Certain statements contained in this quarterly report are not historical facts, including but not limited to statements that can be identified by the use of forward-looking terminology such as "may", "will", "expect", "anticipate", or "continue" or the negative thereof or other variations thereon or comparable terminology are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21B of the Securities Exchange Act of 1934, as amended. Actual results could differ materially from those indicated in such statements due to risks, uncertainties and changes with respect to a variety of market and other factors. The Company assumes no obligation to update any forward-looking statements. General First
Defianceis a unitary thrift holding company that conducts business through its subsidiaries, First Federal, First Insuranceand First Defiance Risk Management. First Federal is a federally chartered stock savings bank that provides financial services to communities through 33 full service banking centers in communities based in northwest Ohio, northeast Indiana, and southeastern Michigan. First Federal provides a broad range of financial services including checking accounts, savings accounts, certificates of deposit, real estate mortgage loans, commercial loans, consumer loans, home equity loans and trust and wealth management services through its extensive branch network. First Insurancesells a variety of property and casualty, group health and life, and individual health and life insurance products. Insurance products are sold through First Insurance'soffices in Defiance, Bryan, Bowling Green, Maumeeand Oregon, Ohioareas. First Defiance Risk Management is a wholly-owned insurance company subsidiary of the Company that insures the Company and its subsidiaries against certain risks unique to the operations of the Company and for which insurance may not be currently available or economically feasible in today's insurance marketplace. First Defiance Risk Management pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. First Defiance Risk Management was incorporated on December 20, 2012. Impact of Legislation - Over the last several years, Congressand the U.S. Department of the Treasuryhave enacted legislation and taken actions to address the disruptions in the financial system, declines in the housing market, and the overall regulation of financial institutions and the financial system. In this regard, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"), includes provisions affecting large and small financial institutions alike, including several provisions that profoundly affect the regulation of community banks, thrifts, and bank and thrift holding companies, such as First Defiance. Also, the Dodd-Frank Act abolished the Office of Thrift Supervisioneffective July 21, 2011and transferred its functions to the Office of the Comptroller of the Currency("OCC"), FDIC, and Federal Reserve. The Dodd-Frank Act relaxed rules regarding interstate branching, allows financial institutions to pay interest on business checking accounts, changed the scope of federal deposit insurance coverage, imposed new capital requirements on bank and thrift holding companies, and imposed limits on debit card interchange fees charged by issuer banks (commonly known as the Durbin Amendment). 45 The Dodd-Frank Act also established the Consumer Financial Protection Bureau("CFPB") as an independent bureau within the Federal Reserve, which has broad authority to regulate consumer financial products and services and entities offering such products and services, including banks. Many of the consumer financial protection functions formerly assigned to the federal banking and other designated agencies are now performed by the CFPB. The CFPBhas broad rulemaking authority over providers of credit, savings, and payment services and products. In this regard, the CFPBhas the authority to implement regulations under federal consumer protection laws and enforce those laws against, and examine, financial institutions. State officials also will be authorized to enforce consumer protection rules issued by the CFPB. This bureau also is authorized to collect fines and provide consumer restitution in the event of violations, engage in consumer financial education, track consumer complaints, request data, and promote the availability of financial services to underserved consumers and communities. The CFPBalso is directed to prevent "unfair, deceptive or abusive practices" and ensure that all consumers have access to markets for consumer financial products and services and that such markets are fair, transparent, and competitive. Although the CFPBhas begun to implement its regulatory, supervisory, examination, and enforcement authority, there continues to be significant uncertainty as to how the agency's strategies and priorities will impact First Defiance. The CFPBhas indicated that mortgage lending is an area of supervisory focus and that it will concentrate its examination and rulemaking efforts on the variety of mortgage-related topics required under the Dodd-Frank Act, including steering consumers to less-favorable products, discrimination, abusive or unfair lending practices, predatory lending, origination disclosures, minimum mortgage underwriting standards, mortgage loan originator compensation, and servicing practices. The CFPBrecently published several final regulations impacting the mortgage industry, including rules related to ability-to-pay, mortgage servicing, and mortgage loan originator compensation. The ability-to-repay rule makes lenders liable if they fail to assess ability to repay under a prescribed test, but also creates a safe harbor for so called "qualified mortgages." The "qualified mortgages" standards include a tiered cap structure that places limits on the total amount of certain fees that can be charged on a loan, a 43% cap on debt-to-income (i.e., total monthly payments on debt to monthly gross income), exclusion of interest-only products, and other requirements. The 43% debt-to-income cap does not apply for the first seven years the rule is in effect for loans that are eligible for sale to Fannie Mae or Freddie Mac or eligible for government guarantee through the FHA or the Veterans Administration. Failure to comply with the ability-to-repay rule may result in possible CFPBenforcement action and special statutory damages plus actual, class action, and attorney fees damages, all of which a borrower may claim in defense of a foreclosure action at any time. First Defiance'smanagement team is currently assessing the impact of these requirements on our mortgage lending business.
