10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents
Index to Financial Statements

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

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

For the fiscal year ended December 31, 2010

OR

 

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

For the transition period from                     to                     

Commission File No. 000-49747

 

 

FIRST SECURITY GROUP, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Tennessee   58-2461486
(State of Incorporation)   (I.R.S. Employer Identification No.)
531 Broad Street, Chattanooga, TN   37402
(Address of Principal Executive Offices)   (Zip Code)

(423) 266-2000

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.01 par value   The NASDAQ Stock Market LLC

Securities Registered Pursuant to Section 12(g) of the Act:

None

 

 

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

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and 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 during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

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

The aggregate market value of the registrant’s outstanding common stock held by nonaffiliates of the registrant as of June 30, 2010, was approximately $29.4 million, based on the registrant’s closing sales price as reported on the NASDAQ Global Select Market. There were 16,418,140 shares of the registrant’s common stock outstanding as of April 15, 2011.

DOCUMENTS INCORPORATED BY REFERENCE

 

Document

 

Parts Into Which Incorporated

None.

 

 

 

 


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Index to Financial Statements

TABLE OF CONTENTS

 

PART I

  

Item 1.

  

Business

     1   

Item 1A.

  

Risk Factors

     23   

Item 1B.

  

Unresolved Staff Comments

     35   

Item 2.

  

Properties

     35   

Item 3.

  

Legal Proceedings

     38   

Item 4.

  

[Removed and Reserved.]

     38   

PART II

     

Item 5.

  

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

     39   

Item 6.

  

Selected Financial Data

     41   

Item 7.

  

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

     47   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     84   

Item 8.

  

Financial Statements and Supplementary Data

     87   

Item 9A.

  

Controls and Procedures

     139   

Item 9B.

  

Other Information

     142   

PART III

     

Item 10.

  

Directors, Executive Officers and Corporate Governance

     143   

Item 11.

  

Executive Compensation

     143   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     143   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     143   

Item 14.

  

Principal Accountant Fees and Services

     143   

PART IV

     

Item 15.

  

Exhibits and Financial Statement Schedules

     144   

SIGNATURES

     146   

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of our statements contained in this Annual Report, including, without limitation, matters discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements relate to future events or our future financial performance and include statements about the competitiveness of the banking industry, potential regulatory obligations, our entrance and expansion into other markets, our other business strategies and other statements that are not historical facts. Forward-looking statements are not guarantees of performance or results. When we use words like “may,” “plan,” “contemplate,” “anticipate,” “believe,” “intend,” “continue,” “expect,” “project,” “predict,” “estimate,” “could,” “should,” “would,” “will,” and similar expressions, you should consider them as identifying forward-looking statements, although we may use other phrasing. These forward-looking statements involve risks and uncertainties and are based on our beliefs and assumptions, and on the information available to us at the time that these disclosures were prepared.

These forward-looking statements involve risks and uncertainties and may not be realized due to a variety of factors, including, but not limited to the following:

 

   

deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses;

 

   

changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments;

 

   

the failure of assumptions underlying the establishment of reserves for possible loan losses;

 

   

changes in political and economic conditions, including the political and economic effects of the current economic downturn and other major developments, including the ongoing war on terrorism;

 

   

changes in financial market conditions, either internationally, nationally or locally in areas in which First Security conducts its operations, including, without limitation, reduced rates of business formation and growth, commercial and residential real estate development, and real estate prices;

 

   

First Security’s ability to comply with any requirements imposed on it or FSGBank by their respective regulators, and the potential negative consequences that result;

 

   

fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing;

 

   

governmental monetary and fiscal policies, as well as legislative and regulatory changes, including, but not limited to, implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

 

   

First Security’s participation or lack of participation in governmental programs implemented under the Emergency Economic Stabilization Act (the “EESA”) and the American Recovery and Reinvestment Act (the “ARRA”), including, without limitation, the Capital Purchase Program (the “CPP”) administered under the Troubled Asset Relief Program (“TARP”), and the Temporary Liquidity Guarantee Program (the “TLGP”) and the impact of such programs and related regulations on First Security and on international, national, and local economic and financial markets and conditions;

 

   

First Security’s lack of participation in a “stress test” under the Federal Reserve’s Supervisory Capital Assessment Program; the diagnostic and stress testing we conducted differs from that administered under the Supervisory Capital Assessment Program, and the results of our test may be inaccurate;

 

   

the impact of the EESA and the ARRA and related rules and regulations on the business operations and competitiveness of First Security and other participating American financial institutions, including the impact of the executive compensation limits of these acts, which may impact the ability of First Security to retain and recruit executives and other personnel necessary for their businesses and competitiveness;

 

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the risk that First Security may be required to contribute additional capital to FSGBank in the future to enable it to meet its regulatory capital requirements or otherwise;

 

   

the impact of certain provisions of the EESA and ARRA and related rules and regulations on the attractiveness of governmental programs to mitigate the effects of the current economic downturn, including the risks that certain financial institutions may elect not to participate in such programs, thereby decreasing the effectiveness of such programs;

 

   

the risks of changes in interest rates on the level and composition of deposits, loan demand and the values of loan collateral, securities and interest sensitive assets and liabilities;

 

   

the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in our market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone and the Internet; and

 

   

the effect of any mergers, acquisitions or other transactions, to which we or our subsidiary may from time to time be a party, including, without limitation, our ability to successfully integrate any businesses that we acquire.

Many of these risks are beyond our ability to control or predict, and you are cautioned not to put undue reliance on such forward-looking statements. First Security does not intend to update or reissue any forward-looking statements contained in this Annual Report as a result of new information or other circumstances that may become known to First Security.

All written or oral forward-looking statements attributable to us are expressly qualified in their entirety by this Cautionary Note. Our actual results may differ significantly from those we discuss in these forward-looking statements.

For other factors, risks and uncertainties that could cause our actual results to differ materially from estimates and projections contained in these forward-looking statements, please read the “Risk Factors” section of this Annual Report beginning on page 23.

 

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PART I

 

Item 1. Business

Unless otherwise indicated, all references to “First Security,” “we,” “us,” and “our” in this Annual Report on Form 10-K refer to First Security Group, Inc. and our wholly-owned subsidiary, FSGBank, National Association (“FSGBank”).

BUSINESS

First Security Group, Inc.

We are a bank holding company headquartered in Chattanooga, Tennessee. We currently operate 37 full-service banking offices through our wholly-owned bank subsidiary, FSGBank. We serve the banking and financial needs of various communities in eastern and middle Tennessee, as well as northern Georgia.

Through FSGBank, we offer a range of lending services that are primarily secured by single and multi-family real estate, residential construction and owner-occupied commercial buildings. In addition, we focus on serving the needs of small- to medium-sized businesses, by offering a range of lending, deposit and wealth management services to these businesses and their owners. Our principal source of funds for loans and securities is core deposits gathered through our branch network. We offer a wide range of deposit services, including checking, savings, money market accounts and certificates of deposit, and obtain most of our deposits from individuals and businesses in our market areas, including the vast majority of our loan customers. Our wealth management division offers private client services, financial planning, trust administration, investment management and estate planning services. We also provide mortgage banking and electronic banking services, such as Internet banking, online bill payment, cash management, ACH originations, and remote deposit capture. We actively pursue business relationships by utilizing the business contacts of our Board of Directors, senior management and local bankers, thereby capitalizing on our extensive knowledge of the local marketplace.

First Security Group, Inc. was incorporated in 1999 as a Tennessee corporation to serve as a bank holding company, and is regulated and supervised by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). As of December 31, 2010, we had total assets of approximately $1.2 billion, total deposits of approximately $1.0 billion and stockholders’ equity of approximately $93.4 million.

FSGBank, National Association

FSGBank currently operates 37 full-service banking-offices along the Interstate corridors of eastern and middle Tennessee and northern Georgia, and is primarily regulated by the Office of the Comptroller of the Currency (the “OCC”). In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank, while FSGBank operates under the name of Jackson Bank & Trust along the Interstate 40 corridor. FSGBank also provides trust and investment management, mortgage banking, financial planning and electronic banking services, such as Internet banking (www.FSGBank.com), online bill payment, cash management, ACH originations, and remote deposit capture.

FSGBank is the successor to our three previous banks: Dalton Whitfield Bank (organized in 1999), Frontier Bank (acquired in 2000) and First State Bank (acquired in 2002). Dalton Whitfield Bank was a state bank organized under the laws of Georgia engaged in a general commercial banking business. Dalton Whitfield Bank opened for business in September 1999, and simultaneously acquired selected assets and substantially all of the deposits of Colonial Bank’s three branches located in Dalton, Georgia. In 2003, Premier National Bank of Dalton merged with and into Dalton Whitfield Bank for an aggregate purchase price of $11.7 million in cash and stock.

Frontier Bank was a state savings bank organized under the laws of Tennessee in 2000 as First Central Bank of Monroe County. We acquired First Central Bank of Monroe County in 2000 for an aggregate purchase price of

 

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$2.3 million in cash. After the acquisition, First Central Bank of Monroe County was renamed Frontier Bank and re-chartered as a state bank under the laws of Tennessee to engage in a general commercial banking business. Outside of the Chattanooga market, Frontier Bank operated under the name of “First Security Bank.”

First State Bank was a state bank organized under the laws of Tennessee engaged in a general commercial banking business since its organization in 1974. We acquired First State Bank in 2002 for an aggregate purchase price of $8.6 million in cash.

During 2003, we converted each of our three subsidiary banks into national banks, renamed each bank “FSGBank, National Association” and merged the banks under the charter previously held by Frontier Bank. As a result, we consolidated our banking operations into one subsidiary, FSGBank. FSGBank currently conducts its banking operations in Dalton, Georgia under the name “Dalton Whitfield Bank.”

Since the mergers in 2003, FSGBank has continued the commercial banking business of its predecessors. In addition, in December of 2003, FSGBank acquired certain assets and assumed substantially all of the deposits and other liabilities of National Bank of Commerce’s three branch offices located in Madisonville, Sweetwater and Tellico Plains, Tennessee.

In October 2004, FSGBank acquired 100% of the capital stock of Kenesaw Leasing and J&S Leasing, both Tennessee corporations, from National Bank of Commerce for $13.0 million in cash. Both companies continue to operate as wholly-owned subsidiaries of FSGBank. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery primarily to companies in the trucking and construction industries.

In August 2005, we acquired Jackson Bank & Trust (“Jackson Bank”) for an aggregate purchase price of $33.3 million in cash. Jackson Bank was a state commercial bank headquartered in Gainesboro, Tennessee. Jackson Bank was merged into FSGBank, but we continue to operate our banking operations in Jackson and Putnam Counties, Tennessee under the name of “Jackson Bank & Trust.”

FSGBank is a member of the Federal Reserve Bank of Atlanta and a member of the Federal Home Loan Bank of Cincinnati (the “FHLB”). FSGBank’s deposits are insured by the FDIC. FSGBank operates 31 full-service banking offices in eastern and middle Tennessee and six offices in northern Georgia.

Market Area and Competition

We currently conduct business principally through 37 branches in our market areas of Bradley, Hamilton, Jackson, Jefferson, Knox, Loudon, McMinn, Monroe, Putnam and Union Counties, Tennessee and Catoosa and Whitfield Counties, Georgia. Our markets follow the Interstate 75 corridor between Dalton, Georgia (approximately one hour north of Atlanta, Georgia) and Jefferson City, Tennessee (approximately 30 minutes north of Knoxville, Tennessee) and the Interstate 40 corridor between Nashville, Tennessee and Knoxville, Tennessee. Based upon data available from the FDIC as of June 30, 2010, FSGBank’s total deposits ranked 6th among financial institutions in our market area, representing approximately 4.9% of the total deposits in our market area.

 

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The table below shows our deposit market share in the counties we serve according to data from the FDIC website as of June 30, 2010.

 

Market

   Number of
Branches
     Our Market
Deposits
     Total
Market
Deposits
     Ranking      Market Share
Percentage
(%)
 
     (dollar amounts in millions)  

Tennessee

              

Bradley County

     2       $ 18       $ 1,467         10         1.3

Hamilton County1, 2

     9         507         6,467         4         7.8

Jackson County

     3         64         118         1         55.0

Jefferson County

     2         110         525         1         20.9

Knox County

     3         65         9,033         12         0.7

Loudon County

     2         31         726         7         4.3

McMinn County

     1         35         881         6         3.9

Monroe County

     5         67         602         5         11.1

Putnam County

     3         79         1,475         6         5.4

Union County

     2         45         122         2         36.9

Georgia

              

Catoosa County

     1         6         862         9         0.7

Whitfield County2

     6         143         1,764         4         8.1
                                

FSGBank

     39       $ 1,169       $ 24,043         6         4.9
                                

 

1

Our brokered deposits, totaling $352.5 million at June 30, 2010, are included in the totals for Hamilton County.

2

Subsequent to June 30, 2010, we closed a branch in Whitfield County and a branch in Hamilton County.

Our retail, commercial and mortgage divisions operate in highly competitive markets. We compete directly in retail and commercial banking markets with other commercial banks, savings and loan associations, credit unions, mortgage brokers and mortgage companies, mutual funds, securities brokers, consumer finance companies, other lenders and insurance companies, locally, regionally and nationally. Many of our competitors compete with offerings by mail, telephone, computer and/or the Internet. Interest rates, both on loans and deposits, and prices of services are significant competitive factors among financial institutions generally. Office locations, types and quality of services and products, office hours, customer service, a local presence, community reputation and continuity of personnel are also important competitive factors that we emphasize.

Many other commercial or savings institutions currently have offices in our primary market areas. These institutions include many of the largest banks operating in Tennessee and Georgia, including some of the largest banks in the country. Many of our competitors serve the same counties we do. Within our market area, there are 69 different commercial or savings institutions.

Virtually every type of competitor has offices in Atlanta, Georgia, approximately 75 miles from Dalton and 100 miles from Chattanooga. In our market area, our largest competitors include First Tennessee, SunTrust, Regions, BB&T and Wells Fargo. These institutions, as well as other competitors of ours, have greater resources, have broader geographic markets, have higher lending limits, offer various services that we do not offer and can better afford and make broader use of media advertising, support services and electronic technology than we do. To offset these competitive disadvantages, we depend on our reputation as being an independent and locally-owned community bank and as having greater personal service, community involvement and ability to make credit and other business decisions quickly and locally.

 

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Lending Activities

We originate loans primarily secured by single and multi-family real estate, residential construction and owner-occupied commercial buildings. In addition, we make loans to small and medium-sized commercial businesses, as well as to consumers for a variety of purposes.

Our loan portfolio at December 31, 2010 was comprised as follows:

 

         Amount              Percentage of    
Portfolio
 
     (in thousands, except percentages)  

Loans secured by real estate—

     

Residential 1-4 family

   $ 252,026         34.7

Commercial

     226,357         31.1

Construction

     84,232         11.6

Multi-family and farmland

     36,393         5.0
                 
     599,008         82.4

Commercial loans

     82,807         11.4

Consumer installment loans

     33,860         4.7

Leases, net of unearned income

     7,916         1.1

Other

     3,500         0.4
                 

Total loans

   $ 727,091         100.0
                 

In addition, we have entered into contractual obligations, via lines of credit and standby letters of credit, to extend approximately $127.4 million and $14.1 million, respectively, in credit as of December 31, 2010. We use the same credit policies in making these commitments as we do for our other loans. At December 31, 2010, our contractual obligations to extend credit were comprised as follow:

 

         Amount              Percentage of    
Contractual
Obligations
 
     (in thousands, except percentages)  

Contractual obligations secured by real estate—

     

Residential 1-4 family

   $ 71,117         50.2

Commercial

     11,057         7.8

Construction

     5,787         4.1

Multi-family and farmland

     1,857         1.3
                 
     89,818         63.4

Commercial loans

     43,949         31.1

Consumer installment loans

     5,027         3.6

Leases, net of unearned income

     —           —  

Other

     2,673         1.9
                 

Total contractual obligations

   $ 141,467         100.0
                 

Real EstateResidential 1-4 Family. Our residential mortgage loan program primarily originates loans for the purchase of residential property to individuals for other third-party lenders. Residential loans to individuals retained in our loan portfolio primarily consist of first liens on 1-4 family residential mortgages, home equity loans and lines of credit. These loans are generally made on the basis of the borrower’s ability to repay the loan from his or her employment and other income and are secured by residential real estate, the value of which is reasonably ascertainable. We expect that these loan-to-value ratios will be sufficient to compensate for fluctuations in real estate market value and to minimize losses that could result from a downturn in the residential real estate market. We generally do not retain long term, fixed rate residential real estate loans in our portfolio due to interest rate and collateral risks and low levels of profitability.

 

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Real EstateCommercial, Multi-Family and Farmland. We make commercial mortgage loans to finance the purchase of real property as well as loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, including letters of credit, that are also secured by real estate. Commercial mortgage lending typically involves higher loan principal amounts, and the repayment of loans is dependent, in large part, on sufficient income from the properties collateralizing the loans to cover operating expenses and debt service. As a general practice, we require our commercial mortgage loans to be collateralized by well-managed income producing property with adequate margins and to be guaranteed by responsible parties. In addition, a substantial percentage of our commercial mortgage loan portfolio is secured by owner-occupied commercial buildings. We look for opportunities where cash flow from the business located in the owner-occupied building provides adequate debt service coverage and the guarantor’s net worth is centered on assets other than the project we are financing. Our commercial mortgage loans are generally collateralized by first liens on real estate, have fixed or floating interest rates and amortize over a 10 to 20-year period with balloon payments due at the end of one to five years. Payments on loans collateralized by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market.

In underwriting commercial mortgage loans, we seek to minimize our risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition. Our underwriting analysis also includes credit checks, reviews of appraisals and environmental hazards or EPA reports and a review of the financial condition of the borrower. We attempt to limit our risk by analyzing our borrowers’ cash flow and collateral value on an ongoing basis.

Real EstateConstruction. We also make construction and development loans to residential and, to a lesser extent, commercial contractors and developers located within our market areas. Construction loans generally are secured by first liens on real estate and have floating interest rates. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the value of the project is dependent on its successful completion. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, upon the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, there is no assurance that we will be able to recover all of the unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While we have underwriting procedures designed to identify what we believe to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above. We are currently in the process of reducing our exposure to construction and development loans.

CommercialLoans. Our commercial loan portfolio includes loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, as well as letters of credit that are generally secured by collateral other than real estate. Commercial borrowers typically secure their loans with assets of the business, personal guaranties of their principals and often mortgages on the principals’ personal residences. Our commercial loans are primarily made within our market areas and are underwritten on the basis of the commercial borrower’s ability to service the debt from income. In general, commercial loans involve more credit risk than residential and commercial mortgage loans, but less risk than consumer loans. The increased risk in commercial loans is generally due to the type of assets collateralizing these loans. The increased risk also derives from the expectation that commercial loans generally will be serviced from the operations of the business, and those operations may not be successful.

Consumer. We make a variety of loans to individuals for personal, family and household purposes, including secured and unsecured installment and term loans. Consumer loans entail greater risk than other loans, particularly in the case of consumer loans that are unsecured or secured by depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an

 

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adequate source of repayment for the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by job loss, divorce, illness or personal hardships.

Leases, Net of Unearned Income. Our commercial lease portfolio includes leases made by our leasing companies, Kenesaw Leasing and J&S Leasing. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery to owner-managed businesses primarily in the trucking and construction industries. The leased property usually serves as collateral for the lease. Our commercial leases are underwritten on the basis of the value of the underlying leased property as well as the basis of the commercial lessee’s ability to service the lease. Commercial leases generally entail greater risks than commercial loans or loans secured by real estate, but less risk than unsecured consumer loans. The increased risk in commercial leases is generally due to the rolling stock nature of the items leased, as well as the illiquid nature of the secondary market for used equipment. The increased risk also derives from the low barriers to entry in the trucking and construction industries. We are currently in the process of reducing our exposure to commercial leases by focusing our efforts on portfolio management of existing relationships instead of new business development.

Credit Risks. The principal economic risk associated with each category of the loans that we make is the creditworthiness of the borrower and the ability of the borrower to repay the loan. General economic conditions and the strength of the services and retail market segments affect borrower creditworthiness. General factors affecting a commercial borrower’s ability to repay include interest rates, inflation and the demand for the commercial borrower’s products and services, as well as other factors affecting a borrower’s customers, suppliers and employees.

Risks associated with real estate loans also include fluctuations in the value of real estate, new job creation trends, tenant vacancy rates and, in the case of commercial borrowers, the quality of the borrower’s management. Consumer loan repayments depend upon the borrower’s financial stability and are more likely to be adversely affected by divorce, job loss, illness and personal hardships.

Lending Policies. Our Board of Directors has established and periodically reviews our bank’s lending policies and procedures. We have established common documentation and standards based on the type of loans among our regions. There are regulatory restrictions on the dollar amount of loans available for each lending relationship. National banking regulations provide that no loan relationship may exceed 15% of a bank’s Tier 1 capital. At December 31, 2010, our legal lending limit was approximately $12.8 million. In addition, we have established a “house” limit of $10 million for each lending relationship. Any loan request exceeding the house limit must be approved by a committee of our Board of Directors. We occasionally sell participation interests in loans to other lenders, primarily when a loan exceeds our house lending limits.

