loss at March 31, 2011.  The increase in charge-offs for 2011 was primarily attributed to charging down previously recorded specific reserves on non-performing loans whose condition worsened during 2011.  Allowance for loan losses to total non-performing loans declined to 39% at March 31, 2011 from 57% at March 31, 2010.  Although non-performing loans increased for the period, several of these credits are secured by real estate and we have provided adequate allowance based on current information.

 
39

 

Federal regulations require banks to classify their own assets on a regular basis.  The regulations provide for three categories of classified loans — substandard, doubtful and loss.

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

   
March 31,
   
December 31,
   
September 30,
   
June 30,
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
   
2010
   
2010
   
2010
 
Criticized Loans:
                             
Total Criticized
  $ 35,338     $ 28,309     $ 29,285     $ 52,564     $ 53,024  
                                         
Classified Loans:
                                       
Substandard
  $ 105,370     $ 95,663     $ 97,544     $ 74,305     $ 65,028  
Doubtful
    638       583       43       463       407  
Loss
    178       64       2,506       231       26  
Total Classified
  $ 106,186     $ 96,310     $ 100,093     $ 74,999     $ 65,461  
                                         
Total Criticized and Classified
  $ 141,524     $ 124,619     $ 129,378     $ 127,563     $ 118,485  
 
As we focused on credit quality during 2008, 2009, 2010 and the first quarter of 2011, there was a significant migration of loans into the substandard loan category.  If economic conditions continue to put stress on our borrowers going forward, this may require higher provisions for loan losses in future periods.  Credit quality will continue to be a primary focus during 2011 and going forward.
 
The $40.3 million increase in substandard assets for March 31, 2011 compared to March 31, 2010 was primarily the result of downgrading loans with thirteen borrowers with balances ranging from $1.7 million to $11.5 million.  Offsetting this increase was the transfer of five classified loans totaling $13.7 million to real estate acquired through foreclosure, the upgrades of two classified loans totaling $2.4 million whose cash flow is adequate to service the debt, a $1.2 payoff on a commercial real estate loan and a $3.8 million pay down on another commercial real estate loan. Approximately $98.1 million or 92% of the total classified loans were related to real estate development or real estate construction loans in our market area.  Several of the non-performing loans that were added during the period were adequately collateralized and therefore did not require additional reserves.  Classified consumer loans totaled $1.4 million, classified mortgage loans totaled $5.0 million and classified commercial loans totaled $1.7 million.  The change in our level of allowance for loan losses is a result of a consistent allowance methodology that is driven by risk ratings.  For more information on collection efforts, evaluation of collateral and how loss amounts are estimated, see “Non-Performing Assets,” below.

Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for active charge-offs.  We develop our allowance estimates based on actual loss experience adjusted for current economic conditions.  Allowance estimates represent a prudent measurement of the risk in the loan portfolio, which we apply to individual loans based on loan type.

Non-Performing Assets

Non-performing assets consist of certain restructured loans for which interest rate or other terms have been renegotiated, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets.   We do not have any loans longer than 90 days past due still on accrual.  Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection.  Loans are considered impaired when we no longer anticipate full principal or interest payments in accordance with the contractual loan terms.  If a loan is impaired, we allocate a portion of the allowance 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 collateral.

We review our loans on a regular basis and implement normal collection procedures when a borrower fails to make a required payment on a loan.  If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action.  We generally charge off consumer loans when management deems a loan uncollectible and any available collateral has been liquidated.  We handle commercial business and real estate loan delinquencies on an individual basis with the advice of legal counsel.

 
40

 

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

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

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure.  Fair value is based on the appraised market value of the property based on sales of similar assets.  The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. We monitor market information and the age of appraisals on existing real estate owned properties and obtain new appraisals as circumstances warrant.  Real estate acquired through foreclosure decreased $899,000 to $24.9 million at March 31, 2011.  We anticipate that our level of real estate acquired through foreclosure will remain at elevated levels for some period of time as foreclosures reflecting both weak economic conditions and soft commercial real estate values continue.  All properties held in other real estate owned are listed for sale with various independent real estate agents.
 