In addition, the Federal Reserve and other federal bank regulatory agencies have issued a proposed rule under the Dodd-Frank Act that would exempt "qualified residential mortgages" from the securitization risk retention requirements of the Dodd-Frank Act. The final definition of what constitutes a "qualified residential mortgage" may impact the pricing and depth of the secondary market into which the Company may sell mortgages it originates. At this time, First
Defiancecannot predict the content of the final CFPBand other federal agency regulations or the impact they might have on First Defiance's financial results. The CFPB'sauthority over mortgage lending, and its authority to change regulations adopted in the past by other regulators, or to rescind or ignore past regulatory guidance, could increase First Defiance's compliance costs
and litigation exposure. 46 First
Defiance'smanagement team continues to actively monitor the implementation of the Dodd-Frank Act and the regulations promulgated thereunder and assess its probable impact on the business, financial condition, and results of operations of First Defiance. However, the ultimate effect of the Dodd-Frank Act on the financial services industry in general, and First Defiance in particular, continues to be uncertain. New Capital Rules - On July 2, 2013, the Federal Reserve approved final rules that substantially amend the regulatory risk-based capital rules applicable to First Defiance and First Federal. The FDICand the OCC have subsequently approved these rules. The final rules were adopted following the issuance of proposed rules by the Federal Reserve in June 2012, and implement the " BaselIII" regulatory capital reforms and changes required by the Dodd-Frank Act. The rules include new risk-based capital and leverage ratios, which will be phased in from 2015 to 2019, and will refine the definition of what constitutes "capital" for purposes of calculating those ratios. The new minimum capital level requirements applicable to First Defiance and First Federal under the final rules are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The final rules also establish a "capital conservation buffer" above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. The capital conservation buffer will be phased-in over four years beginning on January 1, 2016, as follows: the maximum buffer will be 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. This will result in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. The final rules implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses, as well as certain instruments that will no longer qualify as Tier 1 capital, some of which will be phased out over time. However, the final rules provide that small depository institution holding companies with less than $15 billionin total assets as of December 31, 2009(which includes First Defiance) will be able to permanently include non-qualifying instruments that were issued and included in Tier 1 or Tier 2 capital prior to May 19, 2010in additional Tier 1 or Tier 2 capital until they redeem such instruments or until the instruments mature. 47 The final rules also contain revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including First Federal, if their capital levels begin to show signs of weakness. These revisions take effect January 1, 2015. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions will be required to meet the following increased capital level requirements in order to qualify as "well capitalized": (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%). The final rules set forth certain changes for the calculation of risk-weighted assets, which First Federal will be required to utilize beginning January 1, 2015. The standardized approach final rule utilizes an increased number of credit risk exposure categories and risk weights, and also addresses: (i) an alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (ii) revisions to recognition of credit risk mitigation; (iii) rules for risk weighting of equity exposures and past due loans; (iv) revised capital treatment for derivatives and repo-style transactions; and (v) disclosure requirements for top-tier banking organizations with $50 billionor more in total assets that are not subject to the "advanced approaches rules" that apply to banks with greater than $250 billionin consolidated assets.
Based on our current capital composition and levels, management believes it will be in compliance with the requirements as set forth in the final rules.
Business Strategy- First Defiance's primary objective is to be a high performing community banking organization, well regarded in its market areas. First
Defianceaccomplishes this through emphasis on local decision making and empowering its employees with tools and knowledge to serve its customers' needs. First Defiancebelieves in a "Customer First" philosophy that is strengthened by its Trusted Advisor initiative. First Defiancealso has a tagline of "Better Together" as an indication of its commitment to local, responsive, personalized service. First Defiancebelieves this strategy results in greater customer loyalty and profitability through core relationships. First Defianceis focused on diversification of revenue sources and increased market penetration in areas where the growth potential exists for a balance between acquisition and organic growth. The primary elements of First Defiance's business strategy are commercial banking, consumer banking, including the origination and sale of single family residential loans, enhancement of fee income, wealth management and insurance sales, each united by a strong customer service culture throughout the organization. Commercial and Commercial Real Estate Lending - Commercial and commercial real estate lending have been an ongoing focus and a major component of First Federal's success. First Federal provides primarily commercial real estate and commercial business loans with an emphasis on owner occupied commercial real estate and commercial business lending with a focus on the deposit balances that accompany these relationships. First Federal's client base tends to be small to middle market customers with annual gross revenues generally between $1 millionand $50 million. First Federal's focus is also on securing multiple guarantors in addition to collateral where possible. These customers require First Federal to have a high degree of knowledge and understanding of their business in order to provide them with solutions to their financial needs. First Federal's Customer First philosophy and culture complements this need of its clients. First Federal believes this personal service model differentiates First Federal from its competitors, particularly the larger regional institutions. First Federal offers a wide variety of products to support commercial clients including remote deposit capture and other cash management services. First Federal also believes that the small business customer is a strong market for First Federal. First Federal participates in many of the Small Business Administrationlending programs and implemented a new program in 2014 targeting the small business customer. Maintaining a diversified portfolio with an emphasis on monitoring industry concentrations and reacting to changes in the credit characteristics of industries is an ongoing focus. 48 Consumer Banking - First Federal offers customers a full range of deposit and investment products including demand, checking, money market, certificates of deposits, Certificate of Deposit Account Registry Service ("CDARS") and savings accounts. First Federal offers a full range of investment products through the wealth management department and a wide variety of consumer loan products, including residential mortgage loans, home equity loans, and installment loans. First Federal also offers online banking services, which include mobile banking, online bill pay along with debit cards.