Concentrations. The retail nature of our commercial banking operations allows for diversification of depositors and borrowers, and we believe that our business does not depend upon a single or a few customers. We also do not believe that our credits are concentrated within a single industry or group of related industries.

The economy in our Dalton, Georgia market area is generally dependent upon the carpet industry and changes in construction of residential and commercial establishments. While the Dalton economy is dominated by the carpet and carpet-related industries, we do not have any one customer from whom more than 10% of our revenues are derived. However, we have multiple customers, commercial and retail, that are directly or indirectly affected by, or are engaged in businesses related to the carpet industry that, in the aggregate, have historically provided greater than 10% of our revenues.

The federal banking regulators have issued guidance regarding the risks posed by commercial real estate (“CRE”) lending concentrations. CRE loans generally include land development, construction loans and loans

 

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secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines to help identify institutions that are potentially exposed to significant CRE risk:

 

   

total reported loans for construction, land development and other land represent 100% or more of the institution’s total capital, or

 

   

total commercial real estate loans represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more.

As of December 31, 2010, our concentrations were within the thresholds of the CRE guidance.

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2010, approximately 82.4% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized.

We offer a variety of loan products with payment terms and rate structures that have been designed to meet the needs of our customers within an established framework of acceptable credit risk. Payment terms range from fully amortizing loans that require periodic principal and interest payments to terms that require periodic payments of interest-only with principal due at maturity. Interest-only loans are a typical characteristic in commercial and home equity lines-of-credit and construction loans (residential and commercial). As of December 31, 2010, we had approximately $279.5 million of interest-only loans, which primarily consist of home equity loans 28.5% construction and land development loans (22.9%), commercial and industrial loans (18.2%) and commercial real estate loans (14.8%). The loans have an average maturity of approximately 18 months or less, with the exception of home equity lines-of-credit which have an average maturity of approximately six and a half years. The interest-only loans are fully underwritten and within our lending policies.

We do not offer, hold or service option adjustable rate mortgages that may expose the borrowers to future increases in repayments in excess of changes resulting solely from increases in the market rate of interest (loans subject to negative amortization).

Deposits

Our principal source of funds for loans and investing in securities is core deposits. We offer a wide range of deposit services, including checking, savings, money market accounts and certificates of deposit. We obtain most of our deposits from individuals and businesses in our market areas. We believe that the rates we offer for core deposits are competitive with those offered by other financial institutions in our market areas. We have also chosen to obtain a portion of our deposits from outside our market through brokered deposits. Our brokered deposits represented 30.0% of total deposits as of December 31, 2010. Other sources of funding include advances from the FHLB, subordinated debt and other borrowings. These other sources enable us to borrow funds at rates and terms, which at times, are more beneficial to us. During the fourth quarter of 2009 and first quarter of 2010, we enhanced our liquidity by issuing over $255 million in brokered certificates of deposits and placing the excess funds in our interest bearing deposit account at the Federal Reserve Bank of Atlanta. At December 31, 2010, our balance at the Federal Reserve Bank of Atlanta was approximately $199 million. This excess cash is available to fund our contractual obligations and prudent investment opportunities.

Other Banking Services

Given client demand for increased convenience and account access, we offer a range of products and services, including 24-hour internet banking, ACH transactions, remote deposit capture, wire transfers, direct deposit, traveler’s checks, safe deposit boxes, and United States savings bonds. We earn fees for most of these

 

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services. We also receive ATM transaction fees from transactions performed by our customers participating in a shared network of ATMs and a debit card system that our customers can use throughout Tennessee and Georgia, as well as in other states. Additionally, we offer wealth management services including private client services, financial planning, trust administration, investment management and estate planning services.

Securities

After establishing necessary cash reserves and funding loans, we invest our remaining liquid assets in securities allowed under banking laws and regulations. We invest primarily in obligations of the United States or obligations guaranteed as to principal and interest by the United States, other taxable securities and in certain obligations of states and municipalities. We also invest excess funds in federal funds with our correspondent banks and in our interest bearing account at the Federal Reserve Bank of Atlanta. The sale of federal funds represents a short-term loan from us to another bank. Risks associated with securities include, but are not limited to, interest rate fluctuation, market illiquidity, maturity and concentration.

Seasonality and Cycles

Although we do not consider our commercial banking business to be seasonal, our mortgage banking business is somewhat seasonal, with the volume of home financings, in particular, being lower during the winter months. Additionally, the Dalton, Georgia economy is seasonal and cyclical as a result of its dependence upon the carpet industry and changes in construction of residential and commercial establishments. While the Dalton, Georgia economy is dominated by the carpet and carpet-related industries, we do not have any one customer from whom more than 10% of our revenues are derived. However, we have multiple customers, commercial and retail, that are directly or indirectly affected by, or are engaged in businesses related to the carpet industry that, in the aggregate, have historically provided greater than 10% of our revenues.

Employees

On December 31, 2010, we had 302 full-time employees and 14 part-time employees. We consider our employee relations to be good, and we have no collective bargaining agreements with any employees.

Website Address

Our corporate website address is www.FSGBank.com. From this website, select the “About” tab followed by selecting “Investor Relations.” Our filings with the Securities and Exchange Commission (the “SEC”), including but not limited to our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to these reports are available and accessible soon after we file them with the SEC.

 

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SUPERVISION AND REGULATION

Both First Security and FSGBank are subject to extensive state and federal banking regulations that impose restrictions on and provide for general regulatory oversight of their operations. These laws are generally intended to protect depositors, not stockholders. Legislation and regulations authorized by legislation influence, among other things:

 

   

how, when and where we may expand geographically;

 

   

into what product or service market we may enter;

 

   

how we must manage our assets or liabilities; and

 

   

under what circumstances money may or must flow between the parent bank holding company and the subsidiary bank.

Set forth below is an explanation of the major pieces of legislation affecting our industry and how that legislation affects our actions. The following summary is qualified by reference to the statutory and regulatory provisions discussed. Changes in applicable laws or regulations may have a material effect on our business and prospects, and legislative changes and the policies of various regulatory authorities may significantly affect our operations. We cannot predict the effect that fiscal or monetary policies, or new federal or state legislation may have on our business and earnings in the future.

First Security

Because we own all of the capital stock of FSGBank, we are a bank holding company under the Federal Bank Holding Company Act of 1956. As a result, we are primarily subject to the supervision, examination and reporting requirements of the Bank Holding Company Act and the regulations of the Federal Reserve Board.

Written Agreement. Effective September 7, 2010, First Security entered into a Written Agreement (the “Agreement”) with the Federal Reserve Bank of Atlanta (the “Federal Reserve Bank”). The Agreement is designed to enhance our ability to act as a source of strength to FSGBank. Substantially all of the requirements of the Agreement are similar to those already in effect for FSGBank pursuant to the Consent Order entered into with the Office of the Comptroller of the Currency on April 28, 2010, and discussed below.

Pursuant to the Agreement, First Security is prohibited from declaring or paying dividends without prior written consent from the Federal Reserve Bank. In addition, pursuant to the Agreement, without the prior written consent of regulators, First Security is prohibited from taking dividends, or any other form of payment representing a reduction of capital, from FSGBank; incurring, increasing or guaranteeing any debt; or redeeming any shares of First Security’s common stock. First Security is also obligated to provide quarterly written progress reports to the Federal Reserve Bank.

In accordance with the Agreement, First Security submitted to the Federal Reserve Bank a copy of FSGBank’s capital plan that had previously been submitted to the OCC. The Agreement does not contain specific target capital ratios or specific timelines, but requires that the plan address First Security’s current and future capital requirements, FSGBank’s current and future capital requirements, the adequacy of FSGBank’s capital taking into account its risk profile, and the source and timing of additional funds necessary to fulfill First Security’s and FSGBank’s future capital requirements. Neither the OCC nor the Federal Reserve Bank have approved FSGBank’s capital plan and FSGBank is not in compliance with the capital requirements contained in the Consent Order.

The provisions of the Agreement remain in effect and enforceable until stayed, modified, terminated or suspended by the Federal Reserve Bank. We are currently deemed not in compliance with several provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve Bank. We can provide no assurances that we will be able to comply fully with the Agreement, that

 

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efforts to comply with the Agreement will not have a material adverse effect on the operations and financial condition of First Security, or that further enforcement actions won’t be imposed on First Security.

Acquisitions of Banks. The Bank Holding Company Act requires every bank holding company to obtain the Federal Reserve Board’s prior approval before:

 

   

acquiring direct or indirect ownership or control of any voting shares of any bank if, after the acquisition, the bank holding company will directly or indirectly own or control more than 5% of the bank’s voting shares;

 

   

acquiring all or substantially all of the assets of any bank; or

 

   

merging or consolidating with any other bank holding company.

Additionally, the Bank Holding Company Act provides that the Federal Reserve Board may not approve any of these transactions if it would result in or tend to create a monopoly, substantially lessen competition or otherwise function as a restraint of trade, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve Board is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks concerned. The Federal Reserve Board’s consideration of financial resources generally focuses on capital adequacy, which is discussed below.

Under the Bank Holding Company Act, if we are adequately capitalized and adequately managed, we or any other bank holding company located within Tennessee or Georgia, may purchase a bank located outside of Tennessee or Georgia. Conversely, an adequately capitalized and adequately managed bank holding company located outside of Tennessee or Georgia may purchase a bank located inside Tennessee or Georgia. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in specified concentrations of deposits. Currently, Georgia law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been incorporated for three years, and Tennessee law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been incorporated for five years. Because FSGBank has been chartered for more than five years, this restriction would not limit our ability to sell.

Change in Bank Control. Subject to various exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with related regulations, require Federal Reserve Board approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of a bank holding company. Control is also presumed to exist, although rebuttable, if a person or company acquires 10% or more, but less than 25%, of any class of voting securities and either:

 

   

the bank holding company has registered securities under Section 12 of the Securities Exchange Act of 1934; or

 

   

no other person owns a greater percentage of that class of voting securities immediately after the transaction.

Our common stock is registered under Section 12 of the Securities Exchange Act of 1934. The regulations provide a procedure for challenging rebuttable presumptions of control.

Permitted Activities. The Bank Holding Company Act has generally prohibited a bank holding company from engaging in activities other than banking or management or controlling banks or other permissible subsidiaries and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those determined by the Federal Reserve Board to be closely related to banking or managing or controlling banks, as to be a proper incident thereto. Provisions of the Gramm-Leach-Bliley Act have expanded the permissible activities of a bank holding company that qualifies as a financial holding company. Under the

 

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regulations implementing the Gramm-Leach-Bliley Act, a financial holding company may engage in additional activities that are financial in nature or incidental or complementary to financial activity. Those activities include, among other activities, certain insurance and securities activities.

To qualify to become a financial holding company, FSGBank and any other depository institution subsidiary of First Security must be well capitalized and well managed and must have a Community Reinvestment Act rating of at least “satisfactory.” Additionally, we must file an election with the Federal Reserve Board to become a financial holding company and must provide the Federal Reserve Board with 30 days’ written notice prior to engaging in a permitted financial activity. To date, we have not elected to become a financial holding company.

Support of FSGBank. Under Federal Reserve Board policy, we are expected to act as a source of financial strength for FSGBank and to commit resources to support FSGBank. In addition, pursuant to the Dodd-Frank Wall Street and Consumer Protection Act (the “Dodd-Frank Act”), the federal banking regulators are required to issue, within two years of enactment, rules that require a bank holding company to serve as a source of financial strength for any depository institution subsidiary. This support may be required at times when, without this Federal Reserve Board policy or the impending rules, we might not be inclined to provide it. In addition, any capital loans made by us to FSGBank will be repaid only after FSGBank’s deposits and various other obligations are repaid in full. In the unlikely event of our bankruptcy, any commitment that we give to a bank regulatory agency to maintain the capital of FSGBank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

Non-Bank Subsidiary Examination and Enforcement. As a result of the Dodd-Frank Act, all non-bank subsidiaries not currently regulated by a state or federal agency will now be subject to examination by the Federal Reserve Board in the same manner and with the same frequency as if its activities were conducted by the lead bank subsidiary. These examinations will consider whether the activities engaged in by the non-bank subsidiary pose a material threat to the safety and soundness of its insured depository institution affiliates, are subject to appropriate monitoring and control, and comply with applicable laws. Pursuant to this authority, the Federal Reserve Board may also take enforcement action against non-bank subsidiaries.

TARP Participation. On October 14, 2008, the U.S. Treasury announced the capital purchase component of TARP. This program was instituted by the U.S. Treasury pursuant to the Emergency Economic Stabilization Act of 2008, which provides up to $700 billion to the U.S. Treasury to, among other things, take equity ownership positions in financial institutions. The TARP capital purchase program is intended to encourage financial institutions to build capital and thereby increase the flow of financing to businesses and consumers. We participated in the capital purchase component of TARP.

FSGBank

Because FSGBank is chartered as a national bank, it is primarily subject to the supervision, examination and reporting requirements of the National Bank Act and the regulations of the OCC. The OCC regularly examines FSGBank’s operations and has the authority to approve or disapprove mergers, the establishment of branches and similar corporate actions. The OCC also has the power to prevent the continuance or development of unsafe or unsound banking practices or other violations of law. Because FSGBank’s deposits are insured by the FDIC to the maximum extent provided by law, FSGBank is subject to certain FDIC regulations and the FDIC also has back-up examination and enforcement power over FSGBank. FSGBank is also subject to numerous state and federal statutes and regulations that affect its business, activities and operations.

Consent Order. On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order, FSGBank consented and agreed to the issuance of a Consent Order (the “Order”) by the OCC. In the negotiated Order, FSGBank and the OCC agreed as to areas of FSGBank’s operations that warrant improvement and a plan for making those improvements. The Order imposes no fines or penalties on FSGBank. FSGBank’s customer deposits remain fully insured by the FDIC to the maximum extent allowed by law; the Order does not impact this coverage in any manner.

 

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We are currently deemed not in compliance with the provisions of the Order, including the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. We can provide no assurances that we will be able to comply fully with the Order, that efforts to comply with the Order will not have a material adverse effect on the operations and financial condition of FSGBank, or that further enforcement actions won’t be imposed on FSGBank.

Pursuant to the Order, FSGBank was required to appoint a compliance committee to oversee FSGBank’s compliance with the Order. FSGBank’s compliance committee currently consists of the Bank’s independent directors: William C. Hall, Carol H. Jackson, Ralph L. Kendall, D. Ray Marler, and Ralph E. Mathews, Jr.

Under the Order, FSGBank is required to develop and submit to the OCC for review a written strategic plan covering at least a three-year period. The strategic plan is required to, among other things, include objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, and reduction in the volume of nonperforming assets, together with strategies to achieve these objectives. The OCC has not accepted our written strategic plan.

Within 120 days from the effective date of the Order, the Bank was required to achieve and thereafter maintain total capital at least equal to 13% of risk-weighted assets and Tier 1 capital at least equal to 9% of adjusted total assets. Within 90 days from the effective date of the Order, the Bank was required to develop and submit to the OCC for review a written capital plan covering at least a three-year period. The capital plan shall, among other things, included specific plans for maintaining adequate capital and a discussion of the sources and timing of additional capital and contingency plans for alternative sources of capital. The OCC has not accepted our capital plan. As of December 31, 2010, FSGBank’s total risk-based capital ratio was 12.2% and its leverage ratio was 7.1%. We are considering a variety of strategic alternatives intended to achieve and maintain the prescribed capital ratios.

Under the Order, FSGBank’s Board of Directors prepared a written assessment of the capabilities of the Bank’s executive officers to perform present and anticipated duties, including the execution of the strategic plan. If any changes are deemed necessary by the Board, the OCC shall have the power to disapprove the appointment of a new proposed executive officer. The Order also requires annual written performance appraisals for each executive officer.

Within 60 days from the effective date of the Order, FSGBank was required to review and revise its existing credit policy to improve the Bank’s loan portfolio management, as well as FSGBank’s policies related to leasing, retail credit, and collateral exceptions. Within 90 days of the effective date of the Order, FSGBank was required to review and revise its independent and on-going loan review program. Ongoing reviews may, however, continue to result in positive or negative changes to certain loan classifications.

FSGBank was also required to review and revise its program for the Allowance for Loan and Lease Losses (“ALLL”). The Board of Directors is required to review the adequacy of the ALLL quarterly, and any deficiency shall be remedied in the calendar quarter it is discovered. Within 90 days of the effective date of the Order, FSGBank was required to review and revise its existing program to protect the Bank’s interest in criticized assets. Beginning with the effective date of the Order, FSGBank may not extend any credit to, or for the benefit of, any borrower who has a loan that is criticized as “doubtful,” “substandard” or “special mention,” unless FSGBank documents that such extension of credit is in FSGBank’s best interest. We continue to work with the OCC to address these policies.

Within 90 days of the effective date of the Order, FSGBank was required to review and revise the Bank’s existing written concentration management program, and adopt plans to reduce the risk of exposure to any concentration deemed imprudent. Within 60 days of the effective date of the Order, FSGBank was required to review and revise its comprehensive liquidity risk management program, including the preparation of periodic liquidity reports and a contingency funding plan. We continue to work with the OCC to address these policies.

 

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The Order will remain in effect and enforceable until it is modified, terminated, suspended or set aside by the OCC.

Because the Order establishes specific capital amounts to be maintained by FSGBank, FSGBank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if FSGBank exceeds the levels of capital set forth in the Order. As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.

FSGBank is committed to complying with the terms of the Order. FSGBank reports to the OCC monthly regarding its progress in complying with the provisions included in the Order. Compliance with the terms of the Order is an ongoing priority for the Board of Directors and management of FSGBank.

Branching. National banks are required by the National Bank Act to adhere to branching laws applicable to state banks in the states in which they are located. Under both Tennessee and Georgia law, FSGBank may open branch offices throughout Tennessee or Georgia with the prior approval of the OCC. Prior to the enactment of the Dodd-Frank Act, FSGBank and any other national- or state-chartered bank were generally permitted to branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. However, interstate branching is now permitted for all national- and state-chartered banks as a result of the Dodd-Frank Act, provided that a state bank chartered by the state in which the branch is to be located would also be permitted to establish a branch.

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, the federal banking regulators have established five capital categories in which all institutions are placed: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The federal banking agencies have also specified by regulation the relevant capital levels for each category.

As a bank’s capital position deteriorates, federal banking regulators are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. As of December 31, 2010, the Bank was considered “adequately capitalized” for regulatory purposes.

A “well capitalized” bank is one that is not required to meet and maintain a specific capital level for any capital measure, pursuant to any written agreement, order, capital directive, or other remediation, and significantly exceeds all of its capital requirements, which include maintaining a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, and a Tier 1 leverage ratio of at least 5%. Generally, a classification as well capitalized will place a bank outside of the regulatory zone for purposes of prompt corrective action. However, a well capitalized bank may be reclassified as “adequately capitalized” based on criteria other than capital, if the federal regulator determines that a bank is in an unsafe or unsound condition, or is engaged in unsafe or unsound practices, which requires certain remedial action.

An “adequately capitalized” bank meets the required minimum level for each relevant capital measure, including a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a Tier 1 leverage ratio of at least 4%. A bank that is adequately capitalized is prohibited from directly or indirectly accepting, renewing or rolling over any brokered deposits, absent applying for and receiving a waiver from the applicable regulatory authorities. Institutions that are not well capitalized are also prohibited, except in very limited circumstances where the FDIC permits use of a higher local market rate, from paying yields for deposits in excess of 75 basis points above a national average rate for deposits of comparable maturity, as calculated by the FDIC. In addition, all institutions are generally prohibited from making capital distributions and paying

 

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management fees to controlling persons if, subsequent to such distribution or payment, the institution would be undercapitalized. Finally, an adequately capitalized bank may be forced to comply with operating restrictions similar to those placed on undercapitalized banks.

An “undercapitalized” bank fails to meet the required minimum level for any relevant capital measure. A bank that reaches the undercapitalized level is likely subject to a formal agreement or another formal supervisory sanction. An undercapitalized bank is not only subject to the requirements placed on adequately capitalized banks, but also becomes subject to the following operating and managerial restrictions, which:

 

   

prohibit capital distributions;

 

   

prohibit payment of management fees to a controlling person;

 

   

require the bank to submit a capital restoration plan within 45 days of becoming undercapitalized;

 

   

require close monitoring of compliance with capital restoration plans, requirements and restrictions by the primary federal regulator;

 

   

restrict asset growth by requiring the bank to restrict its average total assets to the amount attained in the preceding calendar quarter;

 

   

require prior approval by the primary federal regulator for acquisitions, branching and new lines of business; and

 

   

prohibit any material changes in accounting methods.

Finally, an undercapitalized institution may be required to comply with operating restrictions similar to those placed on significantly undercapitalized institutions.

A “significantly undercapitalized” bank has a total risk-based capital ratio less than 6%, a Tier 1 risk-based capital less than 3%, and a Tier 1 leverage ratio less than 3%. In addition to being subject to the restrictions applicable to undercapitalized institutions, significantly undercapitalized banks become subject to the following additional restrictions, which:

 

   

require the sale of enough securities so that the bank is adequately capitalized or, if grounds for conservatorship or receivership exist, the merger or acquisition of the bank;

 

   

restrict affiliate transactions;

 

   

further restrict growth, including a requirement that the bank reduce its total assets;

 

   

restrict or prohibit all activities that are determined to pose an excessive risk to the bank;

 

   

require the bank to elect new directors, dismiss directors or senior executive officers, or employ qualified senior executive officers to improve management;

 

   

prohibit the acceptance of deposits from correspondent banks, including renewals and rollovers of prior deposits;

 

   

require prior approval of capital distributions by holding companies;

 

   

require holding company divestiture of the financial institution, bank divestiture of subsidiaries and/or holding company divestiture of other affiliates; and

 

   

require the bank to take any other action the federal regulator determines will “better achieve” prompt corrective action objectives.