A summary of the real estate acquired through foreclosure activity is as follows:

   
March 31,
   
December 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Beginning balance
  $ 25,807     $ 8,428  
Additions
    1,932       24,622  
Sales
    (2,629 )     (4,928 )
Writedowns
    (202 )     (2,315 )
Ending balance
  $ 24,908     $ 25,807  
 
The following table provides information with respect to non-performing assets for the periods indicated.

   
March 31,
   
December 31,
 
(Dollar in thousands)
 
2011
   
2010
 
             
Restructured
  $ 18,751     $ 3,906  
Past due 90 days still on accrual
    -       -  
Loans on non-accrual status
    44,899       42,169  
                 
Total non-performing loans
    63,650       46,075  
Real estate acquired through foreclosure
    24,908       25,807  
Other repossessed assets
    39       40  
Total non-performing assets
  $ 88,597     $ 71,922  
                 
Interest income that would have been earned on non-performing loans
  $ 3,634     $ 2,654  
Interest income recognized on non-performing loans
    377       277  
Ratios:  Non-performing loans to total loans
               
    (excluding loans held for sale)
    7.42 %     5.22 %
  Non-performing assets to total assets
    6.89 %     5.45 %
 
 
41

 

Non-performing loans increased $17.6 million to $63.7 million at March 31, 2011 compared to $46.1 million at December 31, 2010.  The increase for the three months ended March 31, 2011 was the result of an increase in restructured loans from short term interest only periods granted for two loan relationships totaling $13.5 million.  Our exposure to residential subdivision developments in Jefferson and Oldham Counties was the primary cause of the increase in non-performing loans and non-performing assets for 2011, 2010 and 2009. At March 31, 2011, substantially all of the residential housing development loan portfolio concentration in these counties has been classified as impaired.  The remaining credits in this concentration are smaller credits with strong guarantors.  Six loan relationships totaling $42.9 million make up 48% of our non-performing assets.  These high-end subdivisions, while showing initial progress, have stalled due to the recession.  Non-accrual loans increased due to the addition of five credit relationships totaling $6.6 million.  These credit relationships are secured by real estate and we have provided adequate allowance based on current information.  Offsetting this increase was three non-accrual relationships totaling $2.0 million that were transferred to real estate acquired through foreclosure and one non-accrual relationship totaling $1.2 million that was paid off.  All non-performing loans are considered impaired.

Non-performing assets for the 2011 period include $18.8 million in restructured commercial, mortgage and consumer loans.  The increase for the three months ended March 31, 2011 resulted from short term interest only periods granted for two loan relationships totaling $13.5 million.  The two newly restructured credits are strip centers that experienced vacancies.  One strip center lost a big box retailer and is currently in discussions with another larger retailer to fill the vacancy.  The interest only period is to allow for the borrower to secure the new tenant.  The second strip center had a vacancy due to a patio furniture store vacancy.  This center has partially replaced the space with another tenant and was granted an interest only period to fill the remaining space.  Both strip center loans are active strip centers in vibrant areas.  We fully anticipate a favorable resolution of these credits.  Both loans were evaluated as impaired loans and appropriately allocated specific reserve allowances based on updated appraisals.   Four credit relationships comprise $17.9 million of our restructured loans.  The terms of our restructured loans have been renegotiated to reduce the rate of interest or extend the term, thus reducing the amount of cash flow required from the borrower to service the loans. The borrowers are currently meeting the terms of the restructured loans.  We anticipate that our level of restructured loans will continue to increase as we identify borrowers in financial difficulty and work with them to modify to more affordable terms.

Investment Securities

Interest on securities provides us our largest source of interest income after interest on loans, constituting 12.9% of the total interest income for the quarter ended March 31, 2011.  The securities portfolio serves as a source of liquidity and earnings and contributes to the management of interest rate risk.  We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers' acceptances, and federal funds.  We may also invest a portion of our assets in certain commercial paper and corporate debt securities.  We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The available-for-sale investment portfolio increased by $47.4 million due to the purchase of U.S. Government agency securities. Offsetting this increase was the sale of one agency security and two government-sponsored mortgage-backed securities.

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

The unrealized losses on our U. S. Treasury and agency securities and our government sponsored mortgage-backed residential securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we have the ability and intent to hold these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2011.
 