Deposit Growth -First Federal's focus has been to grow core deposits with an emphasis on total relationship banking with both our retail and commercial customers. First Federal has initiated a pricing strategy that considers the whole relationship of the customer. First Federal will continue to focus on increasing its market share in the communities it serves by providing quality products with extraordinary customer service, business development strategies and branch expansion. First Federal will look to grow its footprint in areas believed to further complement its overall market share and complement its strategy of being a high performing community bank. Asset Quality -Maintaining a strong credit culture is of the utmost importance to First Federal. First Federal has maintained a strong credit approval and review process that has allowed the Company to maintain a credit quality standard that balances the return with the risks of industry concentrations and loan types. First Federal is primarily a collateral lender with an emphasis on cash flow performance, while obtaining additional support from personal guarantees and secondary sources of repayment. First Federal has directed its attention on loan types and markets that it knows well and in which it has historically been successful. First Federal strives to have loan relationships that are well diversified in both size and industry, and monitor the overall trends in the portfolio to maintain its industry and loan type concentration targets. First Federal maintains a problem loan remediation process that focuses on detection and resolution. First Federal maintains a strong process of internal control that subjects the loan portfolio to periodic internal reviews as well as independent third party loan review. Expansion Opportunities - First Defiance believes it is well positioned to take advantage of acquisitions or other business opportunities in its market areas. First
Defiancebelieves it has a track record of successfully accomplishing both acquisitions and de novo branching in its market area. This track record puts the Company in a solid position to enter or expand its business. First Defiancewill consider expansion opportunities, including bank and insurance acquisitions, de novo branching, with a particular focus on its primary geographic market area, as well as loan production offices. 49
Investments- First Defiance invests in U.S. Treasury and federal government agency obligations, obligations of municipal and other political subdivisions, mortgage-backed securities which are issued by federal agencies, corporate bonds, and collateralized mortgage obligations ("CMOs") and real estate mortgage investment conduits ("REMICs"). Management determines the appropriate classification of all such securities at the time of purchase in accordance
with FASB ASC Topic 320. Securities are classified as held-to-maturity when First Defiance has the positive intent and ability to hold the security to maturity. Held-to-maturity securities are stated at amortized cost and had a recorded value of
$378,000at March 31, 2014. Securities not classified as held-to-maturity are classified as available-for-sale, which are stated at fair value and had a recorded value of $209.3 millionat March 31, 2014. The available-for-sale portfolio consists of obligations of U.S. Governmentcorporations and agencies ( $4.9 million), certain municipal obligations ( $83.8 million), CMOs/REMICs ( $69.7 million), corporate bonds ( $7.0 million), mortgage backed securities ( $42.3 million), and trust preferred and preferred stock ( $1.6 million). In accordance with ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income. Lending - In order to properly assess the collateral dependent loans included in its loan portfolio, the Company has established policies regarding the monitoring of the collateral underlying such loans. The Company requires an appraisal that is less than one year old for all new collateral dependent real estate loans, and all renewed collateral dependent real estate loans where significant new money is extended. The appraisal process is handled by the Credit Department, which selects the appraiser and orders the appraisal. First Defiance'sloan policy prohibits the account officer from talking or communicating with the appraiser to insure that the appraiser is not influenced by the account officer in any way in making their determination of value.
First Federal generally does not require updated appraisals for performing loans unless significant new money is requested by the borrower.
When a collateral dependent loan is downgraded to classified status, First Federal reviews the most current appraisal on file and if necessary, based on First Federal's assessment of the appraisal, such as age, market, etc, First Federal will discount this amount to a more appropriate current value based on inputs from lenders and realtors. This amount may then be discounted further by First Federal's estimation of the carrying and selling costs. In most instances, if the appraisal is more than twelve to fifteen months old, we may require a new appraisal. Finally, First Federal assesses whether there is any collateral short fall, taking into consideration guarantor support and liquidity, and determines if a charge off is necessary. 50 When a collateral dependent loan moves to non-performing status, First Federal generally gets a new third party appraisal and charges the loan down appropriately based upon the new appraisal and an estimate of costs to liquidate the collateral. All properties that are moved into the Other Real Estate Owned ("OREO") category are supported by current appraisals, and the OREO is carried at the lower of cost or fair value, which is determined based on appraised value less First Federal's estimate of the liquidation costs. First Federal does not adjust any appraisals upward without written documentation of this valuation change from the appraiser. When setting reserves and charge offs on classified loans, appraisal values may be discounted downward based upon First Federal's experience with liquidating similar properties.
All loans over 90 days past due and/or on non-accrual are classified as non-performing loans. Non-performing status automatically occurs in the month in which the 90 day delinquency occurs.
As stated above, once a collateral dependent loan is identified as non-performing, First Federal generally gets an appraisal.
Appraisals are received within approximately 60 days after they are requested. The First Federal Loan Loss Reserve Committee reviews the amount of each new appraisal and makes any necessary charge off decisions at its meeting prior
to the end of each quarter. Any partially charged-off collateral dependent loans are considered non-performing, and as such, would need to show an extended period of time with satisfactory payment performance as well as cash flow coverage capability supported by current financial statements before First Federal will consider an upgrade to performing status. First Federal may consider moving the loan to accruing status after approximately six months of satisfactory payment performance. For loans where First Federal determines that an updated appraisal is not necessary, other means are used to verify the value of the real estate, such as recent sales of similar properties on which First Federal had loans as well as calls to appraisers, brokers, realtors and investors. First Federal monitors and tracks its loan to value quarterly to determine accuracy and any necessary charge offs. Based on these results, changes may occur in the processes used. Loan modifications constitute a Troubled Debt Restructuring ("TDR") if First Federal for economic or legal reasons related to the borrower's financial difficulties grants a concession to the borrower that it would not otherwise consider. For loans that are considered TDRs, First Federal either computes the present value of expected future cash flows discounted at the original loan's effective interest rate or it may measure impairment based on the fair value of the collateral. For those loans measured for impairment utilizing the present value of future cash flows method, any discount is carried as a reserve in the allowance for loan and lease losses. For those loans measured for impairment utilizing the fair value of the collateral, any shortfall is charged off. 51 Earnings - The profitability of First Defiance is primarily dependent on its net interest income and non-interest income. Net interest income is the difference between interest income on interest-earning assets, principally loans and securities, and interest expense on interest-bearing deposits, FHLB advances, and other borrowings. The Company's non-interest income is mainly derived from service fees and other charges, mortgage banking income, and insurance commissions. First
Defiance'searnings also depend on the provision for loan losses and non-interest expenses, such as employee compensation and benefits, occupancy and equipment expense, deposit insurance premiums, and miscellaneous other expenses, as well as federal income tax expense.