Finally, without prior regulatory approval, a significantly undercapitalized institution must restrict the compensation paid to its senior executive officers, including the payment of bonuses and compensation that exceeds the officer’s average rate of compensation during the 12 calendar months preceding the calendar month in which the bank became undercapitalized.

 

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A “critically undercapitalized” bank has a Tier 1 leverage ratio that is equal to or less than 2%. In addition to the appointment of a receiver in not more than 90 days, or such other action as determined by an institution’s primary federal regulator, an institution classified as critically undercapitalized is subject to the restrictions applicable to undercapitalized and significantly undercapitalized institutions, and is further prohibited from doing the following without the prior written regulatory approval:

 

   

entering into material transactions other than in the ordinary course of business;

 

   

extending credit for any highly leveraged transaction;

 

   

amending the institution’s charter or bylaws, except to the extent necessary to carry out any other requirements of law, regulation or order;

 

   

making any material change in accounting methods;

 

   

engaging in certain types of transactions with affiliates;

 

   

paying excessive compensation or bonuses, including golden parachutes;

 

   

paying interest on new or renewed liabilities at a rate that would increase the institution’s weighted average cost of funds to a level significantly exceeding the prevailing rates of its competitors; and

 

   

making principal or interest payment on subordinated debt 60 days or more after becoming critically undercapitalized.

In addition, a bank’s primary federal regulator may impose additional restrictions on critically undercapitalized institutions consistent with the intent of the prompt corrective action regulations. Once an institution has become critically undercapitalized, subject to certain narrow exceptions such as a material capital remediation, federal banking regulators will initiate the resolution of the institution.

FDIC Insurance Assessments. FSGBank’s deposits are insured by the Deposit Insurance Fund (the “DIF”) of the FDIC up to the maximum amount permitted by law, which was permanently increased to $250,000 by the Dodd-Frank Act. The FDIC uses the DIF to protect against the loss of insured deposits if an FDIC-insured bank or savings association fails. Pursuant to the Dodd-Frank Act, the FDIC must take steps, as necessary, for the DIF reserve ratio to reach 1.35% of estimated insured deposits by September 30, 2020. The Bank is thus subject to FDIC deposit premium assessments.

Currently, the FDIC uses a risk-based assessment system that assigns insured depository institutions to one of four risk categories based on three primary sources of information—supervisory risk ratings for all institutions, financial ratios for most institutions, including the Bank, and long-term debt issuer ratings for large institutions that have such ratings. For institutions assigned to the lowest risk category, the annual assessment rate ranges between 7 and 16 cents per $100 of domestic deposits. For institutions assigned to higher risk categories, assessment rates range from 17 to 77.5 cents per $100 of domestic deposits. These ranges reflect a possible downward adjustment for unsecured debt outstanding and possible upward adjustments for secured liabilities and, in the case of institutions outside the lowest risk category, brokered deposits.

On September 29, 2009, the FDIC announced a uniform three basis points increase effective January 1, 2011, and on November 12, 2009, adopted a rule requiring nearly all FDIC-insured depository institutions, including the Bank, to prepay their DIF assessments for the fourth quarter of 2009 and for the following three years on December 30, 2009. At that time, the FDIC indicated that the prepayment of DIF assessments was in lieu of additional special assessments; however, there can be no guarantee that continued pressures on the DIF will not result in additional special assessments being collected by the FDIC in the future.

Pursuant to the Dodd-Frank Act, the FDIC issued proposed regulations, which are anticipated to become effective April 1, 2011, that amend current regulations to redefine the “assessment base” used for calculating deposit insurance assessments. Rather than the current system, whereby the assessment base is calculated by using an insured depository institution’s domestic deposits less a few allowable exclusions, the new assessment base will be calculated using the average consolidated total assets of an insured depository institution less the

 

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average tangible equity of such institution. In the proposed regulations, the FDIC defines tangible equity as Tier 1 capital. The FDIC continues to utilize a risk-based assessment system in which institutions will be subject to assessment rates ranging from 2.5 to 45 basis points, subject to adjustments for unsecured debt and, in the case of institutions outside the lowest risk category, brokered deposits. The proposed rules eliminate adjustments for secured liabilities.

The proposed rules retain the FDIC Board’s flexibility to, without further notice-and-comment rulemaking, adopt rates that are higher or lower than the stated base assessment rates, provided that the FDIC cannot (i) increase or decrease the total rates from one quarter to the next by more than three basis points, or (ii) deviate by more than three basis points from the stated assessment rates. Although the Dodd-Frank Act requires that the FDIC eliminate its requirement to pay dividends to depository institutions when the reserve ratio exceeds a certain threshold, the FDIC proposes a decreasing schedule of assessment rates that would take effect when the DIF reserve ratio first meets or exceeds 1.15%. As proposed, if the DIF reserve ratio meets or exceeds 1.15%, base assessment rates would range from 1.5 to 40 basis points; if the DIF reserve ratio meets or exceeds 2%, base assessment rates would range from 1 to 38 basis points; and if the DIF reserve ratio meets or exceeds 2.5%, base assessment rates would range from 0.5 to 35 basis points. All base assessment rates would continue to be subject to adjustments for unsecured debt and brokered deposits.

The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of The Financing Corporation (“FICO”). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and in 2010 ranged from 1.06 cents to 1.04 cents per $100 of assessable deposits. These assessments will continue until the debt matures between 2017 and 2019.

The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, or condition imposed by the FDIC.

FDIC Temporary Liquidity Guarantee Program. On October 14, 2008, the FDIC announced that its Board of Directors, under the authority to prevent “systemic risk” in the U.S. banking system, approved the Temporary Liquidity Guarantee Program (“TLGP”). The purpose of the TLGP is to strengthen confidence and encourage liquidity in the banking system. The TLGP is composed of two components, the Debt Guarantee Program and the Transaction Account Guarantee Program, and institutions had the opportunity to opt-out of either or both components of the TLGP.

The Debt Guarantee Program: Under the TLGP, the FDIC guaranteed certain newly issued senior unsecured debt issued by participating financial institutions through October 31, 2009. The annualized fee that the FDIC assessed to guarantee the senior unsecured debt varied by the length of maturity of the debt. For debt with a maturity of 180 days or less (excluding overnight debt), the fee was 50 basis points; for debt with a maturity between 181 days and 364 days, the fee was 75 basis points, and for debt with a maturity of 365 days or longer, the fee was 100 basis points. Neither First Security nor FSGBank issued any debt guaranteed by the FDIC under the Debt Guarantee component of the program.

The Transaction Account Guarantee Program: Under the TLGP, the FDIC fully guaranteed funds in non-interest bearing deposit accounts held at participating FDIC-insured institutions, regardless of dollar amount. The temporary guarantee was originally scheduled to expire at the end of 2009, but was subsequently extended to December 31, 2010. Pursuant to the Dodd-Frank Act, beginning on the scheduled termination date for the Transaction Account Guarantee Program, or TAGP, and continuing through December 31, 2012, unlimited insurance coverage will be provided for funds held in non-interest bearing transaction accounts, including Interest on Lawyer Trust Accounts (IOLTAs). During the TAGP extension period, the FDIC imposed a surcharge between 15 and 25 basis points on the daily average balance in excess of $250,000 held in non-interest bearing transaction accounts. Pursuant to the Dodd-Frank Act, however, institutions are no longer separately assessed for the additional coverage, and the unlimited insurance is included in assessments for the overall insurance

 

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program. One distinction from this new insurance and the TAGP, is the exclusion of minimal interest-bearing NOW accounts, which were previously covered under the TAGP. FSGBank did not opt out of the original or extension periods of the Transaction Account Guarantee component of the TLGP, thus providing the maximum available insurance for our customers.

Community Reinvestment Act. The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their respective jurisdictions, the federal banking regulators shall evaluate the record of each financial institution in meeting the credit needs of its local community, including low and moderate-income neighborhoods. These facts are also considered in evaluating mergers, acquisitions and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on FSGBank. Additionally, we must publicly disclose the terms of various Community Reinvestment Act-related agreements.

Allowance for Loan and Lease Losses. The Allowance for Loan and Lease Losses (“ALLL”) represents one of the most significant estimates in our financial statements and regulatory reports. Because of its significance, we have developed a system by which we develop, maintain and document a comprehensive, systematic and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses. The “Interagency Policy Statement on the Allowance for Loan and Lease Losses” issued on December 13, 2006, encourages all banks to ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the bank’s stated policies and procedures, management’s best judgment and relevant supervisory guidance. Consistent with supervisory guidance, we maintain a prudent and conservative, but not excessive, ALLL, that is at a level that is appropriate to cover estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio. The allowance for loan and lease losses, and our methodology for calculating the allowance, are fully described in Note 1 to our consolidated financial statements under “Allowance for Loan and Lease Losses” on page 97, and in the “Management’s Discussion and Analysis—Statement of Financial Condition—Allowance for Loan and Lease Losses” section on pages 65 through 71.

Commercial Real Estate Lending. Our lending operations may be subject to enhanced scrutiny by federal banking regulators based on our concentration of commercial real estate loans. On December 6, 2006, the federal banking regulators issued final guidance to remind financial institutions of the risk posed by commercial real estate (“CRE”) lending concentrations. CRE loans generally include land development, construction loans and loans secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines for its examiners to help identify institutions that are potentially exposed to significant CRE risk and may warrant greater supervisory scrutiny:

 

   

total reported loans for construction, land development and other land represent 100% or more of the institution’s total capital, or

 

   

total commercial real estate loans represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more.

As of December 31, 2010, our CRE concentrations were within the thresholds of the CRE guidance.

Enforcement Powers. The Financial Institution Reform Recovery and Enforcement Act (“FIRREA”) expanded and increased civil and criminal penalties available for use by the federal regulatory agencies against depository institutions and certain “institution-affiliated parties.” Institution-affiliated parties primarily include management, employees, and agents of a financial institution, as well as independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs. These practices can include the failure of an institution to timely file required reports or the filing of false or misleading information or the submission of inaccurate reports. Civil penalties may be as high as $1,100,000 per

 

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day for such violations. Criminal penalties for some financial institution crimes have been increased to 20 years. In addition, regulators are provided with greater flexibility to commence enforcement actions against institutions and institution-affiliated parties.

Possible enforcement actions include the termination of deposit insurance. Furthermore, banking agencies’ power to issue regulatory orders were expanded. Such orders may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the ordering agency to be appropriate. The Dodd-Frank Act increases regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.

Other Regulations. Interest and other charges collected or contracted for by FSGBank are subject to state usury laws and federal laws concerning interest rates. Our loan operations will be subject to federal laws applicable to credit transactions, such as the:

 

   

Federal Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 

   

Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 

   

Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;

 

   

Fair Credit Reporting Act of 1978, as amended by the Fair and Accurate Credit Transactions Act, governing the use and provision of information to credit reporting agencies, certain identity theft protections, and certain credit and other disclosures;

 

   

Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

   

Soldiers’ and Sailors’ Civil Relief Act of 1940, as amended by the Servicemembers’ Civil Relief Act, governing the repayment terms of, and property rights underlying, secured obligations of persons currently on active duty with the United States military;

 

   

Talent Amendment in the 2007 Defense Authorization Act, establishing a 36% annual percentage rate ceiling, which includes a variety of charges including late fees, for consumer loans to military service members and their dependents; and

 

   

rules and regulations of the various federal banking regulators charged with the responsibility of implementing these federal laws.

FSGBank’s deposit operations are subject to federal laws applicable to depository accounts, such as:

 

   

Truth-In-Savings Act, requiring certain disclosures of consumer deposit accounts:

 

   

Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;

 

   

Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve to implement that act, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; and

 

   

rules and regulations of the various federal banking regulators charged with the responsibility of implementing these federal laws.

The Consumer Financial Protection Bureau. The Dodd-Frank Act creates the Consumer Financial Protection Bureau (the “Bureau”) within the Federal Reserve Board. The Bureau is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The Bureau has rulemaking authority over many

 

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of the statutes governing products and services offered to bank consumers. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are more stringent than those regulations promulgated by the Bureau and state attorneys general are permitted to enforce consumer protection rules adopted by the Bureau against state-chartered institutions.

Capital Adequacy

First Security and FSGBank are required to comply with the capital adequacy standards established by the Federal Reserve. The Federal Reserve has established a risk-based and a leverage measure of capital adequacy for member banks and bank holding companies.

The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance-sheet exposure, and to minimize disincentives for holding liquid assets. Assets and off-balance-sheet items, such as letters of credit and unfunded loan commitments, are assigned to broad risk categories, each with appropriate risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance-sheet items.

The minimum guideline for the ratio of total capital to risk-weighted assets, and classification as adequately capitalized, is 8%. A bank that fails to meet the required minimum guidelines is classified as undercapitalized and subject to operating and managerial restrictions. A bank, however, that significantly exceeds its capital requirements and maintains a ratio of total capital to risk-weighted assets of 10% is classified as well capitalized unless it is subject to a regulatory order requiring it to maintain specified capital levels, in which case it is considered adequately capitalized.

Total capital consists of two components: Tier 1 capital and Tier 2 capital. Tier 1 capital generally consists of common stockholders’ equity, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock and a limited amount of qualifying cumulative perpetual preferred stock, less goodwill and other specified intangible assets. Tier 1 capital must equal at least 4% of risk-weighted assets. Tier 2 capital generally consists of subordinated debt, other preferred stock and hybrid capital, and a limited amount of loan loss reserves. The total amount of Tier 2 capital is limited to 100% of Tier 1 capital. FSGBank’s ratio of total capital to risk-weighted assets and ratio of Tier 1 capital to risk-weighted assets were 12.2% and 10.9% at December 31, 2010, respectively, compared 12.8% and 11.5%, as of December 31, 2009.

In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 capital to average assets, less goodwill and other specified intangible assets, of 3% for bank holding companies that meet specified criteria, including having the highest regulatory rating and implementing the Federal Reserve risk-based capital measure for market risk. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%. At December 31, 2010, our leverage ratio was 7.1%, as compared to 9.6% on December 31, 2009. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without reliance on intangible assets. The Federal Reserve considers the leverage ratio and other indicators of capital strength in evaluating proposals for expansion or new activities.

Provisions of the Dodd-Frank Act commonly referred to as the “Collins Amendment” established new minimum leverage and risk-based capital requirements on bank holding companies and eliminated the inclusion of “hybrid capital” instruments in Tier 1 capital by certain institutions.

The Dodd-Frank Act establishes certain regulatory capital deductions with respect to hybrid capital instruments, such as trust preferred securities, that will effectively disallow the inclusion of such instruments in Tier 1 capital if such capital instrument is issued on or after May 19, 2010. However, preferred shares issued to

 

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the U.S. Department of the Treasury (the “Treasury”) pursuant to the TARP Capital Purchase Program (“TARP CPP”) or TARP Community Development Capital Initiative are exempt from the Collins Amendment and are permanently includable in Tier 1 capital.

Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and certain other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements. See “Prompt Corrective Action” above.

The OCC, the Federal Reserve Board, and the FDIC have authority to compel or restrict certain actions if FSGBank’s capital should fall below adequate capital standards as a result of operating losses, or if its regulators otherwise determine that it has insufficient capital. Among other matters, the corrective actions may include, removing officers and directors; and assessing civil monetary penalties; and taking possession of and closing and liquidating the Bank.

Generally, the regulatory capital framework under which the First Security and FSGBank operate is in a period of change with likely legislation or regulation that will continue to revise the current standards and very likely increase capital requirements for the entire banking industry. Pursuant to the Dodd-Frank Act, bank regulators are required to establish new minimum leverage and risk-based capital requirements for certain bank holding companies and systematically important non-bank financial companies. The new minimum thresholds will not be lower than existing regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, be higher once established.

Payment of Dividends

First Security is a legal entity separate and distinct from FSGBank. The principal sources of First Security’s cash flow, including cash flow to pay dividends to its stockholders, are dividends and management fees that FSGBank pays to its sole stockholder, First Security. Statutory and regulatory limitations apply to FSGBank’s payment of dividends to First Security as well as to First Security’s payment of dividends to its stockholders.

FSGBank is required by federal law to obtain prior approval of the OCC for payments of dividends if the total of all dividends declared by FSGBank’s Board of Directors in any year will exceed (1) the total of FSGBank’s net profits for that year, plus (2) FSGBank’s retained net profits of the preceding two years, less any required transfers to surplus.

When First Security received a capital investment from the Treasury under the CPP on January 9, 2009, we became subject to additional limitations on the payment of dividends. These limitations require, among other things, that (i) all dividends for the securities purchased under the CPP be paid before other dividends can be paid and (ii) the Treasury must approve any increases in quarterly common dividends above five cents per share for three years following the Treasury’s investment.

The payment of dividends by First Security and FSGBank may also be affected by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. In addition, the OCC may require, after notice and a hearing, that FSGBank stop or refrain from engaging in any practice it considers unsafe or unsound. The federal banking agencies have indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act of 1991, a depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

On February 24, 2009, the Federal Reserve clarified its guidance on dividend policies for bank holding companies through the publication of a Supervisory Letter. As part of the letter, the Federal Reserve encouraged

 

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bank holding companies, particularly those that had participated in the CPP, to consult with the Federal Reserve prior to dividend declarations, and redemption and repurchase decisions even when not explicitly required to do so by federal regulations. The Federal Reserve has indicated that CPP recipients, such as First Security, should consider and communicate in advance to regulatory staff how a company’s proposed dividends, capital repurchases and capital redemptions are consistent with First Security’s obligation to eventually redeem the securities held by the Treasury. This new guidance is largely consistent with prior regulatory statements encouraging bank holding companies to pay dividends out of net income and to avoid dividends that could adversely affect the capital needs or minimum regulatory capital ratios of the bank holding company and its subsidiary bank. Additionally, pursuant to the Agreement, First Security is required to obtain prior written authorization before declaring a dividend.

Restrictions on Transactions with Affiliates

First Security and FSGBank are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:

 

   

a bank’s loans or extensions of credit to affiliates;

 

   

a bank’s investment in affiliates;

 

   

assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve;

 

   

loans or extensions of credit to third parties collateralized by the securities or obligations of affiliates; and

 

   

a bank’s guarantee, acceptance or letter of credit issued on behalf of an affiliate.

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. We must also comply with other provisions designed to avoid the taking of low-quality assets.

First Security and FSGBank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibit an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.

FSGBank is also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders, and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Within one year of enactment of the Dodd-Frank Act, an insured depository institution will be prohibited from engaging in asset purchases or sales transactions with its officers, directors or principal shareholders unless on market terms and, if the transaction represents greater than 10% of the capital and surplus of the bank, has been approved by a majority of the disinterested directors.

Limitations on Senior Executive Compensation

In June of 2010, federal banking regulators issued guidance designed to help ensure that incentive compensation policies at banking organizations do not encourage excessive risk-taking or undermine the safety and soundness of the organization. In connection with this guidance, the regulatory agencies announced that they will review incentive compensation arrangements as part of the regular, risk-focused supervisory process.

 

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Regulatory authorities may also take enforcement action against a banking organization if its incentive compensation arrangement or related risk management, control, or governance processes pose a risk to the safety and soundness of the organization and the organization is not taking prompt and effective measures to correct the deficiencies. To ensure that incentive compensation arrangements do not undermine safety and soundness at insured depository institutions, the incentive compensation guidance sets forth the following key principles:

 

   

incentive compensation arrangements should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose the organization to imprudent risk;

 

   

incentive compensation arrangements should be compatible with effective controls and risk management; and

 

   

incentive compensation arrangements should be supported by strong corporate governance, including active and effective oversight by the board of directors.

Due to First Security’s participation in the CPP, First Security is also subject to additional executive compensation limitations. For example, First Security must:

 

   

ensure that its senior executive incentive compensation packages do not encourage excessive risk;

 

   

subject senior executive compensation to “clawback” if the compensation was based on inaccurate financial information or performance metrics;

 

   

prohibit any golden parachute payments to senior executive officers; and

 

   

agree not to deduct more than $500,000 for a senior executive officer’s compensation.

The Dodd-Frank Act

The Dodd-Frank Act has had a broad impact on the financial services industry, including significant regulatory and compliance changes previously discussed and including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased regulatory examination fees; and (iii) numerous other provisions designed to improve supervision and oversight of, and strengthening safety and soundness for, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve Board, the OCC and the FDIC.

Many of the requirements called for in the Dodd-Frank Act will be implemented over time and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

Proposed Legislation and Regulatory Action

New regulations and statutes are regularly proposed that contain wide-ranging potential changes to the structures, regulations and competitive relationships of financial institutions operating and doing business in the United States. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.

 

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Effect of Governmental Monetary Policies

Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve Board affect the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. We cannot predict the nature or impact of future changes in monetary and fiscal policies.

 

Item 1A. Risk Factors

An investment in our common stock involves risks. If any of the following risks or other risks, which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed. In such a case, the trading price of our common stock could decline, and you may lose all or part of your investment. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements.