 
42

 

The unrealized losses on the state and municipal securities were caused primarily by interest rate decreases.  The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment.  Because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these investments to be other-than-temporarily impaired at March 31, 2011.  We also considered the financial condition and near term prospects of the issuer and identified no matters that would indicate less than full recovery.

We have evaluated the decline in the fair value of our trust preferred securities, which are directly related to the credit and liquidity crisis that the financial services industry has experienced in recent years.   The trust preferred securities market is currently inactive making the valuation of trust preferred securities very difficult.  We value trust preferred securities using unobservable inputs through a discounted cash flow analysis as permitted under current accounting guidance and using the expected cash flows appropriately discounted using present value techniques.   Refer to Note 8 – Fair Value for more information.

We recognized other-than-temporary impairment charges of $37,000 for the expected credit loss during the first quarter of 2011 and $1.9 million during the time we have held these securities on five of our trust preferred securities with an original cost basis of $3.0 million.  All of our trust preferred securities are currently rated below investment grade. One of our trust preferred securities continues to pay interest as scheduled through March 31, 2011, and is expected to continue paying interest as scheduled.  The other four trust preferred securities are paying either partial or full interest in kind instead of full cash interest.    See Note 3 – Securities for more information.  Management will continue to evaluate these securities for impairment quarterly. 

Deposits

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

In conjunction with our initiatives to expand and enhance our retail branch network, we emphasize growing our customer checking account base to better enhance profitability and franchise value. Total deposits decreased $7.1 million compared to December 31, 2010.  Retail and commercial deposits increased $6.9 million. Public funds, brokered deposits and Certificate of Deposits Account Registry Service (“CDARS”) certificates decreased $14.0 million.   Brokered deposits were $41.8 million at March 31, 2011 compared to $50.3 million at December 31, 2010. Due to our agreement with bank regulatory agencies, we are not allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval.

To evaluate our funding needs in light of deposit trends resulting from these changing conditions, management and Board committees evaluate simulated performance reports that forecast changes in margins.  We continue to offer attractive certificate rates for various terms to allow us to retain deposit customers and reduce interest rate risk during the current rate environment, while protecting the margin. However, the Consent Order issued in January 2011, resulted in the Bank being categorized as a "troubled institution" by bank regulators.  The "troubled institution" designation restricts the amount of interest the Bank may pay on deposits.  Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates within .75% of the average rates computed by the FDIC.

The following table breaks down our deposits.

   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
(In Thousands)
 
             
Non-interest bearing
  $ 71,869     $ 73,566  
NOW demand
    130,592       129,887  
Savings
    114,945       109,349  
Money market
    151,123       157,135  
Certificates of deposit
    698,259       703,971  
    $ 1,166,788     $ 1,173,908  
 
 
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Advances from Federal Home Loan Bank

Deposits are the primary source of funds for our lending and investment activities and for our general business purposes.  We can also use advances (borrowings) from the Federal Home Loan Bank (FHLB) of Cincinnati to compensate for reductions in deposits or deposit inflows at less than projected levels.  At March 31, 2011 we had $27.5 million in advances outstanding from the FHLB.  In January 2011, a $25 million convertible fixed rate advance with an interest rate of 5.05% matured and was paid in full. At March 31, 2011, we had sufficient collateral available to borrow, approximately, and additional $50.6 million in advances from the FHLB. Advances from the FHLB are secured by our stock in the FHLB, certain securities, certain commercial real estate loans and substantially all of our first mortgage, multi-family and open end home equity loans.

Subordinated Debentures

In 2008, an unconsolidated trust subsidiary of First Financial Service Corporation, issued $8.0 million in trust preferred securities.  The trust loaned the proceeds of the offering to us in exchange for junior subordinated deferrable interest debentures which we used to finance the purchase of FSB Bancshares, Inc. The subordinated debentures, which mature on June 24, 2038, can be called at par in whole or in part on or after June 24, 2018. The subordinated debentures pay a fixed rate of 8% for thirty years.  We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years.  The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.

A different trust subsidiary issued 30 year cumulative trust preferred securities totaling $10 million at a 10 year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basis points.  The subordinated debentures, which mature March 22, 2037, can be called at par in whole or in part on or after March 15, 2017.  We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.