Changes in Financial Condition
Net loans receivable (excluding loans held for sale) declined
$16.3 millionto $1.54 billion. The variance in loans receivable between March 31, 2014and December 31, 2013include decreases in commercial loans (down $8.1 million), home equity and improvement loans (down $0.3 million), consumer loans (down $0.6 million), commercial real estate loans (down $10.5 million), and construction loans (down $4.0 million) while one to four family residential real estate
$1.2 million. The investment securities portfolio increased $11.1 millionto $209.7 millionat March 31, 2014from $198.6 millionat December 31, 2013. The increase is the result of $17.4 millionof securities being purchased during the first three months of 2014, somewhat offset by $2.1 millionof securities maturing or being called in the period, principal pay downs of $3.4 millionin CMOs and mortgage-backed securities, and $1.7 millionfrom two securities being sold. There was an unrealized gain in the investment portfolio of $3.1 millionat March 31, 2014compared to an unrealized gain of $1.4 millionat December 31, 2013.
Deposits increased from
$1.74 billionat December 31, 2013to $1.76 billionas of March 31, 2014. Non-interest bearing demand deposits decreased $10.5 millionto $338.4 millionand retail time deposits decreased $3.7 millionto $482.1 million. These decreases were mostly offset by increases in interest-bearing demand deposits and money market accounts of $24.8 millionto $740.8 millionand savings accounts of $14.2 millionto $199.4 million. Stockholders' equity increased from $272.1 millionat December 31, 2013to $274.9 millionat March 31, 2014. The increase in stockholders' equity was the result of recording net income of $5.2 millionand an increase in other comprehensive income of $1.1 millionpartially offset by $1.4 millionof common stock dividends being paid in the first quarter of 2014 and $1.8 millionin
repurchased common stock. 52
Average Balances, Net Interest Income and Yields Earned and Rates Paid
The following table presents for the periods indicated the total dollar amount of interest from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in thousands of dollars and rates, and the net interest margin. The table reports interest income from tax-exempt loans and investment on a tax-equivalent basis. All average balances are based upon daily balances (dollars in thousands). Three Months Ended March 31, 2014 2013 Average Yield/ Average Yield/ Balance Interest(1) Rate(2) Balance Interest(1) Rate(2) Interest-earning assets: Loans receivable
$ 1,544,902 $ 16,6724.38 % $ 1,500,222 $ 16,8144.55 % Securities 202,275 1,932 3.93 196,571 1,794 3.85 Interest bearing deposits 172,666 101 0.24 106,332 58 0.22 FHLB stock 17,302 195 4.57 19,964 219 4.45 Total interest-earning assets 1,937,145 18,900 3.96 1,823,089 18,885 4.22 Non-interest-earning assets 209,224 204,817 Total assets $ 2,146,369 $ 2,027,906Interest-bearing liabilities: Deposits $ 1,399,951 $ 1,3580.39 % $ 1,356,547 $ 1,6470.49 % FHLB advances and other 22,363 133 2.41 12,788 90 2.85 Subordinated debentures 36,134 146 1.64 36,136 152 1.71 Notes payable 52,588 41 0.32 46,396 60 0.52 Total interest-bearing liabilities 1,511,036 1,678 0.45 1,451,867 1,949 0.54 Non-interest bearing deposits 341,286 - 294,225 - Total including non-interest bearing demand deposits 1,852,322 1,678 0.37 1,746,092 1,949 0.45 Other non-interest-bearing liabilities 20,302 22,189 Total liabilities 1,872,624 1,768,281 Stockholders' equity 273,745 259,625 Total liabilities and stock- holders' equity $ 2,146,369 $ 2,027,906Net interest income; interest rate spread $ 17,2223.51 % $ 16,9363.68 % Net interest margin (3) 3.61 % 3.78 % Average interest-earning assets to average interest-bearing liabilities 128 % 126 %
(1) Interest on certain tax-exempt loans and securities is not taxable for
Federal income tax purposes. In order to compare the tax-exempt yields on
these assets to taxable yields, the interest earned on these assets is
adjusted to a pre-tax equivalent amount based on the marginal corporate
federal income tax rate of 35%.
(3) Net interest margin is net interest income divided by average
interest-earning assets. 53 Results of Operations
Three Months Ended
On a consolidated basis, First Defiance's net income for the quarter ended
March 31, 2014was $5.2 millioncompared to net income of $5.6 millionfor the comparable period in 2013. On a per share basis, basic and diluted earnings per common share for the three months ended March 31, 2014were $0.53and $0.51, respectively, compared to basic and diluted earnings per common share of $0.57and $0.55, respectively, for the quarter ended March 31, 2013. The first quarter 2014 results were negatively impacted by $511,000( $786,000before tax), or $0.05per diluted common share, for costs related to the termination of the merger with First Community Bank. Net Interest Income First Defiance'snet interest income is determined by its interest rate spread (i.e. the difference between the yields on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income was $16.8 millionfor the quarter ended March 31, 2014, up from $16.5 millionfor the same period in 2013. The tax-equivalent net interest margin was 3.61% for the quarter ended March 31, 2014, down from 3.78% for the same period in 2013. The reduction in margin between the 2013 and 2014 first quarters was due to a reduction in interest-earning asset yields, which decreased to 3.96% for the quarter ended March 31, 2014, down 26 basis points from 4.22% for the same period in 2013. This was partially offset by the cost of interest-bearing liabilities between the two periods decreasing 9 basis points to 0.37% in the first quarter of 2014 from 0.45% in the same period in 2013. Operating at a high level of liquidity along with lower loan yields has impacted the net interest margin negatively in the first quarter of 2014. Management continues to analyze and look for additional opportunities to maintain its margin, as well as other alternatives to minimize the impact of the sustained low rate environment.