RISKS ASSOCIATED WITH OUR BUSINESS

We have incurred operating losses and cannot assure you that we will be profitable in the future.

We incurred a net loss available to common stockholders of $46.4 million, or $2.95 per share, for the year ended December 31, 2010, due primarily to credit losses and associated costs, including a significant provision for loan losses, and the establishment of a $24.6 million deferred tax asset valuation allowance. Although we have taken steps to reduce our credit exposure, we likely will continue to have a higher than normal level of non-performing assets and charge-offs into 2011, which would continue to adversely impact our overall financial condition and results of operations.

We may experience increased delinquencies and credit losses, which could have a material adverse effect on our capital, financial condition and results of operations.

Like other lenders, we face the risk that our customers will not repay their loans. A customer’s failure to repay us is usually preceded by missed monthly payments. In some instances, however, a customer may declare bankruptcy prior to missing payments, and, following a borrower filing bankruptcy, a lender’s recovery of the credit extended is often limited. Since our loans are secured by collateral, we may attempt to seize the collateral when and if customers default on their loans. However, the value of the collateral may not equal the amount of the unpaid loan, and we may be unsuccessful in recovering the remaining balance from our customers. Rising delinquencies and rising rates of bankruptcy in our market area generally and among our customers specifically can be precursors of future charge-offs and may require us to increase our allowance for loan and lease losses. Higher charge-off rates and an increase in our allowance for loan and lease losses may hurt our overall financial performance if we are unable to increase revenue to compensate for these losses and may also increase our cost of funds.

Our allowance for loan and lease losses may not be adequate to cover actual losses, and we may be required to materially increase our allowance, which may adversely affect our capital, financial condition and results of operations.

We maintain an allowance for loan and lease losses, which is a reserve established through a provision for loan losses charged to expenses, which represents management’s best estimate of probable credit losses that have been incurred within the existing portfolio of loans. The allowance for loan and lease losses and our methodology for calculating the allowance are fully described in Note 1 to our consolidated financial statements under “Allowance for Loan and Lease Losses” on page 97, and in the “Management’s Discussion and Analysis—

 

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Statement of Financial Condition—Allowance for Loan and Lease Losses” section on pages 65 through 71. In general, an increase in the allowance for loan and lease losses results in a decrease in net income, and possibly risk-based capital, and may have a material adverse effect on our capital, financial condition and results of operations.

The allowance, in the judgment of management, is established to reserve for estimated loan losses and risks inherent in the loan portfolio. The determination of the appropriate level of the allowance for loan and lease losses involves a high degree of subjectivity and requires us to make significant estimates of current credit risks using existing qualitative and quantitative information, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in the allowance for loan and lease losses. In addition, bank regulatory agencies periodically review our allowance for loan and lease losses and may require an increase in the provision for loan losses or the recognition of additional loan charge offs, based on judgments that are different than those of management. As we are consistently adjusting our loan portfolio and underwriting standards to reflect current market conditions, we can provide no assurance that our methodology will not change, which could result in a charge to earnings.

We continually reassess the creditworthiness of our borrowers and the sufficiency of our allowance for loan and lease losses as part of FSGBank’s credit functions. Our allowance for loan and lease losses increased from 2.78% of total loans at December 31, 2009 to 3.30% at December 31, 2010. We recorded a provision for loan losses during the year ended December 31, 2010 of approximately $33.6 million, which was significantly higher than in previous periods. We charged-off approximately $36.1 million in loans, net of recoveries, during the year ended December 31, 2010, which was also significantly higher than in previous periods. We will likely experience additional classified loans and non-performing assets in the foreseeable future, as well as related increases in loan charge-offs, as the deterioration in the credit and real estate markets causes borrowers to default. Further, the value of the collateral underlying a given loan, and the realizable value of such collateral in a foreclosure sale, likely will be negatively affected by the current downturn in the real estate market, and therefore may result in an inability to realize a full recovery in the event that a borrower defaults on a loan. Any additional non-performing assets, loan charge-offs, increases in the provision for loan losses or the continuation of aggressive charge-off policies or any inability by us to realize the full value of underlying collateral in the event of a loan default, will negatively affect our business, financial condition, and results of operations and the price of our securities. Further, there can be no assurance that our allowance for loan and lease losses at December 31, 2010 will be sufficient to cover future credit losses.

We make and hold in our portfolio a significant number of land acquisition and development and construction loans, which pose more credit risk than other types of loans typically made by financial institutions.

We offer land acquisition and development, and construction loans for builders and developers, and as of December 31, 2010, we had $84.2 million in such loans outstanding, representing 88.3% of FSGBank’s total risk-based capital. These land acquisition and development, and construction loans are more risky than other types of loans. The primary credit risks associated with land acquisition and development and construction lending are underwriting and project risks. Project risks include cost overruns, borrower credit risk, project completion risk, general contractor credit risk, and environmental and other hazard risks. Market risks are risks associated with the sale of the completed residential units. They include affordability risk, which means the risk that borrowers cannot obtain affordable financing, product design risk, and risks posed by competing projects. There can be no assurance that losses in our land acquisition and development and construction loan portfolio will not exceed our reserves, which could adversely impact our earnings. Given the current environment, the non-performing loans in our land acquisition and development and construction portfolio are likely to increase during 2011, and these non-performing loans could result in a material level of charge-offs, which would negatively impact our capital and earnings.

 

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If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2010, approximately 82.4% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our core markets were to decline further, a significant portion of our loan portfolio could become under-collateralized. As a result, if we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

The amount of our OREO may increase significantly, resulting in additional losses, and costs and expenses that will negatively affect our operations.

At December 31, 2009, we had a total of $15.3 million of OREO, and at December 31, 2010, we had a total of $24.4 million of OREO, reflecting a $9.1 million increase over the past twelve months. This increase in OREO is due, among other things, to the continued deterioration of the residential real estate market and the tightening of the credit market. As the amount of OREO increases, our losses, and the costs and expenses to maintain the real estate likewise increase. Due to the on-going economic downturn, the amount of OREO may continue to increase in the coming months. Any additional increase in losses, and maintenance costs and expenses due to OREO may have material adverse effects on our business, financial condition, and results of operations. Such effects may be particularly pronounced in a market of reduced real estate values and excess inventory, which may make the disposition of OREO properties more difficult, increase maintenance costs and expenses, and may reduce our ultimate realization from any OREO sales.

Our ability to retain, attract and motivate qualified individuals may be limited by our financial and regulatory condition, restrictions on our ability to compensate those individuals, and the need for regulatory non-objection to fill certain positions.

Our success depends on our ability to retain, attract and motivate qualified individuals in key positions throughout the organization. Our financial and regulatory condition may limit our ability to retain, attract and motivate qualified individuals. Among other factors, the decline in our stock price has limited the real and perceived value of our historical stock compensation, and our condition may be viewed as a liability by current and prospective employees.

We are generally prohibited from entering into, amending, or renewing any agreement that provides for golden parachute payments to an institution-affiliated party or from making such golden parachute payments, absent approval from the federal banking regulators. As a participant in the CPP, we are subject to specified limits on the compensation we can pay to certain senior executive officers. The limitations, which include restrictions on bonus and other incentive compensation payable to First Security’s senior executive officers, a prohibition on any “golden parachute” payments and a “clawback” of any bonus that was based on materially inaccurate financial data or other performance metric, could limit our ability to retain, attract and motivate the best executive officers because other competing employers may not be subject to these limitations.

We are also currently required to notify the federal banking regulators in advance of employing any senior executive officer or changing the responsibilities of a senior executive officer. This requirement could prevent us from hiring the individuals of our choosing, could discourage potential applicants, or otherwise delay our ability to fill vacant positions.

If we are unable to retain, attract and motivate qualified individuals in key positions, our business and results of operations could be adversely affected.

 

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Our use of appraisals in deciding whether to make a loan on or secured by real property or how to value such loan in the future may not accurately describe the net value of the real property collateral that we can realize.

In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and, as real estate values in our market area have experienced changes in value in relatively short periods of time, this estimate might not accurately describe the net value of the real property collateral after the loan has been closed. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize an amount equal to the indebtedness secured by the property. The valuation of the property may negatively impact the continuing value of such loan and could adversely affect our operating results and financial condition.

We will realize additional future losses if the proceeds we receive upon liquidation of non-performing assets are less than the fair value of such assets.

We have announced a strategy to manage our non-performing assets aggressively, a portion of which may not be currently identified. Non-performing assets are recorded on our financial statements at fair value, as required under GAAP, unless these assets have been specifically identified for liquidation, in which case they are recorded at the lower of cost or estimated net realizable value. In current market conditions, we are likely to realize additional future losses if the proceeds we receive upon dispositions of non-performing assets are less than the recorded fair value of such assets.

Negative publicity about financial institutions, generally, or about First Security or FSGBank, specifically, could damage First Security’s reputation and adversely impact its liquidity, business operations or financial results.

Reputation risk, or the risk to our business from negative publicity, is inherent in our business. Negative publicity can result from the actual or alleged conduct of financial institutions, generally, or First Security or FSGBank, specifically, in any number of activities, including leasing and lending practices, corporate governance, and actions taken by government regulators in response to those activities. Negative publicity can adversely affect our ability to keep and attract customers and can expose us to litigation and regulatory action, any of which could negatively affect our liquidity, business operations or financial results.

Increases in our expenses and other costs, including those related to centralizing our credit functions, could adversely affect our financial results.

Our expenses and other costs, such as operating expenses and hiring new employees to enhance our credit and underwriting administration, directly affect our earnings results. In light of the extremely competitive environment in which we operate, and because the size and scale of many of our competitors provides them with increased operational efficiencies, it is important that we are able to successfully manage such expenses. We are aggressively managing our expenses in the current economic environment, but as our business develops, changes or expands, and as we hire additional personnel, additional expenses can arise. Other factors that can affect the amount of our expenses include legal and administrative cases and proceedings, which can be expensive to pursue or defend. In addition, changes in accounting policies can significantly affect how we calculate expenses and earnings.

Changes in the interest rate environment could reduce our net interest income, which could reduce our profitability.

As a financial institution, our earnings significantly depend on our net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Therefore, any change in general market interest rates, including changes in the Federal Reserve Board’s fiscal and monetary policies, affects us more than non-financial institutions and can have a significant effect on our net

 

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interest income and total income. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets and liabilities. As a result, an increase or decrease in market interest rates could have material adverse effects on our net interest margin and results of operations.

In addition, we cannot predict whether interest rates will continue to remain at present levels. Changes in interest rates may cause significant changes, up or down, in our net interest income. Depending on our portfolio of loans and investments, our results of operations may be adversely affected by changes in interest rates. In addition, any significant increase in prevailing interest rates could adversely affect our mortgage banking business because higher interest rates could cause customers to request fewer refinancings and purchase money mortgage originations.

We face strong competition from larger, more established competitors that may inhibit our ability to compete and expose us to greater lending risks.

The banking business is highly competitive, and we experience strong competition from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other financial institutions, which operate in our primary market areas and elsewhere.

We compete with these institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established and much larger financial institutions. While we believe we can and do successfully compete with these other financial institutions in our markets, we may face a competitive disadvantage as a result of our smaller size and lack of geographic diversification.

Our ability to diversify our economic risks is limited by our own local markets and economies. We lend primarily to individuals and to small to medium-sized businesses, which may expose us to greater lending risks than those of banks lending to larger, better capitalized businesses with longer operating histories. As an example, our market area in northern Georgia is highly dependent on the home furnishings and carpet industry centered near Dalton, Georgia. Because of the downturn in residential construction, this industry has suffered a business decline, which has adversely affected the performance of our operations in Dalton and surrounding areas. As a community bank, we are less able to spread the risk of unfavorable local economic conditions than larger or more regional banks. Moreover, we cannot give any assurance that we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.

The soundness of our financial condition may also affect our competitiveness. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Customers may decide not to do business with us due to our financial condition. In addition, our ability to compete is impacted by the limitations on our activities imposed under the Order and the Agreement. We have and continue to face additional regulatory restrictions that our competitors may not be subject to, including improving the overall risk profile of the Company and restrictions on the amount of interest we can pay on deposit accounts, which could adversely impact our ability to compete and attract and retain customers.

Although we compete by concentrating our marketing efforts in our primary market area with local advertisements, personal contacts and greater flexibility in working with local customers, we can give no assurance that this strategy will be successful.

Our agreement with the Treasury under the CPP is subject to unilateral change by the Treasury, which could adversely affect our business, financial condition, and results of operations.

Under the CPP, the Treasury may unilaterally amend the terms of its agreement with us in order to comply with any changes in federal law. We cannot predict the effects of any of these changes and of the associated amendments. It is possible, however, that any such amendment could have a material impact on us or our operations.

 

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The costs and effects of litigation, investigations or similar matters, or adverse facts and developments related thereto, could materially affect our business, operating results and financial condition.

We may be involved from time to time in a variety of litigation, investigations or similar matters arising out of our business. Our insurance may not cover all claims that may be asserted against it and indemnification rights to which we are entitled may not be honored, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation. Should the ultimate judgments or settlements in any litigation or investigation significantly exceed our insurance coverage, they could have a material adverse effect on our business, financial condition and results of operations. In addition, premiums for insurance covering the financial and banking sectors are rising. We may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms or at historic rates, if at all.

Changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance could materially affect our business, operating results and financial condition.

We are subject to various taxing jurisdictions where we conduct business. We assess the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintain tax accruals consistent with our evaluation. This evaluation incorporates assumptions and estimates that involve a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our operating results.

Environmental liability associated with lending activities could result in losses.

In the course of our business, we may foreclose on and take title to properties securing our loans. If hazardous substances are discovered on any of these properties, we may be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site, even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses and may materially limit the use of properties that we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Our loan policies require certain due diligence of high risk industries and properties with the intention of lowering our risk of a non-performing loan and/or foreclosed property.

RISKS RELATED TO RECENT MARKET, LEGISLATIVE AND REGULATORY EVENTS

We are subject to an Order that could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock. In addition, addressing the Order will require significant time and attention from our management team, which may increase our costs, impede the efficiency of our internal business processes and adversely affect our profitability in the near-term.

On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order the Bank by and through its Board of Directors consented and agreed to the issuance of a Consent Order by the OCC, the Bank’s primary regulator. The Bank and the OCC agreed as to the areas of the Bank’s operations that warrant improvement and a plan for making those improvements. The Order required the Bank to develop and submit written strategic and capital plans covering at least a three-year period. The Bank is required to review and revise various policies and procedures, including those associated with concentration management, the allowance for loan and lease losses, liquidity management, criticized asset, loan review and credit.

While the Company intends to take such actions as may be necessary to enable the Bank to comply with the requirements of the Order, there can be no assurance that the Bank will be able to comply fully with the provisions of the Order, or that efforts to comply with the Order, particularly the limitations on interest rates offered by the Bank, will not have adverse effects on the operations and financial condition of the Company and the Bank.

 

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We are currently deemed not in compliance with the provisions of the Order, including the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. We can provide no assurances that we will be able to comply fully with the Order, that efforts to comply with the Order will not have a material adverse effect on the operations and financial condition of FSGBank, or that further enforcement actions won’t be imposed on FSGBank.

We are not currently in compliance with the capital requirements contained in our Order and may need to raise capital to comply, but that capital may not be available when it is needed or it could be dilutive to our existing stockholders, which could adversely affect our financial condition and our results of operations.

The Order required the Bank to, within 120 days of the effective date of the Order, achieve and thereafter maintain total capital at least equal to 13% of risk-weighted assets and Tier 1 capital at least equal to 9% of adjusted total assets. As of December 31, 2010, the Bank’s total risk-based capital ratio was approximately 12.2% and its leverage ratio was approximately 7.1%. The Company is considering a variety of strategic alternatives intended to achieve and maintain the prescribed capital ratios.

Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. If we need to raise additional capital, there is no guarantee that we will be able to borrow funds or successfully raise capital at all or on terms that are favorable or otherwise not dilutive to existing stockholders. If we cannot raise additional capital when needed, our ability to operate our business could be materially impaired. The failure to satisfy the capital requirements of the Order could result in further enforcement actions by the OCC, including the OCC requiring that the Bank develop a plan to sell, merge or liquidate the Bank.

We are subject to an Agreement that could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock.

On September 7, 2010, First Security entered into an Agreement with the Federal Reserve Bank. The Agreement is designed to enhance the Company’s ability to act as a source of strength to the Bank. Pursuant to the Agreement, the Company will be prohibited from declaring or paying dividends without prior written consent from the Federal Reserve Bank. In addition, pursuant to the Agreement, without the prior written consent of regulators, the Company is prohibited from taking dividends, or any other form of payment representing a reduction of capital, from the Bank; incurring, increasing or guaranteeing any debt; redeeming any shares of the Company’s common stock. The Company will also provide quarterly written progress reports to the Federal Reserve Bank. The Company was also required to submit to the Federal Reserve Bank a written plan designed to maintain sufficient capital at the Company, on a consolidated basis, and at the Bank.

We are currently deemed not in compliance with several provisions of the Agreement, including the submission of an acceptable capital plan. Any material failure to comply with the provisions of the Agreement could result in further enforcement actions by the Federal Reserve Bank. While the Company intends to take such actions as may be necessary to comply with the requirements of the Agreement, there can be no assurance that the Company will be able to comply fully with the provisions of the Agreement, or that efforts to comply with the Agreement, particularly the limitations on dividend payments, will not have adverse effects on the operations and financial condition of the Company and the value of our common stock.

Our inability to accept, renew or roll over brokered deposits without the prior approval of the FDIC could adversely affect our liquidity.

As of December 31, 2010, we had approximately $314.9 million in out of market deposits, including brokered certificates of deposit and CDARS®, which represented approximately 30.0% of our total deposits. Because the Order establishes specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the

 

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levels of capital set forth in the Order. As an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. As of December 31, 2010, brokered deposits maturing in the next 24 months totaled $125.9 million. Funding sources for the maturing brokered deposits include, among other sources: our cash account at the Federal Reserve Bank of Atlanta; growth, if any, of core deposits from current and new retail and commercial customers; scheduled repayments on existing loans; and the possible pledge or sale of investment securities. As an adequately capitalized institution, the Bank also may not pay interest on deposits that are more than 75 basis points above the rate applicable to the applicable market of the Bank as determined by the FDIC. These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers. The limitations on our ability to accept, renew or roll over brokered deposits, or pay more than 75 basis points above the applicable rate could adversely affect our liquidity.

A continuation of the current economic downturn in the housing market and the homebuilding industry and in our markets generally could adversely affect our financial condition, results of operations or cash flows.

Our long-term success depends upon the growth in population, income levels, deposits and housing starts in our primary market areas. If the communities in which FSGBank operates do not grow, or if prevailing economic conditions locally or nationally are unfavorable, our business may not succeed. The unpredictable economic conditions we have faced over the last 24 months have had an adverse effect on the quality of our loan portfolio and our financial performance. Economic recession over a prolonged period or other economic problems in our market areas could have a material adverse impact on the quality of the loan portfolio and the demand for our products and services. Future adverse changes in the economies in our market areas may have a material adverse effect on our financial condition, results of operations or cash flows. Further, the banking industry in Tennessee and Georgia is affected by general economic conditions such as inflation, recession, unemployment and other factors beyond our control.

Since the third quarter of 2007, the residential construction and commercial development real estate markets have experienced a variety of difficulties and changed economic conditions. As a result, there has been substantial concern and publicity over asset quality among financial institutions due in large part to issues related to subprime mortgage lending, declining real estate values and general economic concerns. As of December 31, 2010, our non-performing assets had increased to $79.2 million, or 6.78% of our total assets, as compared to $64.6 million, or 4.78% as of December 31, 2009. Furthermore, the housing and the residential mortgage markets continue to experience a variety of difficulties and changed economic conditions.

The homebuilding and residential mortgage industry has experienced a significant and sustained decline in demand for new homes and a decrease in the absorption of new and existing homes available for sale in various markets. Our customers who are builders and developers face greater difficulty in selling their homes in markets where these trends are more pronounced. Consequently, we are facing increased delinquencies and non-performing assets as these builders and developers are forced to default on their loans with us. We do not know when the housing market will improve, and accordingly, additional downgrades, provisions for loan losses and charge-offs related to our loan portfolio may occur. If market conditions continue to deteriorate, our non-performing assets may continue to increase and we may need to take additional valuation adjustments on our loan portfolios and real estate owned as we continue to reassess the market value of our loan portfolio, the losses associated with the loans in default and the net realizable value of real estate owned.

Negative developments in the financial industry, and the domestic and international credit markets may adversely affect our operations and results.

Negative developments during 2008 in the global credit and derivative markets resulted in uncertainty in the financial markets in general with the expectation of the general economic downturn continuing into 2011. As a result of this “credit crunch,” commercial as well as consumer loan portfolio performances have deteriorated at many institutions and the competition for deposits and quality loans has increased significantly. Global securities

 

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markets, and bank holding company stock prices in particular, have been negatively affected, as has the ability of banks and bank holding companies to raise capital or borrow in the debt markets. If these negative trends continue, our business operations and financial results may be negatively affected.

The FDIC Deposit Insurance assessments that we are required to pay may continue to materially increase in the future, which would have an adverse effect on our earnings.