Our trust subsidiaries loaned the proceeds of their offerings of trust preferred securities to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts (variable interest entity), therefore the trusts are not consolidated in our financial statements, but rather the subordinated debentures are shown as a liability.  Our investment in the common stock of the trusts was $310,000.

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes, together having an outstanding principal amount of $18 million, relating to outstanding trust preferred securities.  We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty.  After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities.  The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of March 31, 2011, these accrued but unpaid interest payments totaled $682,000.

LIQUIDITY

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we can meet the cash flow requirements of depositors and borrowers, as well as our operating cash needs, at a reasonable cost, taking into account all on- and off-balance sheet funding demands. Our investment and funds management policy identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The Asset Liability Committee continually monitors our liquidity position.

Our banking centers provide access to retail deposit markets.  If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources. In addition to maintaining a stable core deposit base, we maintain adequate liquidity primarily through the use of investment securities.  We also secured federal funds borrowing lines from two of our correspondent banks.  One line is for $15 million and the other is for $10 million.    Traditionally, we have also borrowed from the FHLB to supplement our funding requirements.  At March 31, 2011, we had sufficient collateral available to borrow, approximately, and additional $50.6 million in advances from the FHLB.  We believe that we have adequate funding sources through unused borrowing capacity from our correspondent banks, unpledged investment securities, loan principal repayment and potential asset maturities and sales to meet our foreseeable liquidity requirements.

 
44

 

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

The primary source of funding for the Corporation has been dividends and returns of investment from the Bank. Kentucky banking laws limit the amount of dividends that may be paid to the Corporation by the Bank without prior approval of the KDFI.  Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods. The Bank currently has a regulatory agreement with the FDIC and KDFI that requires us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends.  The Corporation has also entered into an agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends.  We may not redeem shares or obtain additional borrowings without prior approval.  Because of these limitations, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to the Corporation.  During the first quarter of 2011, the Bank did not declare or pay any dividends to the Corporation. At March 31, 2011, cash held by the Corporation is $156,000.
  
CAPITAL

Stockholders’ equity decreased $1.2 million for the period ended March 31, 2011 compared to December 31, 2010 primarily due to a net loss recorded during the period.  Offsetting this decrease was a decrease in unrealized losses on securities available-for-sale.  Our average stockholders’ equity to average assets ratio decreased to 5.97% for the quarter ended March 31, 2011 compared to 6.98% for the 2010 quarter.

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

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

On October 29, 2010, we gave written notice to the U.S. Treasury that we were suspending the payment of regular quarterly cash dividends on our fixed rate cumulative perpetual preferred stock, Series A (“Series A Preferred Stock”).  Since the dividends are cumulative, failure to pay dividends for six quarters would trigger board appointment rights for the holder of the Series A Preferred Stock.  The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes.

In addition to our agreement with the Federal Reserve that requires prior written consent to repurchase common shares, the terms of our Senior Preferred Shares do not allow us to repurchase shares of our common stock without the consent of the holder until the Senior Preferred Shares are redeemed.  During the first quarter of 2011, we did not purchase any shares of our common stock.

Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.  We intend to maintain a capital position that meets or exceeds the capital levels required to qualify as “well capitalized” established for banks by the FDIC.

 
45

 
 
On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of 8.5% and a total risk-based capital ratio of 11.5% by March 31, 2011 and achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011.   At March 31, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements.  We notified the bank regulatory agencies that the increased capital levels would not be achieved and as we remain in regular contact with the FDIC and KDFI, we expect the agencies will reevaluate our progress toward the higher capital ratios at June 30, 2011. To achieve the capital requirements that we have agreed to with the FDIC and KDFI, we are working on various specific initiatives to increase our regulatory capital and to reduce our total assets such as sales of loans, raising common stock, or the sale of branch offices or the institution.
 
The following table shows the ratios of Tier 1 capital, total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of March 31, 2011.

   
Capital Adequacy Ratios as of
 
   
March 31, 2011
 
   
Regulatory
             
Risk-Based Capital Ratios
 
Minimums
   
The Bank
   
The Corporation
 
Tier 1 capital (1)
    4.00 %     10.16 %     10.05 %
Total risk-based capital (2)
    8.00 %     11.43 %     11.32 %
Tier 1 leverage ratio (3)
    4.00 %     7.08 %     7.01 %
 
Although the Corporation and the Bank remain above the regulatory capital levels for “well-capitalized” standards, the Consent Order entered into between the FDIC, KDFI and the Bank has resulted in the Bank being categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized" despite its current capital levels.
 