Total interest income remained flat at
$18.5 millionfor the quarters ended March 31, 2014and March 31, 2013. An increase in the investment portfolio was partially offset by a decrease in loan interest income caused by a drop in yields, which declined 17 basis points to 4.38% at March 31, 2014. Interest income from investments increased to $1.5 millionfor the quarter ended March 31, 2014compared to $1.4 millionfor the same period in 2013, while income from loans decreased to $16.7 millionfor the quarter ended March 31, 2014compared to $16.8 millionfor the same period in 2013. Interest expense decreased by $271,000 millionin the first quarter of 2014 compared to the same period in 2013, to $1.7 millionfrom $1.9 million. This decrease was due to a 9 basis point decline in the average cost of interest-bearing liabilities in the first quarter of 2014 from the continued low rate environment resulting in slight decreases in rate on all the interest-bearing liability categories. Interest expense related to interest-bearing deposits was $1.4 millionin the first quarter of 2014 compared to $1.6 millionfor the same period in 2013. Interest expense recognized by the Company related to subordinated debentures was $146,000in the first quarter of 2014 compared to $152,000for the same period in 2013. Expenses on FHLB advances and securities sold under repurchase agreements were $133,000and $41,000respectively in the first quarter of 2014 compared to $90,000and $60,000respectively for the same period in 2013. 54 Allowance for Loan Losses The allowance for loan losses represents management's assessment of the estimated probable credit losses in the loan portfolio at each balance sheet date. Management analyzes the adequacy of the allowance for loan losses regularly through reviews of the loan portfolio. Consideration is given to economic conditions, changes in interest rates and the effect of such changes on collateral values and borrower's ability to pay, changes in the composition of the loan portfolio and trends in past due and non-performing loan balances. The allowance for loan losses is a material estimate that is susceptible to significant fluctuation and is established through a provision for loan losses based on management's evaluation of the inherent risk in the loan portfolio. In addition to extensive in-house loan monitoring procedures, the Company utilizes an outside party to conduct an independent loan review of all commercial loan and commercial real estate loan relationships that exceed $1.0 millionof aggregate exposure over a twelve month period. Management utilizes the results of this outside loan review to assess the effectiveness of its internal loan grading system as well as to assist in the assessment of the overall adequacy of the allowance for loan losses associated with these types of loans. The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management's best estimate, is necessary to absorb incurred credit losses within the existing loan portfolio in the normal course of business. The allowance for loan loss is made up of two basic components. The first component is the specific allowance in which the Company sets aside reserves based on the analysis of individual credits that are cash flow dependent, yet there is a discount between the present value of the future cash flows and the carrying value. This was $1.3 millionat March 31, 2014. The second component is the general reserve. The general reserve is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolios based on quantitative and qualitative factors. Due to the uncertainty of risks in the loan portfolio, the Company's judgment on the amount of the allowance necessary to absorb loans losses is approximate. Due to regulatory guidance, the Company no longer carries specific reserves on collateral dependent loans, and instead charges off any shortfall. First Federal analyzes all loans on its classified and special mention lists at least quarterly and makes judgments about the risk of loss based on the cash flow of the borrower, the value of any collateral and the financial strength of any guarantor in determining the amount of impairment of individual loans and the charge off to be taken. For purposes of the general reserve analysis, the loan portfolio is stratified into nine different loan pools based on loan type and by market area to allocate historic loss experience. The loss experience factor applied to the non-impaired loan portfolio was based upon historical losses of the most recent rolling twelve quarters ending March 31, 2014. 55
The stratification of the loan portfolio resulted in a quantitative general allowance of
In addition to the quantitative analysis, a qualitative analysis is performed each quarter to provide additional general reserves on the non-impaired loan portfolio for various factors. The overall qualitative factors are based on nine sub-factors. The nine sub-factors have been aggregated into three qualitative factors: economic, environment and risk.
1) Changes in international, national and local economic business conditions and
developments, including the condition of various market segments.
2) Changes in the value of underlying collateral for collateral dependent loans.
3) Changes in the nature and volume in the loan portfolio.
4) The existence and effect of any concentrations of credit and changes in the
level of such concentrations.
5) Changes in lending policies and procedures, including underwriting standards
and collection, charge-off and recovery practices.
6) Changes in the quality and breadth of the loan review process.
7) Changes in the experience, ability and depth of lending management and staff.
8) Changes in the trends of the volume and severity of delinquent and classified
loans, and changes in the volume of non-accrual loans, trouble debt
restructuring, and other loan modifications.
9) Changes in the political and regulatory environment.