As a member institution of the FDIC, we are assessed a quarterly deposit insurance premium. Failed banks nationwide have significantly depleted the insurance fund and reduced the ratio of reserves to insured deposits. As a result, we may be required to pay significantly higher premiums or additional special assessments that could adversely affect our earnings.

On April 1, 2009, the FDIC modified the risk-based assessments to account for each institution’s unsecured debt, secured liabilities and use of brokered deposits. Starting with the second quarter of 2009, assessment rates were increased and currently range from 7 to 77.5 basis points (annualized). Further increased FDIC assessment premiums, due to our risk classification, level of brokered deposits, special assessments, or implementation of the modified DIF reserve ratio, could adversely impact our earnings.

The Dodd-Frank Act and related regulations may adversely affect our business, financial condition, liquidity or results of operations.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was enacted on July 21, 2010. The Dodd-Frank Act creates a new Consumer Financial Protection Bureau with power to promulgate and enforce consumer protection laws. Smaller depository institutions, including those with $10 billion or less in assets, will be subject to the Consumer Financial Protection Bureau’s rule-writing authority, and existing depository institution regulatory agencies will retain examination and enforcement authority for such institutions. The Dodd-Frank Act also establishes a Financial Stability Oversight Council chaired by the Secretary of the Treasury with authority to identify institutions and practices that might pose a systemic risk and, among other things, includes provisions affecting (1) corporate governance and executive compensation of all companies whose securities are registered with the SEC, (2) FDIC insurance assessments, (3) interchange fees for debit cards, which would be set by the Federal Reserve under a restrictive “reasonable and proportional cost” per transaction standard and (4) minimum capital levels for bank holding companies, subject to a grandfather clause for financial institutions with less than $15 billion in assets.

At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting regulations may adversely impact us. However, compliance with these new laws and regulations may increase our costs, limit our ability to pursue attractive business opportunities, cause us to modify our strategies and business operations and increase our capital requirements and constraints, any of which may have a material adverse impact on our business, financial condition, liquidity or results of operations.

RISKS ASSOCIATED WITH AN INVESTMENT IN OUR COMMON STOCK

If we fail to continue to meet all applicable continued listing requirements of the Nasdaq Global Select Market and Nasdaq determines to delist our common stock, the market liquidity and market price of our common stock could decline, and our ability to access the capital markets could be negatively affected.

Our common stock is listed on the Nasdaq Global Select Market. To maintain that listing, we must satisfy minimum financial and other continued listing requirements. For example, Nasdaq rules require that we maintain a minimum bid price of $1.00 per share for our common stock. This requirement is deemed breached when the bid price of an issuer’s common shares closes below $1.00 per share for 30 consecutive trading days.

On April 4, 2010, we were notified by Nasdaq that we were not in compliance with the minimum bid price rule. We have until October 3, 2011 to regain compliance with the minimum bid price rule by having our common

 

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stock close at or above $1.00 per share for at least ten consecutive business days. In the event we do not regain compliance, Nasdaq may commence delisting proceedings, permit us to transfer listing of our common stock to the Nasdaq Capital Market, or provide additional time to regain compliance.

We intend to actively monitor the bid price of our stock and will consider available options to regain compliance with the Nasdaq requirements. While we intend to maintain our listing on Nasdaq, if we fail to meet the requirements for continued listing or we are unable to cure the events of noncompliance in a timely or effective manner, our common stock could be delisted.

The perception or possibility that our common stock could be delisted in the future could negatively affect its liquidity and price. Delisting would have an adverse effect on the liquidity of the common shares and, as a result, the market price for the common stock might become more volatile. Delisting could also make it more difficult for us to raise additional capital, if needed, on terms acceptable to us or at all. Although quotes for our common stock would continue to be available on the OTC Bulletin Board or on the “Pink Sheets” in the event of a delisting from Nasdaq, such alternatives are generally considered to be less efficient markets, and the stock price, as well as the liquidity of the common stock, may be adversely affected as a result.

We have discovered a material weakness in our internal control over financial reporting, causing a reasonable possibility that material misstatements of our financial statements will not be prevented or detected on a timely basis.

During the preparation of our financial statements for 2010, our management identified a material weakness related to our entity level controls. Specifically, we did not maintain an effective control environment. As a result, there is a reasonable possibility that material misstatements of the financial statements will not be prevented or detected on a timely basis.

Management will continue to monitor and evaluate the effectiveness of our disclosure controls and procedures and our internal controls over financial reporting on an ongoing basis and is committed to taking further action and implementing additional enhancements or improvements, as necessary. Although our management and audit committee intend for the new policies and procedures to provide sufficient assurance of future compliance, we are unable to determine at this time whether the new policies and procedures will be fully effective in correcting this weakness.

Any failure to maintain required controls could result in additional material weaknesses, which could result in errors in our financial statements that could result in restatements of our financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information. Although we believe the actions we have taken will remediate these significant deficiencies during 2011, we may fail to do so or could experience unforeseen difficulties causing new significant deficiencies or material weaknesses. In addition, we may need to operate for an extended period of time with the new or revised controls in place before these significant deficiencies will be determined to be remediated. If we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to express an opinion on the effectiveness of our internal controls, we could lose investor confidence in the accuracy and completeness of our financial reports, which would cause the price of our common stock to decline.

The trading volume of our common stock is less than that of other larger financial services companies.

Although our common stock is traded on the Nasdaq Global Select Market, the trading volume of our common stock is less than that of other larger financial services companies. For the public trading market for our common stock to have the desired characteristics of depth, liquidity and orderliness requires the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause our stock price to fall more than would otherwise be expected if the trading volume of our common stock were commensurate with the trading volumes of the common stock of other financial services companies.

 

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Tennessee law and our charter limit the ability of others to acquire us.

Various anti-takeover protections for Tennessee corporations are set forth in the Tennessee Business Corporation Act, the Business Combination Act, the Control Share Acquisition Act, the Greenmail Act and the Investor Protection Act. Because our common stock is registered with the SEC under the Securities Exchange Act of 1934, the Business Combination Act automatically applies to us unless our stockholders adopt a charter or bylaw amendment which expressly excludes us from the anti-takeover provisions of the Business Combination Act two years prior to a proposed takeover. Our Board of Directors has no present intention of recommending such charter or bylaw amendment.

These statutes have the general effect of discouraging, or rendering more difficult, unfriendly takeover or acquisition attempts. Such provisions could be beneficial to current management in an unfriendly takeover attempt but could have an adverse effect on stockholders who might wish to participate in such a transaction.

Our future operating results may be below securities analysts’ or investors’ expectations, which could cause our stock price to decline.

We may be unable to generate significant revenues or grow at the rate expected by securities analysts or investors. In addition, our costs may be higher than we, securities analysts or investors expect. If we fail to generate sufficient revenues or our costs are higher than we expect, our results of operations will suffer, which in turn could cause our stock price to decline.

Our operating results in any particular period may not be a reliable indication of our future performance. In some future quarters, our operating results may be below the expectations of securities analysts or investors. If this occurs, the price of our common stock will likely decline.

We have elected to defer the dividend payments on our Series A Preferred Stock during 2010; as a result, we are unable to pay dividends on our common stock until we pay all dividends in arrears on the Series A Preferred Stock.

On January 27, 2010, our Board of Directors elected to suspend the dividend on our common stock and elected to defer the dividend payment on our Series A Preferred Stock for the first quarter of 2010; our Board of Directors similarly elected on a quarterly basis to defer the three other scheduled dividend payments on our Series A Preferred Stock during 2010 and the first scheduled dividend payment of 2011. We may not pay dividends on common stock unless all dividends have been paid on the securities issued to the Treasury under the CPP; having deferred these dividend payments, we are prohibited on paying any future dividends on our common stock until all dividends payable to the Treasury under the CPP have been paid in full.

Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our Board of Directors may deem relevant. The holders of our common stock are entitled to receive dividends when, and if declared by our Board of Directors out of funds legally available for that purpose. As part of our consideration to pay future cash dividends, we intend to retain adequate funds from future earnings to support the development and growth of our business. In addition, our ability to pay dividends is restricted by federal policies and regulations. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. Further, our principal sources of funds to pay dividends are cash dividends and management fees that we receive from FSGBank.

The CPP also restricts our ability to increase the amount of quarterly dividends on common stock above $0.05 per share, which potentially limits your opportunity for gain on your investment.

 

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The Series A Preferred Stock issued to the Treasury impacts net income available to our common stockholders and our earnings per share.

On January 9, 2009, we issued senior preferred stock (the “Series A Preferred Stock”) to the Treasury in an aggregate amount of $33 million, along with a warrant to purchase 823,627 shares of common stock (the “Warrant”). As long as shares of our Series A Preferred Stock issued under the CPP are outstanding, no dividends may be paid on our common stock unless all dividends on the Series A Preferred Stock have been paid in full. Additionally, for so long as the Treasury owns shares of the Series A Preferred Stock, we are not permitted to pay cash dividends in excess of $0.05 per share per quarter on our common stock for three years without the Treasury’s consent. The dividends declared on shares of our Series A Preferred Stock will reduce the net income available to common stockholders and our earnings per common share. Additionally, issuance of the Warrant, in conjunction with the issuance of the Series A Preferred Stock, may be dilutive to our earnings per share. The shares of First Security’s Series A Preferred Stock will also receive preferential treatment in the event of liquidation, dissolution or winding up.

We can provide no assurances as to when the Series A Preferred Stock can be redeemed and the Warrant can be repurchased.

Subject to consultation with our banking regulators, we intend to repurchase the Series A Preferred Stock and the Warrant issued to the Treasury when we believe the credit metrics in our loan portfolio have improved for the long-term and the overall economy has rebounded. However, there can be no assurance when the Series A Preferred Stock and the Warrant can be repurchased, if at all. Until such time as the Series A Preferred Stock and the Warrant are repurchased, we will remain subject to the terms and conditions of those instruments, which, among other things, require us to obtain regulatory approval to repurchase or redeem common stock or our other preferred stock or increase the dividends on our common stock over $0.05 per share, except in limited circumstances. Further, our continued participation in the CPP subjects us to increased regulatory and legislative oversight, including with respect to executive compensation. These oversight and legal requirements under the CPP, as well as any other requirement that the Treasury could adopt in the future, may have unforeseen or unintended adverse effects on the financial services industry as a whole, and particularly on CPP participants such as ourselves.

Holders of the Series A Preferred Stock have rights that are senior to those of our common stockholders.

The shares of Series A Preferred Stock that we have issued to the Treasury are senior to our shares of common stock, and holders of the Series A Preferred Stock have certain rights and preferences that are senior to holders of our common stock. The restrictions on our ability to declare and pay dividends to common stockholders are discussed immediately above. In addition, we and our subsidiaries may not purchase, redeem or otherwise acquire for consideration any shares of our common stock unless we have paid in full all accrued dividends on the Series A Preferred Stock for all prior dividend periods, other than in certain circumstances. Furthermore, the Series A Preferred Stock is entitled to a liquidation preference over shares of our common stock in the event of liquidation, dissolution or winding up.

If we continue to defer dividends, as we expect, the holders of the Series A Preferred Stock will have the right to elect two directors to our Board of Directors.

Through February 15, 2011, we had deferred five quarterly dividend payments on our Series A Preferred Stock. The next quarterly dividend payment will be due May 15, 2011. We do not anticipate declaring a dividend on our Series A Preferred Stock payable on May 15, 2011, and would require the approval of the Federal Reserve Bank to make such a declaration. Accordingly, as of May 15, 2011, we anticipate that we will have failed to pay dividends on our Series A Preferred Stock for six quarterly dividend periods. The Treasury has requested, and First Security anticipates agreeing to permit, an observer employed by the Treasury to attend meetings of First Security’s Board of Directors.

 

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In the event that we fail to pay dividends on the Series A Preferred Stock for an aggregate of six quarterly dividend periods or more (whether or not consecutive), holders of the Series A Preferred Stock, together with the holders of any outstanding parity stock with the same voting rights, will be entitled to elect the two additional members of the Board of Directors at the next annual meeting (or at a special meeting called for this purpose) and at each subsequent annual meeting until all accrued and unpaid dividends for all past dividend periods have been paid in full.

Holders of the Series A Preferred Stock have limited voting rights.

Except in connection with the election of directors to our Board of Directors as discussed immediately above and as otherwise required by law, holders of the Series A Preferred Stock have limited voting rights. In addition to any other vote or consent of stockholders required by law or our amended and restated charter, the vote or consent of holders owning at least 66 2/3% of the shares of Series A Preferred Stock outstanding is required for (1) any authorization or issuance of shares ranking senior to the Series A Preferred Stock; (2) any amendment to the rights of the Series A Preferred Stock that adversely affects the rights, preferences, privileges or voting power of the Series A Preferred Stock; or (3) consummation of any merger, share exchange or similar transaction unless the shares of Series A Preferred Stock remain outstanding or are converted into or exchanged for preference securities of the surviving entity other than us and have such rights, preferences, privileges and voting power as are not materially less favorable than those of the holders of the Series A Preferred Stock.

 

Item 1B. Unresolved Staff Comments

There are no written comments from the Commission staff regarding our periodic or current reports under the Act which remain unresolved.

 

Item 2. Properties

During 2010, we conducted our business primarily through our corporate headquarters located at 531 Broad Street, Chattanooga, Hamilton County, Tennessee.

 

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We believe that our banking offices are in good condition, are suitable to our needs and, for the most part, are relatively new. The following table summarizes pertinent details of our owned or leased branch, loan production and leasing offices.

 

Office Address

   Date Opened    Owned/Leased    Square
Footage
   Use of
Office

401 South Thornton Avenue

Dalton, Whitfield County, Georgia

   September 17, 1999    Owned    16,438    Branch

1237 North Glenwood Avenue

Dalton, Whitfield County, Georgia

   September 17, 1999    Owned    3,300    Branch

761 New Highway 68

Sweetwater, Monroe County, Tennessee

   June 26, 2000    Owned    3,000    Branch

1740 Gunbarrel Road

Chattanooga, Hamilton County, Tennessee

   July 3, 2000    Leased    3,400    Branch

4227 Ringgold Road

East Ridge, Hamilton County, Tennessee

   July 28, 2000    Leased    3,400    Branch

835 South Congress Parkway

Athens, McMinn County, Tennessee

   November 6, 2000    Owned    3,400    Branch

4535 Highway 58

Chattanooga, Hamilton County, Tennessee

   May 7, 2001    Owned    3,400    Branch

820 Ridgeway Avenue

Signal Mountain, Hamilton County, Tennessee

   May 29, 2001    Owned    2,500    Branch

1409 Cowart Street

Chattanooga, Hamilton County, Tennessee

   October 22, 2001    Building Owned

Land Leased

   1,000    Branch

9217 Lee Highway

Ooltewah, Hamilton County, Tennessee

   July 8, 2002    Owned    3,400    Branch

2905 Maynardville Highway

Maynardville, Union County, Tennessee

   July 20, 2002    Owned    12,197    Branch

216 Maynardville Highway

Maynardville, Union County, Tennessee

   July 20, 2002    Leased    2,000    Branch

2918 East Walnut Avenue

Dalton, Whitfield County, Georgia

   March 31, 2003    Owned    10,337    Branch

715 South Thornton Avenue

Dalton, Whitfield County, Georgia

   March 31, 2003    Building Owned

Land Leased

   4,181    Branch

2270 Highway 72 N

Loudon, Loudon County, Tennessee

   June 30, 2003    Owned    1,860    Branch

35 Poplar Springs Road

Ringgold, Catoosa County, Georgia

   July 14, 2003    Owned    3,400    Branch

167 West Broadway Boulevard

Jefferson City, Jefferson County, Tennessee

   October 14, 2003    Owned    3,743    Branch

705 East Broadway

Lenoir City, Loudon County, Tennessee

   October 27, 2003    Owned    3,610    Branch

301 North Main Street

Sweetwater, Monroe County, Tennessee

   December 4, 2003    Owned    4,650    Branch

 

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Office Address

   Date Opened    Owned/Leased    Square
Footage
   Use of
Office

215 Warren Street

Madisonville, Monroe County, Tennessee

   December 4, 2003    Owned    8,456    Branch

405 Highway 165

Tellico Plains, Monroe County, Tennessee

   December 4, 2003    Owned    3,565    Branch

155 North Campbell Station Road

Knoxville, Knox County, Tennessee

   March 2, 2004    Building Owned

Land Leased

   3,743    Branch

1013 South Highway 92

Dandridge, Jefferson County, Tennessee

   April 5, 2004    Owned    3,500    Branch

307 Lovell Road

Knoxville, Knox County, Tennessee

   August 16, 2004    Building Owned

Land Leased

   3,500    Branch

1111 Northshore Drive, Suite S600

Knoxville, Knox County, Tennessee

   October 1, 2004    Leased    9,867    Loan &
Leasing

1111 Northshore Drive, Suite P-100

Knoxville, Knox County, Tennessee

   July 25, 2005    Leased    1,105    Branch

307 Hull Avenue

Gainesboro, Jackson County, Tennessee

   August 31, 2005    Owned    9,662    Branch

6766 Granville Highway

Granville, Jackson County, Tennessee

   August 31, 2005    Owned    2,880    Branch

3261 Jennings Creek Highway

Whitleyville, Jackson County, Tennessee

   August 31, 2005    Building Owned

Land Leased

   1,368    Branch

340 South Jefferson Avenue

Cookeville, Putnam County, Tennessee

   August 31, 2005    Owned    3,220    Branch

376 West Jackson Street

Cookeville, Putnam County, Tennessee

   August 31, 2005    Owned    14,780    Branch

301 Keith Street SW

Cleveland, Bradley County, Tennessee

   October 31, 2005    Leased    3,072    Branch

3895 Cleveland Road

Varnell, Whitfield County, Georgia

   November 11, 2005    Owned    1,860    Branch

531 Broad Street

Chattanooga, Hamilton County, Tennessee

   December 11, 2006    Owned    39,700    Branch &
Headquarters

614 West Main Street

Algood, Putnam County, Tennessee

   April 10, 2007    Owned    1,936    Branch

52 Mouse Creek Road

Cleveland, Bradley County, Tennessee

   May 14, 2007    Owned    1,256    Branch

5188 Highway 153

Knoxville, Knox County, Tennessee

   May 22, 2009    Owned    4,194    Branch

As of December 31, 2010, we owned one additional plot of land. The vacant lot is located at 1020 South Highway 92, Dandridge, Jefferson County, Tennessee (1.0 acres). The lot is currently available for sale and is included in our other real estate owned portfolio. We originally purchased this site for bank purposes.

 

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We closed the branch located at 4215 Highway 411, Madisonville, Monroe County, Tennessee on April 30, 2010. Since we own the branch, it is included in our other real estate owned portfolio and is currently available for sale.

Additionally, we closed leased branch locations at 2709 Chattanooga Road, Suite 5, Rocky Face, Whitfield County, Georgia on October 15, 2010 and 817 Broad Street, Chattanooga, Hamilton County, Tennessee on February 25, 2011.

We are not aware of any environmental problems with the properties that we own or lease that would be material, either individually, or in the aggregate, to our operations or financial condition.

 

Item 3. Legal Proceedings

While we are from time to time a party to various legal proceedings arising in the ordinary course of our business, management believes, after consultation with legal counsel, that there are no proceedings threatened or pending against us that will, individually or in the aggregate, have a material adverse affect on our business or consolidated financial condition.

 

Item 4. [Removed and Reserved.]

 

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PART II

 

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

Since August 10, 2005, our common stock has been traded on the Nasdaq Global Select Market under the symbol FSGI. On March 18, 2011, there were 1,090 registered holders of record of our common stock. The high and low prices per share were as follows:

 

Quarter

   High      Low      Dividend  

2010

        

4th Quarter

   $ 1.69       $ 0.55       $ —     

3rd Quarter

     2.06         1.00         —     

2nd Quarter

     3.43         1.90         —     

1st Quarter

     2.63         2.07         —     

2009

        

4th Quarter

   $ 3.91       $ 1.82       $ 0.01   

3rd Quarter

     4.10         3.35         0.01   

2nd Quarter

     4.54         3.25         0.01   

1st Quarter

     5.14         2.80         0.05   

It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries. For a foreseeable period of time, our principal source of cash will be dividends and management fees paid by FSGBank to us. There are certain restrictions on these payments imposed by federal banking laws, regulations and authorities.

The declaration and payment of dividends on our common stock will depend upon our earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, our ability to service any equity or debt obligations senior to our common stock and other factors deemed relevant by our Board of Directors. On January 27, 2010, our Board of Directors elected to suspend the dividend on our common stock and elected to defer the dividend payment on our Series A Preferred Stock for the first quarter of 2010. Over the balance of 2010, the Board of Directors elected on a quarterly basis to continue to defer the dividend payments for the Series A Preferred Stock. In light of this action, we make no assurance that we will pay any dividends in the future. We may not pay dividends on our common stock unless all dividends have been paid on the securities issued to the Treasury under the CPP; having deferred the dividend payments scheduled for payment in 2010, we are prohibited on paying any future dividends on our common stock until all dividends payable to the Treasury under the CPP have been paid in full. The CPP also restricts our ability to increase the amount of quarterly dividends on common stock above $0.05 per share, which potentially limits your opportunity for gain on your investment.

On November 28, 2007, our Board of Directors authorized a plan to repurchase up to 500,000 shares of our common stock in open market transactions, with the specific timing and amount of repurchases based on market conditions, securities law limitations, and other factors. All repurchases are made with our cash resources, and may be suspended or discontinued at any time without prior notice. On April 21, 2008, this repurchase program was suspended. As of the suspension date, we had repurchased 358 thousand shares at a weighted average price of $7.82.