The Consent Order requires the Bank to achieve the minimum capital ratios set forth below:

         
Ratio Required
   
Ratio Required
 
   
Actual as of
   
by the Order
   
by the Order
 
   
3/31/2011
   
at 3/31/2011
   
at 6/30/2011
 
Total capital to risk-weighted assets
    11.43 %     11.50 %     12.00 %
Tier 1 capital to average total assets
    7.08 %     8.50 %     9.00 %

Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset/Liability Management and Market Risk

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

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

Our interest sensitivity profile was asset sensitive at March 31, 2011 and December 31, 2010.  Given a sustained 100 basis point decrease in rates, our base net interest income would decrease by an estimated .91% at March 31, 2011 compared to a decrease of .84% at December 31, 2010.  Given a sustained100 basis point increase in interest rates, our base net interest income would increase by an estimated 2.05% at March 31, 2011 compared to an increase of 2.69% at December 31, 2010.

 
46

 

Our interest sensitivity at any point in time will be affected by a number of factors.  These factors include the mix of interest sensitive assets and liabilities, their relative pricing schedules, market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.
We use various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking.  As demonstrated by the March 31, 2011 and December 31, 2010 sensitivity tables, our balance sheet has an asset sensitive position. This means that our earning assets, which consist of loans and investment securities, will change in price at a faster rate than our deposits and borrowings.  Therefore, if short term interest rates increase, our net interest income will increase.  Likewise, if short term interest rates decrease, our net interest income will decrease.

Our sensitivity to interest rate changes is presented based on data as of March 31, 2011 and December 31, 2010 annualized to a one year period.

    
March 31, 2011
 
   
Decrease in Rates
         
Increase in Rates
 
    200     100           100     200  
(Dollars in thousands)
 
Basis Points
   
Basis Points
   
Base
   
Basis Points
   
Basis Points
 
                                       
Projected interest income
                                     
Loans
  $ 49,528     $ 50,640     $ 51,712     $ 52,871     $ 54,036  
Investments
    8,657       9,081       8,671       9,380       10,101  
Total interest income
    58,185       59,721       60,383       62,251       64,137  
                                         
Projected interest expense
                                       
Deposits
    17,568       17,670       17,967       19,010       19,222  
Borrowed funds
    2,374       2,373       2,373       2,379       2,384  
Total interest expense
    19,942       20,043       20,340       21,389       21,606  
                                         
Net interest income
  $ 38,243     $ 39,678     $ 40,043     $ 40,862     $ 42,531  
Change from base
  $ (1,800 )   $ (365 )           $ 819     $ 2,488  
% Change from base
    (4.50 )%     (0.91 )%             2.05 %     6.21 %
 
    
December 31, 2010
 
   
Decrease in Rates
         
Increase in Rates
 
    200     100           100     200  
(Dollars in thousands)
 
Basis Points
   
Basis Points
   
Base
   
Basis Points
   
Basis Points
 
                                       
Projected interest income
                                     
Loans
  $ 51,538     $ 52,676     $ 53,694     $ 54,888     $ 56,060  
Investments
    7,122       7,287       6,909       7,808       8,745  
Total interest income
    58,660       59,963       60,603       62,696       64,805  
                                         
Projected interest expense
                                       
Deposits
    17,668       17,764       18,068       19,048       19,278  
Borrowed funds
    2,491       2,491       2,490       2,525       2,554  
Total interest expense
    20,159       20,255       20,558       21,573       21,832  
                                         
Net interest income
  $ 38,501     $ 39,708     $ 40,045     $ 41,123     $ 42,973  
Change from base
  $ (1,544 )   $ (337 )           $ 1,078     $ 2,928  
% Change from base
    (3.86 )%     (0.84 )%             2.69 %     7.31 %
 
 
47

 

Item 4.  CONTROLS AND PROCEDURES

Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of March 31, 2011, an evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the restatement of the Company’s financial statements for the quarter and year ended December 31, 2010, the Company’s management and the Risk Management Committee of its Board of Directors determined that the Company’s internal controls over financial reporting of subsequent events related to the appraisal review process for other real estate owned and the timeliness of obtaining and reviewing real estate acquired through foreclosure was not effective.  The Company’s management, overseen by the Risk Management Committee, has implemented steps to improve the process for timely identification and improved communication of the events in the closing procedure that resulted in the material misstatement discovered in the closing procedure for the year and quarter ended December 31, 2010.