The qualitative analysis at
March 31, 2014indicated a general reserve of $14.3 millioncompared with $12.3 millionat December 31, 2013. Management reviewed the overall economic, environmental and risk factors and determined that it was appropriate to increase several of these due in part to a regional economy hampered by severe winter weather conditions in the first quarter and reflecting overall mixed movements in unemployment rates in the Northwest Ohioand adjoining market counties in Indianaand Michigan, recent experience indicating continued declines in appraisal values for commercial real estate and other commercial asset collateral, and the continuation of higher interest rates since mid-2013. First Defiance'sgeneral reserve percentages for main loan segments not otherwise classified ranged from 0.25% for construction loans to 1.71% for nonresidential real estate loans. As a result of the quantitative and qualitative analyses, along with the change in specific reserves, the Company's provision for loan losses for the first quarter of 2014 was $103,000, compared to $425,000for the same period in 2013. The allowance for loan losses was $24.8 millionand $25.0 millionand represented 1.58% and 1.58% of loans, net of undisbursed loan funds and deferred fees and costs, as of March 31, 2014and December 31, 2013, respectively. The provision of $103,000was offset by charge offs of $1.2 millionand recoveries of $906,000, resulting in a decrease to the overall allowance for loan loss of $167,000. In management's opinion, the overall allowance for loan losses of $24.8 millionas of March 31, 2014is adequate. 56 Management also assesses the value of real estate owned as of the end of each accounting period and recognizes write-downs to the value of that real estate in the income statement if conditions dictate. In the three month period ended March 31, 2014, First Defiance had no write-downs. Management believes that the values recorded at March 31, 2014for real estate owned and repossessed assets represent the realizable value of such assets.
Total classified loans decreased to
Defiance'sratio of allowance for loan losses to non-performing loans was 92.6% at March 31, 2014compared with 89.6% at December 31, 2013. Management monitors collateral values of all loans included on the watch list that are collateral dependent and believes that allowances for those loans at March 31, 2014are appropriate. Of the $26.8 millionin non-accrual loans, $14.7 millionor 54.9% are less than 90 days past due. At March 31, 2014, First Defiance had total non-performing assets of $32.8 million, compared to $33.7 millionat December 31, 2013. Non-performing assets include loans that are on non-accrual, real estate owned and other assets held for sale. Non-performing assets at March 31, 2014and December 31, 2013by category were as follows:
Table 1 - Nonperforming Asset
March 31, December 31, 2014 2013 (In Thousands) Non-performing loans: One to four family residential real estate
$ 2,974 $ 3,273Non-residential and multi-family residential real estate 15,682 15,834 Commercial 7,723 8,327 Construction - -
Home equity and improvement - 413 Consumer Finance 395 - Total non-performing loans 26,774 27,847 Real estate owned 6,028 5,859 Other repossessed assets - - Total repossessed assets
$ 6,0285,859 Total Nonperforming assets $
Restructured loans, accruing $
Total nonperforming assets as a percentage of total assets 1.52 % 1.58 % Total nonperforming loans as a percentage of total loans* 1.71 % 1.76 %
Total nonperforming assets as a percentage of total loans plus REO*
2.09 % 2.12 % Allowance for loan losses as a percent of total nonperforming assets 75.55 % 74.02 %
* Total loans are net of undisbursed loan funds and deferred fees and costs.
57 The decrease in non-performing loans between
December 31, 2013and March 31, 2014is primarily in commercial loans. The balance of this type of non-performing loan was $604,000lower at March 31, 2014compared to December 31, 2013. Non-performing loans in the commercial loan category represented 2.03% of the total loans in those categories at March 31, 2014compared to 2.14% for the same category at December 31, 2013. Management believes that the current allowance for loan losses is appropriate and that the provision for loan losses recorded in the first quarter of 2014 is consistent with both charge-off experience and the risk inherent in the overall credits in the portfolio. First Federal's Asset Review Committee meets monthly to review the status of work-out strategies for all criticized relationships, which include all non-accrual loans. Based on such factors as anticipated collateral values in liquidation scenarios, cash flow projections, assessment of net worth of guarantors and all other factors which may mitigate risk of loss, the Asset Review Committee makes recommendations regarding proposed charge-offs which are approved by the Senior Loan Committee or the Loan Loss Reserve Committee. The following table details net charge-offs and nonaccrual loans by loan type. For the three months ended and as of March 31, 2014, commercial real estate, which represented 50.85% of total loans, accounted for (184.08)% of net charge-offs (recovery) and 58.57% of nonaccrual loans, and commercial loans, which represented 23.89% of total loans, accounted for 166.30% of net charge-offs and 28.84% of nonaccrual loans. For the three months ended and as of March 31, 2013, commercial real estate, which represented 52.74% of total loans, accounted for 24.37% of net charge-offs and 70.53% of nonaccrual loans, and commercial loans, which represented 24.04% of total loans, accounted for 19.05% of net charge-offs and 17.44% of nonaccrual loans.
Table 2 - Net Charge-offs and Non-accruals by Loan Type
For the Three Months Ended March 31, 2014 As of March 31, 2014 Net % of Total Net Nonaccrual % of Total Non- Charge- offs(Recovery) Charge-offs Loans Accrual Loans (In Thousands) (In Thousands) Residential $ 172 63.70 %
$ 2,97411.11 % Construction - 0.00 % - 0.00 % Commercial real estate (497 ) (184.08 )% 15,682 58.57 % Commercial 449 166.30 % 7,723 28.84 % Consumer (7 ) (2.59 )% - 0.00 % Home equity and improvement 153 56.67 % 395 1.48 % Total $ 270 100.00 % $ 26,774100.00 % 58 For the Three Months Ended March 31, 2013 As of March 31, 2013 Net % of Total Net Nonaccrual % of Total Non- Charge-offs Charge-offs Loans Accrual Loans (In Thousands) (In Thousands) Residential $ 107 15.81 % $ 4,16311.80 % Construction - 0.00 % - 0.00 %
Commercial real estate 165
24.37 % 24,884 70.53 % Commercial 129 19.05 % 6,152 17.44 % Consumer 27 3.99 % - 0.00 %
Home equity and improvement 249
36.78 % 84 0.23 % Total $ 677 100.00 %
$ 35,283100.00 %
Table 3 - Allowance for Loan Loss Activity
For the Quarter Ended 1st 2014 4th 2013 3rd 2013 2nd 2013 1st 2013 (In Thousands)
Allowance at beginning of period
$ 26,459 $ 26,711Provision for credit losses 103 475 476
448 425 Charge-offs: Residential 228 175 78 184 206 Commercial real estate 228 1,097 829 283 266 Commercial 525 670 39 316 205 Consumer finance 11 7 33 8 46
Home equity and improvement 184 144 170
170 272 Total charge-offs 1,176 2,093 1,149 961 995 Recoveries 906 604 367 324 318 Net charge-offs 270 1,489 782 637 677 Ending allowance
$ 24,783 $ 24,950 $ 25,964 $ 26,270 $ 26,459
The following table sets forth information concerning the allocation of First Federal's allowance for loan losses by loan categories at the dates indicated.