On July 23, 2008, our Board of Directors approved a loan, which was subsequently amended on January 28, 2009, in the amount of $12.7 million from First Security Group, Inc. to First Security Group, Inc. 401(k) and

 

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Employee Stock Ownership Plan (the “401(k) and ESOP Plan”). The purpose of the loan is to purchase Company shares in open market transactions. The shares will be used for future Company matching contributions within the 401(k) and ESOP Plan. As of December 31, 2010, the plan held 577,723 unallocated shares at a weighted average price of $9.01. The purchase program concluded on December 31, 2009.

LOGO

 

     Period Ending  

Index

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

First Security Group, Inc.

     100.00         119.68         95.01         50.20         26.47         10.01   

NASDAQ Composite

     100.00         110.39         122.15         73.32         106.57         125.91   

SNL Bank NASDAQ

     100.00         112.27         88.14         64.01         51.93         61.27   

SNL Southeast Bank

     100.00         117.26         88.33         35.76         35.90         34.86   

 

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Item 6. Selected Financial Data

Our selected financial data is presented below as of and for the years ended December 31, 2006 through 2010. The selected financial data presented below as of December 31, 2010 and 2009 and for each of the years in the three-year period ended December 31, 2010, are derived from our audited financial statements and related notes included in this Annual Report on Form 10-K and should be read in conjunction with the consolidated financial statements and related notes, along with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 47. The selected financial data as of December 31, 2008, 2007 and 2006 and for the two years ended December 31, 2007 have been derived from our audited financial statements that are not included in this Annual Report on Form 10-K. Certain of the measures set forth below are non-GAAP financial measures under the rules and regulations promulgated by the SEC. For a discussion of management’s reasons to present such data and a reconciliation to GAAP, please see “GAAP Reconciliation and Management Explanation for Non-GAAP Financial Measures” on page 43.

 

     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share amounts and full-time
equivalent employees)
 

Earnings:

          

Net interest income

   $ 34,681      $ 42,209      $ 45,227      $ 48,922      $ 47,982   

Provision for loan and lease losses

   $ 33,613      $ 25,404      $ 15,753      $ 2,155      $ 2,184   

Non-interest income

   $ 9,503      $ 10,335      $ 11,682      $ 11,300      $ 10,617   

Non-interest expense

   $ 45,234      $ 68,847      $ 40,382      $ 41,441      $ 40,017   

Dividends and accretion on preferred stock

   $ 2,029      $ 1,954      $ —        $ —        $ —     

Net (loss) income available to common stockholders

   $ (46,371   $ (35,409   $ 1,361      $ 11,356      $ 11,112   

Earnings—Normalized

          

Non-interest expense, excluding goodwill impairment

   $ 45,234      $ 41,691      $ 40,382      $ 41,441      $ 40,017   

Net (loss) income available to common stockholders, excluding goodwill impairment

   $ (46,371   $ (10,647   $ 1,361      $ 11,356      $ 11,112   

Per Share Data:

          

Net (loss) income, basic

   $ (2.95   $ (2.28   $ 0.08      $ 0.67      $ 0.64   

Net (loss) income, diluted

   $ (2.95   $ (2.28   $ 0.08      $ 0.66      $ 0.63   

Cash dividends declared on common shares

   $ —        $ 0.08      $ 0.20      $ 0.20      $ 0.13   

Book value per common share

   $ 3.76      $ 6.69      $ 8.78      $ 8.80      $ 8.15   

Tangible book value per common share

   $ 3.67      $ 6.57      $ 6.98      $ 6.99      $ 6.39   

Per Share Data—Normalized:

          

Net (loss) income, excluding goodwill impairment, basic

   $ (2.95   $ (0.68   $ 0.08      $ 0.67      $ 0.64   

Net (loss) income excluding goodwill impairment, diluted

   $ (2.95   $ (0.68   $ 0.08      $ 0.66      $ 0.63   

Performance Ratios:

          

Return on average assets1

     -3.55     -2.81     0.11     0.97     1.03

Return on average common equity1

     -46.81     -25.92     0.92     7.75     7.91

Return on average tangible assets1

     -3.55     -2.86     0.11     1.00     1.06

Return on average tangible common equity1

     -47.62     -31.00     1.15     9.81     10.22

Net interest margin, taxable equivalent

     2.92     3.75     4.07     4.79     5.09

Efficiency ratio

     102.38     131.03     70.96     68.81     68.29

Non-interest income to net interest income and non-interest income

     21.51     19.67     20.53     18.76     18.12

 

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     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share amounts and full-time
equivalent employees)
 

Performance Ratios—Normalized:

          

Return on average assets, excluding goodwill impairment1

     -3.55     -0.85     0.11     0.97     1.03

Return on average common equity, excluding goodwill impairment1

     -46.81     -7.79     0.92     7.75     7.91

Return on average tangible assets, excluding goodwill impairment1

     -3.55     -0.86     0.11     1.00     1.06

Return on average tangible common equity, excluding goodwill impairment1

     -47.62     -9.32     1.15     9.81     10.22

Capital & Liquidity:

          

Total equity to total assets

     7.99     10.43     11.30     12.19     12.82

Tangible equity to tangible assets

     7.88     10.30     9.20     9.93     10.33

Tangible common equity to tangible assets

     5.16     7.98     9.20     9.93     10.33

Tier 1 risk-based capital ratio

     11.20     12.68     9.85     10.76     12.04

Total risk-based capital ratio

     12.47     13.94     11.10     11.81     13.10

Tier 1 leverage ratio

     7.27     10.59     8.74     9.74     10.50

Dividend payout ratio

     nm        nm        239.02     30.06     19.50

Total loans to total deposits

     69.33     80.50     93.99     105.59     91.93

Asset Quality:

          

Net charge-offs

   $ 36,081      $ 16,273      $ 9,300      $ 1,129      $ 2,215   

Net loans charged-off to average loans

     4.27     1.66     0.93     0.12     0.28

Non-accrual loans

   $ 54,082      $ 45,454      $ 18,453      $ 3,372      $ 2,653   

Other real estate owned

   $ 24,399      $ 15,312      $ 7,145      $ 2,452      $ 1,982   

Repossessed assets

   $ 763      $ 3,881      $ 1,680      $ 1,834      $ 2,231   

Non-performing assets (NPA)

   $ 79,244      $ 64,647      $ 27,278      $ 7,658      $ 6,866   

NPA to total assets

     6.78     4.78     2.14     0.63     0.61

Loans 90 days past due

   $ 4,838      $ 4,524      $ 2,706      $ 2,289      $ 1,325   

NPA + loans 90 days past due to total assets

     7.20     5.11     2.35     0.82     0.72

Non-performing loans (NPL)

   $ 58,920      $ 49,978      $ 21,159      $ 5,661      $ 3,978   

NPL to total loans

     8.10     5.25     2.09     0.59     0.47

Allowance for loan and lease losses to total loans

     3.30     2.78     1.72     1.15     1.18

Allowance for loan and lease losses to NPL

     40.73     53.01     82.16     193.53     250.63

Period End Balances:

          

Loans

   $ 727,091      $ 952,018      $ 1,011,584      $ 953,105      $ 847,593   

Allowance for loan and lease losses

   $ 24,000      $ 26,492      $ 17,385      $ 10,956      $ 9,970   

Intangible assets

   $ 1,461      $ 1,918      $ 29,560      $ 30,356      $ 31,341   

Assets

   $ 1,168,548      $ 1,353,399      $ 1,276,227      $ 1,211,955      $ 1,129,803   

Deposits

   $ 1,048,723      $ 1,182,673      $ 1,076,286      $ 902,629      $ 922,001   

Common stockholders’ equity

   $ 61,657      $ 109,825      $ 144,244      $ 147,693      $ 144,788   

Total stockholders’ equity

   $ 93,374      $ 141,164      $ 144,244      $ 147,693      $ 144,788   

Common stock market capitalization

   $ 14,776      $ 39,075      $ 75,860      $ 150,640      $ 204,796   

Full-time equivalent employees

     311        347        361        371        369   

Common shares outstanding

     16,418        16,418        16,420        16,775        17,762   

 

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     As of and for the Years Ended December 31,  
     2010      2009      2008      2007      2006  
     (in thousands, except per share amounts and full-time
equivalent employees)
 

Average Balances:

              

Loans

   $ 845,945       $ 977,758       $ 997,371       $ 904,490       $ 796,866   

Intangible assets

   $ 1,691       $ 22,382       $ 29,948       $ 30,838       $ 31,699   

Earning assets

   $ 1,213,145       $ 1,150,337       $ 1,132,962       $ 1,041,078       $ 960,966   

Assets

   $ 1,306,831       $ 1,258,662       $ 1,258,469       $ 1,165,948       $ 1,081,375   

Deposits

   $ 1,147,724       $ 1,057,090       $ 956,994       $ 924,587       $ 887,319   

Common stockholders’ equity

   $ 99,067       $ 136,598       $ 148,655       $ 146,582       $ 140,467   

Total stockholders’ equity

   $ 130,579       $ 166,803       $ 148,655       $ 146,582       $ 140,467   

Common shares outstanding, basic—wtd

     15,740         15,550         16,021         16,959         17,315   

Common shares outstanding, diluted—wtd

     15,740         15,550         16,143         17,293         17,680   

 

1 

Performance ratios are calculated using net (loss) income available to common shareholders, excluding the goodwill impairment.

GAAP Reconciliation and Management Explanation for Non-GAAP Financial Measures

The information set forth above contains certain financial information determined by methods other than in accordance with GAAP. Management uses these “non-GAAP” measures in their analysis of First Security’s performance. Non-GAAP measures typically adjust GAAP performance measures to exclude the effects of charges, expenses and gains related to the consummation of mergers and acquisitions and costs related to the integration of merged entities. These non-GAAP measures may also exclude other significant gains, losses or expenses that are unusual in nature and not expected to recur. Since these items and their impact on our performance are difficult to predict, management believes presentations of financial measures excluding the impact of these items provide useful supplemental information that is important for a proper understanding of the operating results of our core business. Additionally, management utilizes measures involving a tangible basis which exclude the impact of intangible assets such as goodwill and core deposit intangibles. As these assets are normally created through acquisitions and not through normal recurring operations, management believes that the exclusion of these items presents a more comparable assessment of the aforementioned measures on a recurring basis.

Specifically, management uses “non-interest expense, excluding goodwill impairment,” “net (loss) income available to common stockholders, excluding goodwill impairment, net of tax,” “net (loss) income, excluding goodwill impairment per share,” “return on average common equity,” “return on average tangible assets,” “return on average tangible common equity,” “return on average assets, excluding goodwill impairment,” “return on average common equity, excluding goodwill impairment,” “return on average tangible assets, excluding goodwill impairment,” and “return on average tangible common equity, excluding goodwill impairment.” Our management uses these non-GAAP measures in its analysis of First Security’s performance, as further described below.

 

   

“Non-interest expense, excluding goodwill impairment” is defined as non-interest expense reduced by the effect of goodwill impairment. “Net (loss) income available to common stockholders, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax. “Net (loss) income, excluding goodwill impairment per share” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by total common shares outstanding. Our management includes these measures because it believes that they are important when measuring First Security’s performance exclusive of the effects of impairment of goodwill. As of September 30, 2009, the annual assessment of goodwill indicated a full impairment of goodwill; accordingly, no further goodwill remains on the books of First Security. The goodwill impairment is a

 

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one-time, non-cash accounting adjustment that has no effect on First Security’s cash flows, liquidity, tangible capital, or ability to conduct business and as such, management believes excluding this charge is appropriate to properly measure First Security’s performance. These three non-GAAP financial measures exclude the effect of the goodwill impairment on the most comparable GAAP measures: non-interest expense (to measure the overall level of First Security’s recurring non-interest related expenses); net (loss) income available to common stockholders (to reflect the recurring overall net income available to stockholders collectively); and net (loss) income per share (to reflect the recurring overall net income available to stockholders on a per share basis).

 

   

“Return on average common equity” is defined as annualized earnings for the period divided by average equity reduced by average preferred stock. Our management includes this measure in addition to return on average equity, the most comparable GAAP measure, because it believes that it is important when measuring First Security’s performance exclusive of the effects of First Security’s outstanding preferred stock, which has a fixed return, and that this measure is important to many investors in First Security’s common stock.

 

   

“Return on average tangible assets” is defined as annualized earnings for the period divided by average assets reduced by average goodwill and other intangible assets. “Return on average tangible common equity” is defined as annualized earnings for the period divided by average equity reduced by average preferred stock and average goodwill and other intangible assets. Our management includes these measures because it believes that they are important when measuring First Security’s performance exclusive of the effects of goodwill and other intangibles recorded in First Security’s historic acquisitions, exclusive of the effects of First Security’s outstanding preferred stock, which has a fixed return, and these measures are used by many investors as part of their analysis of First Security’s performance.

 

   

“Return on average assets, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average assets. “Return on average common equity, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average equity reduced by average preferred stock. “Return on average tangible assets, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average assets reduced by average goodwill and other intangible assets. “Return on average tangible common equity, excluding goodwill impairment” is defined as net income, increased by the effect of impairment of goodwill, net of tax, divided by average equity reduced by average preferred stock and average goodwill and other intangible assets. The most comparable GAAP measure for each of these measures is return on average assets. Our management includes these measures because it believes that they are important when measuring First Security’s performance exclusive of the effects of impairment of goodwill. As of September 30, 2009, the annual assessment of goodwill indicated a full impairment of goodwill; accordingly, no further goodwill remains on the books of First Security. The goodwill impairment is a one-time, non-cash accounting adjustment that has no effect on First Security’s cash flows, liquidity, tangible capital, or ability to conduct business and as such, management believes excluding this charge is necessary to properly measure First Security’s performance.

 

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These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. The following table provides a more detailed analysis of these non-GAAP performance measures.

 

     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share data)  

Return on average assets

     -3.55     -2.81     0.11     0.97     1.03

Effect of intangible assets

     —          -0.05     —          0.03     0.03
                                        

Return on average tangible assets

     -3.55     -2.86     0.11     1.00     1.06
                                        

Return on average assets

     -3.55     -2.81     0.11     0.97     1.03

Effect of goodwill impairment

     —          1.96     —          —          —     
                                        

Return on average assets, excluding goodwill impairment

     -3.55     -0.85     0.11     0.97     1.03

Effect of average intangible assets

     —          -0.01     —          0.03     0.03
                                        

Return on average tangible assets, excluding goodwill impairment

     -3.55     -0.86     0.11     1.00     1.06
                                        

Return on average common equity

     -46.81     -25.92     0.92     7.75     7.91

Effect of goodwill impairment

     —          18.13     —          —          —     
                                        

Return on average common equity, excluding goodwill impairment

     -46.81     -7.79     0.92     7.75     7.91

Effect on average intangible assets

     -0.81     -1.53     0.23     2.06     2.32
                                        

Return on average tangible common equity, excluding goodwill impairment

     -47.62     -9.32     1.15     9.81     10.22
                                        

Total equity to total assets

     7.99     10.43     11.30     12.19     12.82

Effect of intangible assets

     -0.11     -0.13     -2.10     -2.26     -2.49
                                        

Tangible equity to tangible assets

     7.88     10.30     9.20     9.93     10.33
                                        

Effect of preferred stock

     -2.72     -2.32     —          —          —     
                                        

Tangible common equity to tangible assets

     5.16     7.98     9.20     9.93     10.33
                                        

Non-interest expense

   $ 45,234      $ 68,847      $ 40,382      $ 41,441      $ 40,017   

Effect of goodwill impairment

     —          (27,156     —          —          —     
                                        

Non-interest expense, excluding goodwill impairment

   $ 45,234      $ 41,691      $ 40,382      $ 41,441      $ 40,017   
                                        

Net (loss) income available to common stockholders

   $ (46,371   $ (35,409   $ 1,361      $ 11,356      $ 11,112   

Effect of goodwill impairment, net of $2,394 tax effect

     —          24,762        —          —          —     
                                        

Net (loss) income available to common stockholders, excluding goodwill impairment

   $ (46,371   $ (10,647   $ 1,361      $ 11,356      $ 11,112   
                                        

Total stockholders’ equity

   $ 93,374      $ 141,164      $ 144,244      $ 147,693      $ 144,788   

Effect of preferred stock

     (31,717     (31,339     —          —          —     
                                        

Common stockholders’ equity

   $ 61,657      $ 109,825      $ 144,244      $ 147,693      $ 144,788   
                                        

Average assets

   $ 1,306,831      $ 1,258,662      $ 1,258,469      $ 1,165,948      $ 1,081,375   

Effect of average intangible assets

     (1,691     (22,382     (29,948     (30,838     (31,699
                                        

Average tangible assets

   $ 1,305,140      $ 1,236,280      $ 1,228,521      $ 1,135,110      $ 1,049,676   
                                        

 

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     As of and for the Years Ended December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except per share data)  

Average total stockholders’ equity

   $ 130,579      $ 166,803      $ 148,655      $ 146,582      $ 140,467   

Effect of average preferred stock

     (31,512     (30,205     —          —          —     
                                        

Average common stockholders’ equity

     99,067        136,598        148,655        146,582        140,467   
                                        

Effect of average intangible assets

     (1,691     (22,382     (29,948     (30,838     (31,699
                                        

Average tangible common stockholders’ equity

   $ 97,376      $ 114,216      $ 118,707      $ 115,744      $ 108,768   
                                        

Per Share Data

          

Book value per common share

   $ 3.76      $ 6.69      $ 8.78      $ 8.80      $ 8.15   

Effect of intangible assets

     (0.09     (0.12     (1.80     (1.81     (1.76
                                        

Tangible book value per common share

   $ 3.67      $ 6.57      $ 6.98      $ 6.99      $ 6.39   
                                        

Net (loss) income, basic

   $ (2.95   $ (2.28   $ 0.08      $ 0.67      $ 0.64   

Effect of goodwill impairment, net of tax

     —          1.60        —          —          —     
                                        

Net (loss) income, excluding goodwill impairment, basic

   $ (2.95   $ (0.68   $ 0.08      $ 0.67      $ 0.64   
                                        

Net (loss) income, diluted

   $ (2.95   $ (2.28   $ 0.08      $ 0.66      $ 0.63   

Effect of goodwill impairment, net of tax

     —          1.60        —          —          —     
                                        

Net (loss) income, excluding goodwill impairment, diluted

   $ (2.95   $ (0.68   $ 0.08      $ 0.66      $ 0.63   
                                        

 

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

The following is management’s discussion and analysis (MD&A) which should be read in conjunction with “Selected Financial Data” and our consolidated financial statements and notes included in this Annual Report on Form 10-K. The discussion in this Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report. Our actual results could differ materially from those discussed in this Annual Report on Form 10-K.

Year Ended December 31, 2010

The following discussion and analysis sets forth the major factors that affected First Security’s financial condition as of December 31, 2010 and 2009, and results of operations for the three years ended December 31, 2010 as reflected in the audited financial statements.

Strategic Initiatives

During 2009 and 2010, we initiated a set of strategic initiatives to position us appropriately for both short-term stability and long-term success. The following are the primary initiatives with associated target dates for implementation:

 

Strategic Initiative

  

Current and/or Potential Impact

   Actual/Expected
Implementation
 

Capital

     

•    CPP participation

   Received $33 million in Preferred Stock capital      1st quarter 2009   

•    Capital stress test

  

Outsourced a SCAP capital stress test to assist in capital planning

     4th quarter 2009   

Liquidity

     

•    Liquidity enhancement

  

Increased longer term brokered deposits and excess cash to fund future contractual obligations and prudent investments

     1st quarter 2010   

Asset Quality

     

•    Loan review department expansion

  

Added resources to increase frequency and coverage of the review of our portfolio

     4th quarter 2009   

•    Extensive loan review

   Outsourced an extensive loan review prior to year-end 2009      4th quarter 2009   

•    OREO management

  

Transferred OREO management to the special assets department

     3rd quarter 2010   

•    OREO sales

  

Outsourced the marketing and sales function for most foreclosed residential properties to market leading real estate firms

     4th quarter 2010   

 

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Strategic Initiative

  

Current and/or Potential Impact

   Actual/Expected
Implementation
 

Credit Administration

     

•    Lines of business

  

Credit functions aligned by retail and commercial lines of business with dedicated credit officers and staff supporting each portfolio

     4th quarter 2009   

•    Loan underwriting centralization

  

Ensures consistency in underwriting, pricing, loan structure and policy compliance

     2nd quarter 2010   

•    Collections centralization

  

Dedicated collections department created to focus on collection of past due loans and recovery of prior charge-offs

     2nd quarter 2010   

•    Loan document preparation centralization

  

Operational efficiencies and reduction of loan policy exceptions

     2nd quarter 2010   

•    Loan policy

  

Amended existing loan policy to provide the framework and guidelines for current and future loans

     2nd quarter 2010   

Management

     

•    Chief risk officer

  

Elevated risk manager to executive level with expanded responsibilities

     1st quarter 2010   

•    Chief credit officer

  

Hired experienced executive credit officer to oversee credit administration

     2nd quarter 2010   

•    Retail banking president

  

Created new executive level position responsible for consumer and small-business loan and deposit relationships and associated retail lenders

     3rd quarter 2010   

•    Commercial banking president

  

Created new executive level position responsible for commercial loan and deposit relationships and associated commercial lenders

     3rd quarter 2010   

•    Chief operating officer and president

  

Hired experienced bank executive to manage and oversee banking operations, including the credit, financial, retail banking and commercial banking functions

     3rd quarter 2010   

The above initiatives are discussed in additional detail throughout MD&A.