These enhanced procedures are expected to include:

 
·
Starting May 16, 2011, the executive loan committee will review on a weekly basis any classified and/or collateral dependent loans as well as other real estate owned properties for new and updated appraisals, changes in market conditions and the status of the borrowers and/or guarantors; and

 
·
Establish a tracking system to be shared with the finance department, loan officers and special assets officers showing property name, loan/asset number, and the date the appraisals were ordered, received and reviewed, and what, if any, change in valuation occurred.

Management concluded that disclosure controls and procedures as of March 31, 2011, were not effective in ensuring material information required to be disclosed in this quarterly report on Form 10-Q was recorded, processed, summarized, and reported in a timely manner as specified in SEC rules and forms.  There were no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II - OTHER INFORMATION

 
Item 1.
Legal Proceedings

Although, from time to time, we are involved in various legal proceedings in the normal course of business, there are no material pending legal proceedings to which we are a party, or to which any of our property is subject.

 
Item 1A.
Risk Factors

Except as set forth below, there have been no material changes from the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2010 under Item 1A – Risk Factors.  The risk factor entitled, “If we continue to incur significant losses, it may be difficult to continue in operation without additional capital” is being updated.

If we continue to incur significant losses, it may be difficult to continue in operation without additional capital.

We recorded a net loss to common shareholders of $2.3 million for the quarter ended March 31, 2011, a net loss to common shareholders of $10.5 million in 2010 and a net loss to common shareholders of $7.7 million in 2009, for a total loss of $20.5 million.  The net loss for 2010 was due in part to a $4.8 million deferred tax valuation allowance.  The net loss for 2009 was due in part to an $11.9 million non-cash pre-tax goodwill impairment charge.

Provisions for loan losses and investment impairments also contributed to our losses.  During the first quarter of 2011, 2010 and 2009, we recorded total provisions for loan losses of $29.9 million and other than temporary losses on investments of $1.9 million.  While our losses also included a charge off of goodwill of $11.9 million, and a charge to establish an allowance against the realization of our deferred tax asset of $4.8 million, these latter charges were largely influenced by the losses on loans and investments.

 
48

 

We could be required to make additional provisions for loan losses and impairments to investments if asset values continue to decline in the current economic climate.  This in turn may require the Corporation to raise additional capital to fund the Bank's operations so that the Bank can sustain such losses without capital levels decreasing below the minimum levels set forth in the Consent Order.  See Part I, Item 1 – Business – Recent Developments, for a description of the Bank's capital requirements set forth in the Consent Order.

The risks identified in our risk factors are not the only risks we face.  Additional risks and uncertainties not currently known to us or that we have deemed to be immaterial also may materially adversely affect our business, financial condition, and/or operating results.

 
Item 2.
Unregistered Sales of Securities and Use of Proceeds

We did not repurchase any shares of our common stock during the quarter ended March 31, 2011.

 
Item 3.
Defaults Upon Senior Securities

Not Applicable

 
Item 4.
[Removed and Reserved]

 
Item 5.
Other Information

None

 
Item 6.
Exhibits:
 
 
31.1
Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act

 
31.2
Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act

 
32
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
 
 
49

 

FIRST FINANCIAL SERVICE CORPORATION

SIGNATURES

Pursuant to the requirements of Section 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.
 
Date:  May 19, 2011
By: /s/
B. Keith Johnson
   
B. Keith Johnson
   
Chief Executive Officer
   
Date:  May 19, 2011
By: /s/
Gregory S. Schreacke
   
Gregory S. Schreacke
   
President
   
Chief Financial Officer &
   
Principal Accounting Officer
 
 
50

 

INDEX TO EXHIBITS

Exhibit No.
 
Description
     
  31.1
 
Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
     
  31.2
 
Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
     
  32
 
Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
 
 
51