Table 4 - Allowance for Loan Loss Allocation by Loan Category
March 31, 2014 December 31, 2013 September 30, 2013 June 30, 2013 March 31, 2013 Percent of Percent of Percent of Percent of Percent of total loans total loans total loans total loans total loans Amount by category Amount by category Amount by category Amount by category Amount by category (Dollars In Thousands) Residential
$ 2,63912.38 % $ 2,84712.13 % $ 2,79812.14 % $ 3,19712.47 % $ 3,43313.00 % Construction 138 5.15 % 134 5.33 % 119 3.77 % 83 2.63 % 67 2.20 %
Commercial real estate 14,602 50.85 % 14,508
50.80 % 15,616 51.93 % 15,565 51.98 % 15,777 52.74 % Commercial 5,610 23.89 % 5,678 24.06 % 5,546 24.42 % 5,474 25.10 % 5,304 24.04 % Consumer 147 1.03 % 148 1.05 % 162 1.05 % 165 1.07 % 155 1.02 %
Home equity and improvement 1,647 6.70 % 1,635
6.63 % 1,723 6.69 % 1,786 6.75 % 1,723 7.00 %
$ 24,783100.00 % $ 24,950100.00 % $ 25,964100.00 % $ 26,270100.00 % $ 26,459100.00 % 59
Key Asset Quality Ratio Trends
Table 5 - Key Asset Quality Ratio Trends
1st Qtr 2014 4th Qtr 2013 3rd Qtr 2013 2nd Qtr2013 1st Qtr 2013 Allowance for loan losses / loans* 1.58 % 1.58 % 1.66 % 1.68 % 1.76 % Allowance for loan losses to net charge-offs 9178.89 % 1675.62 %
3320.20 % 4124.02 % 3908.27 % Allowance for loan losses / non-performing assets
75.55 % 74.02 % 72.06 % 74.64 % 66.82 % Allowance for loan losses / non-performing loans 92.56 % 89.60 % 85.09 % 91.69 % 74.99 % Non-performing assets / loans plus REO* 2.09 % 2.12 % 2.30 % 2.24 % 2.62 % Non-performing assets / total assets 1.52 % 1.58 % 1.75 % 1.70 % 1.94 % Net charge-offs / average loans (annualized) 0.07 % 0.39 % 0.20 % 0.17 % 0.18 %
* Total loans are net of undisbursed funds and deferred fees and costs.
Total non-interest income decreased
Service Fees. Service fees and other charges decreased by
First Federal's overdraft privilege program generally provides for the automatic payment of modest overdraft limits on all accounts deemed to be in good standing when the account is accessed using paper-based check processing, a teller withdrawal, a point-of-sale terminal, an ACH transaction, an online banking or voice-response transfer, or an ATM. To be in good standing, an account must be brought to a positive balance within a 30-day period and have not excessively used the overdraft privilege program. Overdraft limits are established for all customers without discrimination using a risk assessment approach for each account classification. The approach includes a systematic review and evaluation of the normal deposit flows made to each account classification to establish reasonable and prudent negative balance limits that would be routinely repaid by normal, expected and reoccurring deposits. The risk assessment by portfolio approach assumes a minimal degree of undetermined credit risk associated with unidentified individual accounts that are overdrawn for 30 or more days. Consumer accounts overdrawn for more than 60 days are automatically charged off. Fees are charged as a one-time fee per occurrence, up to five charges per day, and the fee charged for an item that is paid is equal to the fee charged for a non-sufficient fund item that is returned. Overdrawn balances, net of allowance for losses, are reflected as loans on First
Defiance'sbalance sheet. The fees charged for this service are established based both on the return of processing costs plus a profit, and on the level of fees charged by competitors in the Company's market area for similar services. These fees are considered to be compensation for providing a service to the customer and therefore deemed to be noninterest income rather than interest income. Fee income recorded for the quarters ending March 31, 2014and 2013 related to the overdraft privilege product, net of adjustments to the allowance for uncollectible overdrafts, were $699,000and $865,000, respectively. Accounts charged off are included in noninterest expense. The allowance for uncollectible overdrafts was $8,000at March 31, 2014, $22,000at December 31, 2013and $6,000at March 31, 2013. 60 Mortgage Banking Activity. Total revenue from the sale and servicing of mortgage loans decreased $1.6 millionto $1.2 millionfor the first quarter of 2014 compared to $2.8 millionfor the same period of 2013. The slight rise in the long term rates and the harsher weather conditions contributed to the reduction in mortgage banking activity in the first quarter 2014. Gains realized from the sale of mortgage loans decreased in the first quarter of 2014 to $641,000from $2.2 millionin the first quarter of 2013. The amortization of mortgage servicing rights expense decreased $396,000to $292,000in the first quarter of 2014 compared to $689,000in the same period in 2013. The Company recorded a negative valuation adjustment of $7,000on mortgage servicing rights in the first quarter of 2014 compared to a positive valuation adjustment of $473,000in the first quarter of 2013. The negative valuation adjustment in the first quarter of 2014 was driven by a decrease in the fair values of certain sectors of the Company's portfolio of mortgage servicing rights. Insurance and Investment Sales Commissions. Income from the sale of insurance and investment products remained flat at $3.0 millionin the first quarter of 2014 and 2013. First Defiance'sinsurance subsidiary, First Insurance, typically recognizes contingent revenues during the first quarter. These revenues are bonuses paid by insurance carriers when the Company achieves certain loss ratios or growth targets. In the first quarter of 2014, First Insuranceearned $878,000of contingent income compared to $944,000for the first quarter of 2013. Non-Interest Expense.