Recent Regulatory Events

Effective September 7, 2010, First Security entered into an Agreement with the Federal Reserve Bank. The Agreement is designed to ensure First Security is a source of strength to FSGBank. Substantially all of the requirements of the Agreement are similar to those already in effect for FSGBank pursuant to the Consent Order that is described below. On September 14, 2010, we filed a current report on Form 8-K describing the Agreement. The Form 8-K also provides a copy of the fully executed Agreement.

We are currently deemed not in compliance with several provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve Bank. We can provide no assurances that we will be able to comply fully with the Agreement, that efforts to comply with the Agreement will not have a material adverse effect on the operations and financial condition of First Security, or that further enforcement actions won’t be imposed on First Security.

Effective April 28, 2010, FSGBank reached an agreement with its primary regulator, the OCC, regarding the issuance of a Consent Order. The Order is a result of the OCC’s regular examination of FSGBank in the fall of

 

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2009 and directs FSGBank to take actions intended to strengthen its overall condition. All customer deposits remain fully insured by the FDIC to the maximum extent allowed by law; the Order does not impact this coverage in any manner. On April 29, 2010, First Security filed a current report on Form 8-K describing the Order and the related actions taken by the Bank to date. The Form 8-K also provides a copy of the fully executed Order.

We are currently deemed not in compliance with the provisions of the Order, including the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. We can provide no assurances that we will be able to comply fully with the Order, that efforts to comply with the Order will not have a material adverse effect on the operations and financial condition of FSGBank, or that further enforcement actions won’t be imposed on FSGBank.

Prior to and following the OCC’s regularly scheduled exam in the fall of 2009, we developed and began implementing a number of strategic initiatives designed to improve both the operations and the financial performance of First Security. We believe the successful execution of our strategic initiatives will ultimately result in full compliance with the Order and position us for long-term growth and a return to profitability.

The OCC is currently working with the Board and management to address certain items within the previously submitted strategic and capital plans, as well as other policy revisions required by the order. The Order required FSGBank to maintain certain capital ratios within 120 days of it execution. The December 31, 2010 Call Report was the second public financial statement related to a period subsequent to the 120 day requirement. As of December 31, 2010, the Bank’s total capital to risk-weighted assets was 12.2% and the Tier 1 capital to adjusted total assets was 7.1%. The Bank has notified the OCC of the non-compliance. The Bank anticipates submitting revised earnings and capital plans to the OCC during the second quarter of 2011.

Going Concern Discussion

Our independent registered public accounting firm has included language in its audit opinion related to our ability to continue as a going concern. As discussed in Note 2 to our consolidated financial statements, we recognize that the losses recorded during 2009 and 2010 have significantly impacted our operating results for those two years. Our ability to continue as a going concern is contingent upon our ability to devise and successfully execute a management plan to develop profitable operations, satisfy the requirements of the regulatory actions detailed above, and lower the level of problem assets to an acceptable level.

We are developing strategic and capital plans, which include, but are not limited to: (1) reorganizing management into a line of business structure, (2) restructuring credit and lending functions with new policies and centralized processes, (3) reducing adversely classified assets, (4) maintaining an adequate allowance for loan losses, (5) actively working to maintain appropriate liquidity while reducing reliance on non-core sources of funding and (6) evaluating strategic and capital opportunities.

We believe that the successful execution of the strategic initiatives will ultimately result in full compliance with the regulatory requirements and position us for long-term growth and a return to profitability.

Overview

Market Conditions

Most indicators point toward the overall U.S. economy improving during 2011. As our financial results can be a reflection of our regional economy, we closely monitor and evaluate local and regional economic trends.

Announced in 2010, Amazon.com is building two distribution centers in our markets. Both facilities are anticipated to be operational by August or September 2011. The $139 million investments will create more than 1,400 full-time jobs in Hamilton and Bradley counties along with more than 2,000 seasonal jobs.

 

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Announced in 2008, the $1 billion Volkswagen automotive production facility will be producing the all-new 2012 Passat. As of March 9, 2011, Volkswagen had hired over 1,500 of the 2,000 plus estimated direct jobs. Volkswagen anticipates 400 white-collar jobs and an additional 9,500 supplier-related jobs to the region. Also announced in 2008, Wacker Chemical is building a $1.45 billion polysilicon production plant for the solar power industry near Cleveland, Tennessee. The plant is expected to create an additional 650 jobs for our market area. We believe the positive economic impact on Chattanooga and the surrounding region from Volkswagen and other recently announced large economic investments will be significant and it may stabilize and possibly increase real estate values and enhance economic activity within our market area.

While the economic recession has resulted in higher unemployment across the country, our larger market areas benefit from more stable rates of employment. Our major market areas of Chattanooga and Knoxville have a lower unemployment rate of 8.3% and 7.3%, respectively, as of December 2010, than the Tennessee rate of 9.1%. The economy of the Dalton, Georgia MSA is primarily centered on the carpet and floor-covering industries. With the decline in housing starts and the overall economy, Dalton has been the most negatively impacted region in our footprint. The unemployment rate in the Dalton MSA is 12.7% (as of December 2010) compared to the Georgia rate of 10.2%. For the Chattanooga and Knoxville MSAs, the number of unemployed workers is decreasing and, as of December 2010, has declined by 16.8% in Chattanooga and 21.3% in Knoxville since the peak in June 2009. We believe these positive employment trends will continue into 2011.

Our market area has also benefited from a relatively stable housing environment. According to the National Association of REALTORS, the median sales prices of existing single-family homes declined by less than 1% for the Chattanooga MSA and the Knoxville MSA year-over-year. The decline in the median sales price from 2008 to 2010 was 6.0% for the Chattanooga MSA and 5.5% for the Knoxville MSA compared to 11.9% decrease for the nation and a 9.3% decline for the census region identified as the South as of December 31, 2010. We anticipate median home prices to begin to stabilize and possibly increase during 2011.

CPP Investment

On January 9, 2009, as part of the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP), we agreed to issue and sell, and the Treasury agreed to purchase (1) 33,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock (Preferred Shares), Series A, having a liquidation preference of $1,000 per share and (2) a ten-year warrant to purchase up to 823,627 shares of our common stock, $0.01 par value, at an exercise price of $6.01 per share, for an aggregate purchase price of $33 million in cash. The Preferred Shares qualify as Tier 1 capital and pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Dividends are payable quarterly on February 15, May 15, August 15 and November 15 of each year.

Currently, we have deferred five consecutive Preferred Stock dividend payments. Upon the sixth deferred dividend payment, the Treasury will be entitled to elect two members to our Board of Directors at the next annual meeting. Currently, the Treasury has requested, and we anticipate agreeing to permit, an observer employed by the Treasury to attend meetings of our Board of Directors.

Financial Results

As of December 31, 2010, we had total consolidated assets of $1.2 billion, total loans of $727.1 million, total deposits of $1.0 billion and stockholders’ equity of $93.4 million. In 2010, our net loss available to common stockholders was $46.4 million, resulting in a net loss of $2.95 per share (basic and diluted). During 2010, we recognized $33.6 million in provision for loan and lease losses as well as a deferred tax asset valuation allowance of $24.6 million.

As of December 31, 2009, we had total consolidated assets of $1.4 billion, total loans of $952.0 million, total deposits of $1.2 billion and stockholders’ equity of $141.2 million. In 2009, our net loss available to common stockholders was $35.4 million, resulting in net loss of $2.28 per share (basic and diluted). During 2009, we recognized a goodwill impairment of $27.2 million, or $24.8 million after-tax. Excluding the goodwill

 

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impairment, our net loss available to common stockholders was $10.6 million, or $0.68 per share (basic and diluted). The goodwill impairment represents a one-time, non-cash accounting adjustment and had no impact on cash flows, liquidity, tangible capital or our ability to conduct business.

As of December 31, 2008, we had total consolidated assets of $1.3 billion, total loans of $1.0 billion, total deposits of $1.1 billion and stockholders’ equity of approximately $144.2 million. In 2008, our net income was $1.4 million, resulting in basic and diluted net income of $0.08 per share.

Net interest income for 2010 declined by $7.5 million compared to 2009 primarily as a result of the reduction in the loan portfolio as well as the negative spread created by the issuance of brokered deposits and the associated increase in interest bearing cash. The provision for loan and lease losses increased $8.2 million as a result of the increased level of charge-offs. Noninterest income declined by $832 thousand primarily a result of lower deposit fees and lower mortgage loan and related fee income. Noninterest expense, excluding the 2009 goodwill impairment of $27.2 million, increased by $3.5 million. The increase was largely due to increases in write-downs on OREO and repossessions, higher FDIC insurance expense and higher professional fees, partially offset by reductions in salary and benefit expense. Full-time equivalent employees were 311 at December 31, 2010, compared to 347 at December 31, 2009.

Net interest income for 2009 declined by $3.0 million from 2008, primarily as a result of the reductions to the target federal funds rate by the Federal Reserve Board that began in September 2007 and ended in December 2008. The weighted average target fund rate for 2008 was 1.76% compared to 0.25% for 2009. The provision for loan and lease losses increased $9.7 million as a result of declining asset quality and general economic conditions. Noninterest income decreased by $1.3 million, primarily a result of lower deposit fees and lower mortgage loan and related fee income. Noninterest expense, excluding the goodwill impairment of $27.2 million, increased 3.2%, or $1.3 million. Full-time equivalent employees were 347 at December 31, 2009, compared to 361 at December 31, 2008.

Our efficiency ratio, excluding the goodwill impairment, increased to 102.4% in 2010 versus 79.3% in 2009 and 71.0% in 2008. The efficiency ratio for 2010 increased as a result of the combined $8.4 million decline in net interest income and noninterest income and the $3.5 million increase in noninterest expense, excluding the goodwill impairment. The stabilization and improvement of our efficiency ratio to more historical levels is dependent on our ability to stabilize the loan portfolio and reduce expenses associated with nonperforming assets.

Net interest margin in 2010 was 2.92%, or 83 basis points lower, compared to the prior period of 3.75%. The net interest margin of our peer group (as reported on the December 31, 2010 Uniform Bank Performance Report) was 3.69% and 3.50% for 2010 and 2009, respectively. During the fourth quarter of 2009 and first quarter of 2010, we issued over $255 million in brokered deposits to build excess cash reserves to reduce liquidity risk resulting from deteriorating asset quality and the Consent Order. Average other earning assets increased to $217.4 million in 2010 from $30.6 million in 2009. The impact of the excess liquidity is estimated to have reduced our net interest margin by approximately 100 basis points. We anticipate that our margin will improve during 2011 as brokered deposits mature and the excess liquidity declines. Our expectations are dependent on our ability to raise core deposits, our loan and deposit pricing, and any possible actions by the Federal Reserve Board to the target federal funds rate.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our significant accounting policies are described in Note 1, “Accounting Policies,” to the consolidated financial statements and are integral to understanding MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that we reasonably could have

 

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used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan and lease losses and reduced through loan and lease charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that we exercise judgment to estimate an appropriate allowance. Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact our net income as a result of the change in the provision for loan and lease losses. Refer to the “Provision for Loan and Lease Losses” and “Allowance” sections within MD&A for a discussion of our methodology of establishing the allowance as well as Note 1 to our notes to the consolidated financial statements.

Estimates of Fair Value

Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Our available-for-sale securities and held for sale loans are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a non-recurring basis. We use fair value on a non-recurring basis for other real estate owned, repossessions and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.

Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that we make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate our assessments regarding assumptions that market participants would use in pricing the asset or the liability.

Changes in fair value could materially impact our financial results. Refer to Note 18, “Fair Value Measurements” in the notes to our consolidated financial statements for a discussion of our methodology of calculating fair value.

Goodwill

Our policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. Impairment is a condition that exists when the carrying amount of goodwill exceeds its implied fair value. As more fully described below, we recorded a full goodwill impairment during 2009.

Income Taxes

We are subject to various taxing jurisdictions where we conduct business and we estimate income tax expense based on amounts that we expect to owe to these jurisdictions. We evaluate the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income.

 

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The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and are reported in other liabilities or other assets, respectively, in our consolidated balance sheets. We assess the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintain tax accruals consistent with our evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results.

We periodically evaluate our uncertain tax positions and estimate the appropriate level of tax reserves related to each of these positions. Additionally, we evaluate our deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 13, “Income Taxes,” in the notes to our consolidated financial statements as well as the Income Taxes section of MD&A for more information.

Results of Operations

We reported a net loss available to common stockholders for 2010 of $46.4 million versus $35.4 million for 2009 and net income for 2008 of $1.4 million. In 2010, the net loss per share was $2.95 (basic and diluted) on approximately 15.7 million weighted average shares outstanding. Excluding the goodwill impairment of $24.8 million after-tax, or $27.2 million before-tax, our 2009 net loss was $10.6 million, or $0.68 per share (basic and diluted). In 2008, the net income of $1.4 million resulted in net income of $0.08 per share (basic and diluted) on approximately 16.0 million weighted average basic shares and 16.1 million weighted average diluted shares.

The net loss available to common shareholders in 2010 was above the 2009 level predominately as a result of the deferred tax asset valuation allowance of $24.6 million, higher provision expense and a decrease in net interest income. As of December 31, 2010, we had 37 banking offices, including the headquarters and 311 full time equivalent employees.

The following table summarizes the components of income and expense and the changes in those components for the past three years.

 

    Condensed Consolidated Statements of Income
For the Years Ended December 31,
 
    2010     Change
From
Prior
Year
    Percent
Change
    2009     Change
From
Prior
Year
    Percent
Change
    2008     Change
From
Prior
Year
    Percent
Change
 
    (in thousands, except percentages)  

Interest income

  $ 54,916      $ (9,091     (14.2 )%    $ 64,007      $ (12,081     (15.9 )%    $ 76,088      $ (7,435     (8.9 )% 

Interest expense

    20,235        (1,563     (7.2 )%      21,798        (9,063     (29.4 )%      30,861        (3,740     (10.8 )% 
                                                                       

Net interest income

    34,681        (7,528     (17.8 )%      42,209        (3,018     (6.7 )%      45,227        (3,695     (7.6 )% 

Provision for loan and lease losses

    33,613        8,209        32.3     25,404        9,651        61.3     15,753        13,598        631.0
                                                                       

Net interest income after provision for loan and lease losses

    1,068        (15,737     (93.6 )%      16,805        (12,669     (43.0 )%      29,474        (17,293     (37.0 )% 

Noninterest income

    9,503        (832     (8.1 )%      10,335        (1,347     (11.5 )%      11,682        382        3.4

Noninterest expense

    45,234        (23,613     (34.3 )%      68,847        28,465        70.5     40,382        (1,059     (2.6 )% 
                                                                       

Net (loss) income before income taxes

    (34,663     7,044        (16.9 )%      (41,707     (42,481     (5,488.5 )%      774        (15,852     (95.3 )% 

Income tax provision (benefit)

    9,679        17,931        217.3     (8,252     (7,665     1,305.8     (587     (5,857     (111.1 )% 
                                                                       

Net (loss) income

    (44,342     (10,887     (32.5 )%      (33,455     (34,816     (2,558.1 )%      1,361        (9,995     (88.0 )% 

Preferred stock dividends and discount accretion

    2,029        75        3.8     1,954        1,954        100.0     —          —          —     
                                                                       

Net (loss) income available to common stockholders

  $ (46,371   $ (10,962     (31.0 )%    $ (35,409   $ (36,770     (2,701.7 )%    $ 1,361      $ (9,995     (88.0 )% 
                                                                       

Further explanation, with year-to-year comparisons of the income and expense, is provided below.

 

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Net Interest Income

Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. In 2010, net interest income was $34.7 million, or 17.8% less than the 2009 level of $42.2 million, which was 6.7% less than the 2008 level of $45.2 million.

The level of net interest income is determined primarily by the average balances (volume) of interest earning assets and the various rate spreads between our interest earning assets and our funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest earning assets and interest bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits.

The following table summarizes net interest income on a fully tax-equivalent basis and average yields and rates paid for the years ended December 31, 2010, 2009 and 2008.

Average Consolidated Balance Sheets and Net Interest Analysis

Fully Tax-Equivalent Basis

 

    For the Years Ended,  
    2010     2009     2008  
    Average
Balance
    Income/
Expense
    Yield/
Rate
    Average
Balance
    Income/
Expense
    Yield/
Rate
    Average
Balance
    Income/
Expense
    Yield/
Rate
 
    (in thousands, except percentages)  
    (fully tax-equivalent basis)  

ASSETS

                 

Earning assets:

                 

Loans, net of unearned
income1,2

  $ 845,945      $ 49,127        5.81   $ 977,758      $ 57,784        5.91   $ 997,371      $ 69,863        7.00

Debt securities—taxable

    111,526        3,919        3.51     98,797        4,613        4.67     89,711        4,647        5.18

Debt securities—non-taxable 2

    38,232        2,156        5.64     43,134        2,457        5.70     42,780        2,452        5.73

Federal funds sold and other earning assets

    217,442        517        0.24     30,648        72        0.23     3,100        49        1.58
                                                                       

Total earning assets

    1,213,145        55,719        4.59     1,150,337        64,926        5.64     1,132,962        77,011        6.80
                                                     

Allowance for loan losses

    (26,698         (20,582         (12,030    

Intangible assets

    1,691            22,382            29,948       

Cash & due from banks

    8,117            15,292            23,280       

Premises & equipment

    32,362            33,753            34,429       

Other assets

    78,214            57,480            49,880       
                                   

Total assets

  $ 1,306,831          $ 1,258,662          $ 1,258,469       
                                   

LIABILITIES AND STOCKHOLDERS’ EQUITY

                 

Interest bearing liabilities:

                 

NOW accounts

  $ 65,809      $ 186        0.28   $ 61,501      $ 190        0.31   $ 62,911      $ 327        0.52

Money market accounts

    133,298        1,315        0.99     126,219        1,567        1.24     103,137        2,139        2.07

Savings deposits

    38,582        102        0.26     35,986        101        0.28     35,120        146        0.42

Time deposits less than $100 thousand

    228,907        4,673        2.04     244,912        7,183        2.93     256,664        10,549        4.11

Time deposits > $100 thousand

    184,432        4,049        2.20     203,052        6,265        3.09     214,705        9,310        4.34

Brokered CDs and CDARS®

    335,416        9,372        2.79     157,717        5,317        3.37     121,736        4,735        3.89

Brokered money markets and NOWs

    6,561        57        0.87     77,683        653        0.84     4,975        74        1.49

Federal funds purchased

    —          —          —       335        4        1.19     23,710        689        2.91

Repurchase agreements

    18,435        475        2.58     20,828        498        2.39     34,513        835        2.42

Other borrowings

    85        6        7.06     1,723        20        1.16     78,108        2,057        2.63
                                                                       

Total interest bearing liabilities

    1,011,525        20,235        2.00     929,956        21,798        2.34     935,579        30,861        3.30
                                                     

Net interest spread

    $ 35,484        2.59     $ 43,128        3.30     $ 46,150        3.50
                                   

Noninterest bearing demand deposits

    154,719            150,020            157,746       

Accrued expenses and other liabilities

    10,018            11,883            16,489       

Stockholders’ equity

    124,825            160,375            144,622       

Accumulated other comprehensive gain (loss)

    5,744            6,428            4,033       
                                   

Total liabilities and stockholders’ equity

  $ 1,306,831          $ 1,258,662          $ 1,258,469       
                                   

Impact of noninterest bearing sources and other changes in balance sheet composition

        0.33         0.45         0.57
                                   

Net interest margin

        2.92         3.75         4.07
                                   

 

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1 

Nonaccrual loans have been included in the average balance. Only the interest collected on such loans has been included as income.

 

2 

Interest income from securities and loans includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for all years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $803 thousand, $919 thousand and $923 thousand for the years ended December 31, 2010, 2009 and 2008, respectively.

The following table shows the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amounts of the change in each category.