Non-interest expense decreased to
Compensation and Benefits. Compensation and benefits decreased to
$8.5 millionfor the quarter ended March 31, 2014from $8.8 millionfor the same period in 2013. The decrease is mainly attributable to accruals for incentive payments based on meeting performance targets were lower in the first quarter of 2014 compared to the same period in 2013. FDIC Insurance Premium. FDICcosts decreased $271,000to $385,000in the first quarter of 2014 from $656,000for the same period of 2013 due to the improvement in the Company's risk category. Other Non-Interest Expenses. Other non-interest expenses increased $57,000to $4.1 millionfor the quarter ended March 31, 2014from $4.0 millionfor the same period in 2013. Included in the first quarter of 2014 is $786,000of cost associated with the termination of First Federal's merger agreement with First Community Bankand in an increase in management consulting by $248,000. This was offset by a decrease in credit, collection and REO expense of $456,000and a decrease in secondary market buy-back losses of $556,000. The efficiency ratio, considering tax equivalent interest income and excluding securities gains and losses, for the first quarter of 2014 was 67.87% compared to 66.55% for the first quarter of 2013. 61 Income Taxes. First Defiancecomputes federal income tax expense in accordance with ASC Topic 740, Subtopic 942, which resulted in an effective tax rate of 29.61% for the quarter ended March 31, 2014compared to 29.32% for the same period in 2013. The tax rate is lower than the statutory 35% tax rate for the Company mainly because of investments in tax-exempt securities. The earnings on tax-exempt securities are not subject to federal income tax. Liquidity
As a regulated financial institution, First Federal is required to maintain appropriate levels of "liquid" assets to meet short-term funding requirements.
Defiancehad $5.3 millionof cash provided by operating activities during the first three months of 2014. The Company's cash used in operating activities resulted from the origination of loans held for sale mostly offset by the proceeds on the sale of loans. At March 31, 2014, First Federal had $87.9 millionin outstanding loan commitments and loans in process to be funded generally within the next six months and an additional $302.7 millioncommitted under existing consumer and commercial lines of credit and standby letters of credit. Also at that date, First Federal had commitments to sell $14.8 millionof loans held-for-sale. First Defiancebelieves that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If First Defiance requires funds beyond its internal funding capabilities, advances from the FHLB of Cincinnatiand other financial institutions are available. Liquidity risk arises from the possibility that the Company may not be able to meet its financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, the Company's Board of Directors has established a Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates First Federal's Asset/Liability Committee ("ALCO") as the body responsible for meeting these objectives. The ALCO reviews liquidity on a monthly basis and approves significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company's Chief Financial Officer and Controller. Capital Resources Capital is managed at First Federal and on a consolidated basis. Capital levels are maintained based on regulatory capital requirements and the economic capital required to support credit, market, liquidity and operational risks inherent in our business, as well as flexibility needed for future growth and new business opportunities.
First Federal is required to maintain specified amounts of capital pursuant to regulations promulgated by the
Office of the Comptroller of the Currency. The capital standards generally require the maintenance of regulatory capital sufficient to meet a tangible capital requirement, a core capital requirement, and a risk-based capital requirement. The following table sets forth First Federal's compliance with each of the capital requirements at March 31, 2014: (In Thousands) 62 Minimum Required for Minimum Required for Well Actual Adequately Capitalized Capitalized Amount Ratio Amount Ratio Amount Ratio Tier 1 Capital (1) Consolidated $ 248,24111.82 % $ 83,9804.0 % N/A N/A First Federal Bank $ 237,25311.32 % $ 83,8294.0 % $ 104,7865.0 % Tier 1 Capital (to Risk Weighted Assets) (1) Consolidated $ 248,24114.40 % $ 68,9524.0 % N/A N/A First Federal Bank $ 237,25313.77 % $ 68,8994.0 % $ 103,3486.0 % Total Capital (to Risk Weighted Assets) (1) Consolidated $ 269,82915.65 % $ 137,9058.0 % N/A N/A First Federal Bank $ 258,82415.03 % $ 137,7988.0 % $ 172,24710.0 %
(1) Core capital is computed as a percentage of adjusted total assets of
Risk-based capital is computed as a percentage of total risk-weighted assets
$1.72 billionand $1.72 billionfor consolidated and the bank, respectively. Critical Accounting Policies First Defiancehas established various accounting policies which govern the application of accounting principles generally accepted in the United Statesin the preparation of its financial statements. The significant accounting policies of First Defiance are described in the footnotes to the consolidated financial statements included in the Company's Annual Report on Form 10- K. Certainaccounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. Those policies which are identified and discussed in detail in the Company's Annual Report on Form 10-K include the Allowance for Loan Losses, Valuation of Securities, Goodwill, and the Valuation of Mortgage Servicing Rights. There have been no material changes in assumptions or judgments relative to those critical policies during the first three months
of 2014. 63