Change in Interest Income and Expense on a Tax Equivalent Basis

 

    2010 compared to 2009 increase
(decrease) in interest income and
expense due to changes in:
    2009 compared to 2008 increase
(decrease) in interest income and
expense due to changes in:
 
    Volume     Rate     Total     Volume     Rate     Total  
    (in thousands)  

Earning assets:

           

Loans, net of unearned income

  $ (7,927   $ (730   $ (8,657   $ (1,561   $ (10,518   $ (12,079

Debt Securities—taxable

    580        (1,274     (694     457        (491     (34

Debt Securities—non-taxable

    (285     (16     (301     14        (9     5   

Federal funds sold and other earning assets

    437        8        445        434        (411     23   
                                               

Total earning assets

    (7,195     (2,012     (9,207     (656     (11,429     (12,085
                                               

Interest bearing liabilities:

           

NOW accounts

    13        (17     (4     (8     (129     (137

Money market accounts

    83        (335     (252     472        (1,044     (572

Savings deposits

    7        (6     1        3        (48     (45

Time deposits less than $100 thousand

    (488     (2,022     (2,510     (511     (2,855     (3,366

Time deposits > $100

    (590     (1,626     (2,216     (529     (2,516     (3,045

Brokered CDs and CDARS®

    5,960        (1,905     4,055        1,383        (801     582   

Brokered money market accounts

    (598     2        (596     1,078        (499     579   

Federal funds purchased

    (4     —          (4     (679     (6     (685

Repurchase agreements

    (58     35        (23     (332     (5     (337

Other borrowings

    (19     5        (14     (2,012     (25     (2,037
                                               

Total interest bearing liabilities

    4,306        (5,869     (1,563     (1,135     (7,928     (9,063
                                               

Increase (decrease) in net interest income

  $ (11,501   $ 3,857      $ (7,644   $ 479      $ (3,501   $ (3,022
                                               

Net Interest Income—Volume and Rate Changes

Interest income in 2010 was $54.9 million, a 14% decrease from the 2009 level of $64.0 million, which was a 16% decrease from the 2008 level of $76.1 million. For 2010, average loans declined by $131.8 million, or 13.5%. The decline in average loans was fully offset by a $186.8 million increase in other earning assets. The largest component of other earning assets is our interest bearing account at the Federal Reserve Bank of Atlanta that averaged $213.4 million in 2010 compared to $23.0 million during 2009. This account yields approximately 25 basis points. The net impact for changes in volumes of interest-earning assets in 2010 reduced interest income by $7.2 million. For 2009, average interest-earning assets increased 2% to $1.2 billion. However, the associated

 

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increase in earnings from the higher volumes was offset by the decline in the yields of earning assets and a shift in earning assets, as discussed in additional detail below. Average loans in 2009 were $977.8 million, a decrease of $19.6 million, or 2%. Average taxable debt securities increased $9.1 million, or 10%. Other earning assets increased $27.5 million to $30.6 million. The increase in average taxable debt securities and other earning assets was funded by the reductions in loans and increases in brokered deposits. The impact on interest income from the decline in average loans fully offset the increases in the other categories of earning assets. The total impact on interest income from changes in volume was a reduction of $656 thousand comparing 2009 to 2008.

The reduction in yield of average earning assets reduced interest income by $2.0 million in 2010. The tax equivalent yield on earning assets decreased 105 basis points in 2010 to 4.59% from 5.64% in 2009. The reduction in yield on earning assets was primarily related to the shifting of assets from high yielding loans to interest bearing cash. For 2009, the reduction in yield of average earnings assets reduced interest income by $11.4 million, accounting for 95% of the total decline, on a fully tax equivalent basis from 2008 to 2009. The tax equivalent yield on earning assets decreased 116 basis points in 2009 to 5.64% from 6.80% in 2008. The reduction in yield on loans for 2009 was 109 basis points, which was a result of the full impact of the 2008 cuts in the federal funds rate. From September 2007 to December 2008, the Federal Reserve Board reduced the target federal funds rate by 500 basis points to a target rate of 0.25%. We continue to maintain an asset sensitive balance sheet, which means that earning assets reprice faster than interest bearing liabilities and thus interest income declines faster than interest expense in a declining rate environment.

Total interest expense was $20.2 million in 2010 compared to $21.8 million in 2009 and $30.9 million in 2008. During the fourth quarter of 2009 and first quarter of 2010, we issued over $255 million in brokered deposits to reduce the increasing liquidity risk associated with our declining asset quality. The bulk of these funds were placed in our interest-bearing account at the Federal Reserve Bank of Atlanta. These funds will serve as excess liquidity to fund contractual obligations or prudent investments. Average brokered deposits increased by $106.6 million in 2010, adding $5.4 million in interest expense. Reductions in retail and jumbo CDs of $16.0 million and $18.6 million, respectively, reduced interest expense by $1.1 million. For 2010, the net impact on changes in volume of interest bearing liabilities resulted in a $4.3 million increase to interest expense.

For 2009, interest expense decreased due to the reduced cost of funds as well as reduced volumes of interest bearing liabilities. Interest expense for 2008 decreased due to the reduced cost of funds despite the additional volumes of interest bearing liabilities. During 2009, we replaced non-deposit liabilities, primarily short-term other borrowings, with long-term brokered deposits. Average interest bearing liabilities, excluding average deposits, declined by $113.4 million while average brokered deposits increased $108.7 million. In-market certificates of deposits declined by $23.4 million, or 5%, while money markets increased $23.1 million, or 22%. The total impact on the changes in volume of average interest bearing liabilities during 2009 was a decline in interest expense of $1.1 million.

Deposit pricing, especially for time deposits, typically lags changes in the target federal funds rate, and therefore we realized a consistent but gradual reduction in our costs of deposits throughout 2009 and 2010. The reduction of costs on interest bearing liabilities reduced interest expense by $5.9 million in 2010 and $7.9 million in 2009. The average rate paid on interest bearing liabilities for 2010 decreased by 34 basis points from 2.34% to 2.00%. The average rate paid on in-market CDs declined by 89 basis points, resulting in a savings of $3.6 million. The average rate paid on brokered deposits declined by 58 basis points to 2.79% during 2010, resulting in a savings of $1.9 million.

For 2009, the average rate paid on interest bearing liabilities decreased by 96 basis points from 3.30% to 2.34%. Beginning in the second half of 2008 and continuing into 2009, we decided to fortify our balance sheet and improve our contingent funding plans so we significantly reduced our overnight borrowings and replaced them with brokered deposits. During the fourth quarter of 2009, we took advantage of historically low rates and further extended our brokered CD ladder. We issued approximately $161.1 million of brokered CDs during the fourth quarter of 2009 with a weighted average maturity of 41 months and weighted average rate of 2.72%.

 

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We expect average loans to stabilize in 2011 while other earnings assets begin to decrease as brokered deposits mature. The average yield on loans in 2011 should be comparable to 2010 as we do not currently anticipate significant changes to interest rates during 2011. We expect average brokered deposits to decline during 2010 while all other interest bearing liabilities to be comparable or increase during 2011. Rates paid on deposits are expected to be consistent with 2010 rates.

Net Interest Income—Net Interest Spread and Net Interest Margin

The banking industry uses two key ratios to measure relative profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The net interest rate spread does not consider the impact of noninterest bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest bearing deposits in earning assets.

First Security’s net interest rate spread (on a tax equivalent basis) was 2.59% in 2010, 3.30% in 2009 and 3.50% in 2008, while the net interest margin (on a tax equivalent basis) was 2.92% in 2010, 3.75% in 2009 and 4.07% in 2008. The decrease in the net interest spread and net interest margin for 2010 was primarily due to reductions in our loan portfolio as well as the negative spread created by the issuance of brokered deposits in late 2009 and early 2010 and the associated increase in our interest bearing cash account at the Federal Reserve Bank of Atlanta. Additionally, average noninterest bearing deposits increased 3.1% while average earning assets increased by 5.5%. Accordingly, noninterest bearing deposits contributed 33 basis points to the margin during 2010 compared to 45 basis points in 2009.

For 2009, the decline in the spread and margin was primarily due to the full-year impact of the 2008 Federal Reserve Board cuts to the target federal funds rate, partially offset by the repricing of our deposits. During 2008, approximately 47% of our loans repriced simultaneously with changes to an associated index (such as Prime, which is driven by the target federal funds rate), while only approximately 11% of our liabilities repriced simultaneously. As such, the 2008 target rate reductions by the Federal Reserve Board had an immediate negative impact on our net interest spread and net interest margin. Additionally, a decline in average noninterest bearing deposits for 2009 contributed an additional 12 basis points to the reduction in net interest margin. For 2009, noninterest bearing deposits contributed 45 basis points to the net interest margin, as compared to 57 basis points during 2008.

In prior years, we terminated two sets of interest rate swaps. The combined gains at termination were $7.8 million, which are being accreted into income over the remaining life of the originally hedged items. The swaps added $2.0 million, $2.3 million and $1.9 million in interest income for the years ended December 31, 2010, 2009 and 2008, respectively. For 2011, we estimate the terminated swaps will add approximately $1.8 million to interest income.

We anticipate our net interest spread and net interest margin to stabilize and improve during 2011. However, improvement is dependent on multiple factors including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, maturities of brokered deposits, and any possible further action by the Federal Reserve Board to adjust the target federal funds rate.

Provision for Loan and Lease Losses

The provision for loan and lease losses charged to operations during 2010 increased $8.2 million to $33.6 million compared to $25.4 million in 2009 and $15.8 million in 2008. Net charge-offs totaled $36.1 million for 2010, $16.3 million for 2009 and $9.3 million for 2008. Net charge-offs as a percentage of average loans were 4.27% in 2010, 1.66% in 2009 and 0.93% in 2008 and our Bank’s peer group averages (as reported in the December 31, 2010 Uniform Bank Performance Report) were 1.27%, 1.53% and 0.80% in 2010, 2009 and 2008, respectively.

 

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The increase in our provision for loan and lease losses in 2010 relative to 2009 was a result of our analysis of inherent risks in the loan portfolio in relation to the portfolio’s growth, the level of impaired, past due, charged-off, classified and non-performing loans, as well as increased environmental risk factors due to the general economic conditions. During 2010, we experienced significantly higher charge-offs while continuing to increase the ratio of the allowance to total loans from 2.78% to 3.30%. In 2009, we significantly increased our allowance for loan and lease losses from 1.72% of total loans as of December 31, 2008 to 2.78% of total loans as of December 31, 2009. The provision expense associated with the reserve-building was approximately $3.8 million in 2010 and $10.1 million in 2009. As of December 31, 2010, we determined our allowance of $24.0 million was adequate to provide for credit losses, which we describe more fully below in the Allowance for Loan and Lease Loss section of MD&A.

We will continue to provide provision expense to maintain an allowance level adequate to absorb known and estimated losses inherent in our loan portfolio. As the determination of provision expense is a function of the adequacy of the allowance for loan and lease losses, we cannot reasonably estimate the provision expense for 2011. Furthermore, the provision expense could materially increase or decrease in 2011 depending on a number of factors, including, among others, the level of net charge-offs, the amount of classified loans and the value of collateral associated with impaired loans.

Noninterest Income

Total noninterest income for 2010 was $9.5 million compared to $10.3 million in 2009 and $11.7 million in 2008. The following table presents the components of noninterest income for years ended December 31, 2010, 2009 and 2008.

Noninterest Income

 

     For the Years Ended  
     2010      Percent
Change
    2009      Percent
Change
    2008  
     (in thousands, except percentages)  

Non-sufficient funds (NSF) fees

   $ 2,973         (16.3 )%    $ 3,550         (14.1 )%    $ 4,135   

Service charges on deposit accounts

     939         (14.0 )%      1,092         (5.0 )%      1,149   

Point-of-sale (POS) fees

     1,270         12.8     1,126         7.2     1,050   

Mortgage loan and related fees

     909         (11.3 )%      1,025         (29.0 )%      1,443   

Bank-owned life insurance income

     1,032         2.6     1,006         4.0     967   

Net gain (loss) on sales of available-for-sale securities

     57         100.0     —           (100.0 )%      146   

Other income

     2,323         (8.4 )%      2,536         (9.2 )%      2,792   
                                          

Total noninterest income

   $ 9,503         (8.1 )%    $ 10,335         (11.5 )%    $ 11,682   
                                          

Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including non-sufficient funds (NSF) fees, were $3.9 million, or 41% of total noninterest income for 2010, compared with $4.6 million, or 45% of total noninterest income for 2009, and $5.3 million, or 45% for 2008. While service charges and fees on deposit accounts typically correspond to the level and mix of our customer deposits, the implementation of the Dodd-Frank financial reform legislation may directly or indirectly impact the fee structure of our deposit products; therefore, we cannot reasonably estimate deposit fees for future periods.

Point-of-sale fees increased 13% to $1.3 million in 2010 compared to 2009. POS fees are primarily generated when our customers use their debit cards for retail purchases. We anticipate POS fees to continue to grow as customer trends show increased use of debit cards, although it is unclear if provisions affecting interchange fees for card issuers included in the Dodd-Frank financial reform legislation will have a future material impact on this product and its revenue.

 

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Mortgage loan and related fees for 2010 were $909 thousand, compared to $1.0 million in 2009 and $1.4 million in 2008. As discussed in Note 19 to our consolidated financial statements, we began electing the fair value option under applicable accounting guidance to our held for sale loan originations in February 2008. This election impacted the timing and recognition of origination fees and costs, as well as the value of the servicing rights. The recognition of the income is now concurrent with the origination of the loan. We believe the fair value option improves financial reporting by better aligning the underlying economic changes in value of the loans and related hedges to the reported results. Additionally, the election eliminates the complexities and inherent difficulties of achieving hedge accounting.

Our process to originate and sell a conforming mortgage in the secondary market typically takes 30 to 60 days from the date of mortgage origination to the date the mortgage is sold to an investor in the secondary market. Due to the normal processing time, we will have a certain amount of held for sale loans at any time. We sell these loans with the right to service the loan being released to the purchaser for a fee. Mortgages originated for sale in the secondary markets totaled $46.2 million for 2010, $61.1 million for 2009 and $67.0 million in 2008. Mortgages sold in the secondary market totaled $44.9 million for 2010, $61.5 million for 2009 and $69.8 million in 2008. We do not originate sub-prime loans. For 2011, we anticipate mortgage loan production to increase, however, provisions of the Dodd-Frank financial reform legislation may impact the pricing and competitive landscape of the mortgage market.

Bank-owned life insurance income remained stable at $1.0 million for 2010 compared to 2009 and increased from $967 thousand for 2008. The Company is the owner and beneficiary of these contracts. The income generated by the cash value of the insurance policies accumulates on a tax-deferred basis and is tax free to maturity. Additionally, the insurance death benefit will be a tax free payment to the Company. This tax-advantaged asset enables us to provide benefits to our employees. On a fully tax equivalent basis, the weighted average interest rate earned on the policies was 5.3% during 2010.

During 2010, we sold approximately $14.8 million of investment securities for a net gain of $57 thousand. During 2009, we did not sell any available-for-sale securities. During 2008, we sold approximately $13.1 million in senior unsecured debt issued by Freddie Mac and Fannie Mae for a gain of $146 thousand.

Other income for 2010 was $2.3 million, compared to the 2009 level of $2.5 million and the the 2008 level of $2.8 million. The components of other income primarily consist of ATM fee income, trust fee income, underwriting revenue, safe deposit box fee income and gains on sales of other real estate, repossessions, leased equipment and premises and equipment. Gains on sales declined $171 thousand and trust fees increased $30 thousand in 2010 compared to 2009. We anticipate our other income to be consistent or to increase in 2011.

Noninterest Expense

Total noninterest expense for 2010 was $45.2 million, compared to $68.8 million in 2009 and $40.4 million in 2008. Noninterest expense for 2009 included a full impairment to goodwill of $27.2 million. Excluding this one-time, non-cash expense, noninterest expense for 2009 was $41.7 million. For 2010, increases in FDIC insurance, losses and write-downs on nonperforming assets and professional fees offset the savings in salaries and benefits, furniture and equipment and other expense categories. The following table represents the components of noninterest expense for the years ended December 31, 2010, 2009 and 2008.

 

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Noninterest Expense

 

     For the Years Ended  
     2010      Percent
Change
    2009      Percent
Change
    2008  
     (in thousands, except percentages)  

Salaries and benefits

   $ 18,926         (6.5 )%    $ 20,246         (6.2 )%    $ 21,577   

Occupancy

     3,493         2.2     3,418         (2.5 )%      3,505   

Furniture and equipment

     2,032         (17.8 )%      2,473         (19.2 )%      3,059   

Professional fees

     3,144         47.8     2,127         22.0     1,744   

FDIC insurance

     3,803         103.8     1,866         196.7     629   

Data processing

     1,462         1.2     1,445         (1.2 )%      1,463   

Write-downs on other real estate owned and repossessions

     3,539         167.9     1,321         34.1     985   

Losses on other real estate owned, repossessions and fixed assets

     1,162         92.7     603         72.8     349   

OREO and repossession holding costs

     1,637         48.3     1,104         55.5     710   

Impairment of goodwill

     —           (100.0 )%      27,156         100.0     —     

Intangible asset amortization

     457         (5.8 )%      485         (39.1 )%      796   

Communications

     617         (13.8 )%      716         (0.6 )%      720   

Printing and supplies

     358         (10.3 )%      399         (3.2 )%      412   

Advertising

     155         (44.2 )%      278         (25.3 )%      372   

Other expense

     4,449         (14.6 )%      5,210         28.3     4,061   
                                          

Total noninterest expense

   $ 45,234         (34.3 )%    $ 68,847         70.5   $ 40,382   
                                          

Total salaries and benefits decreased $1.3 million, or 7%, in 2010 as compared to 2009. The decrease in salaries and benefits is primarily related to fewer full-time equivalent employees and cost savings in employee benefits including reducing the employer match on the 401(k) and ESOP Plan from 6% to 1% as of July 1, 2010. As of December 31, 2010, we had 37 full service banking offices with 311 full-time equivalent employees. As of December 31, 2009, we had 39 full service banking offices and one leasing/loan production facility with 347 full-time equivalent employees; as of December 31, 2008, we had 39 full service banking offices and three leasing offices with 361 full-time equivalent employees.

Total occupancy expense for 2010 increased by 2% compared with 2009, which was 3% less than total occupancy expense in 2008. The increase in 2010 was primarily due to higher insurance expense and increases in lease expense for branch locations. The decrease in 2009 was due to cost saving initiatives at our branch locations. As of December 31, 2010, we leased eight facilities and the land for five branches. As a result, occupancy expense is higher than if we owned these facilities, including the real estate, but conversely, we have been able to deploy the capital into earning assets rather than capital expenditures for facilities.

Furniture and equipment, communication, advertising, and printing and supplies expense decreased both in 2010 and 2009 due to cost controls implemented.

Professional fees increased by $1.0 million, or 48%, from 2009 to 2010, and increased by $383 thousand, or 22%, from 2008 to 2009. The increase in 2010 was primarily due to additional legal costs associated with the higher levels of non-performing assets. Professional fees also include fees related to investor relations, outsourcing compliance and information technology audits and a portion of internal audit to Professional Bank Services, as well as external audit, tax services and legal and accounting advice related to, among other things, foreclosures, lending activities, employee benefit programs, prospective capital offerings and regulatory matters. The increase in 2009 was primarily due to additional legal costs associated with the higher levels of non-performing assets and the arbitration settlement, described further below, as well as a fourth quarter 2009

 

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third-party loan review, as more fully described in the Asset Quality and Non-performing Assets section of MD&A. We anticipate professional fees to be consistent or lower for 2011.

The premium paid for FDIC deposit insurance increased $1.9 million to $3.8 million in 2010 compared to 2009. The expense in 2009 and 2008 was $1.9 million and $629 thousand, respectively. The increase for 2010 is an indirect result of the items in the Consent Order, including the deterioration of our asset quality and its impact on our financial results, among other items. For 2009, we recorded a $560 thousand charge for the FDIC special assessment that was paid on September 30, 2009. The remaining increase in 2009 was due to an across-the-board increase in the FDIC’s assessment calculation, which became effective in 2009 as well as our participation in the Temporary Liquidity Guarantee Program (TLGP), which is funded through add-on premium fees.

During the fourth quarter of 2009, the FDIC approved a rule mandating all banks prepay deposit premium insurance assessments for the three year period ending December 31, 2012. The total prepayment amount factored in an estimated five percent annual growth rate in the deposit base as well as a uniform three basis point increase in the assessment rate effective January 1, 2011. No additional cash payments or refunds are required or issued until the later of the date the prepayment is exhausted or December 30, 2014. The FDIC indicated that it intends the prepayment option to eliminate the need for additional special assessments. On December 31, 2009, we prepaid $6.0 million to the FDIC. The payment did not adversely impact our liquidity.

Data processing expense was consistent from 2009 to 2010. The monthly fees associated with data processing are typically based on transaction volume.

Write-downs on OREO and repossessions increased $2.2 million, or 167.9%, from 2009 to 2010, and increased $336 thousand, or 34.1% from 2008 to 2009. The increase is primarily related to larger write-downs on other real estate owned. At foreclosure or repossession, the fair value of the property is determined and a charge-off to the allowance is recorded, if applicable. Any decreases in value subsequent to the initial determination of fair value are recorded as a write-down. As a general policy, we re-assess the fair value of OREO and repossessions on at least an annual basis or sooner if indications exist that deterioration in value has occurred. Write-downs are based on property-specific appraisals or valuations. Write-downs for 2011 are dependent on real estate market conditions and our ability to liquidate properties.

Losses on OREO, repossessions and fixed assets increased $559 thousand, or 92.7% from 2009 to 2010, and increased $254 thousand, or 72.8% from 2008 to 2009. The majority of losses were related to sales of repossessions through the liquidation of equipment at our leasing subsidiaries. We anticipate increases in losses as nonperforming assets continue to increase as we seek to liquidate existing properties and repossessions in a timely manner.

OREO and repossession holding costs include, among other items, maintenance, repairs, utilities, taxes and storage costs. Holding costs increased $533 thousand, or 48.3%, from 2009 to 2010, and increased $394 thousand, or 55.5%, from 2008 to 2009. We anticipate the level of holding costs to remain elevated for 2011 with our increased amount of nonperforming assets.

Our policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Accounting guidance requires us to estimate the fair value in making the assessment of impairment at least annually. We engaged an independent valuation firm to assist in computing the fair value estimate for the goodwill as of September 30, 2009. The firm utilizes two separate valuation methodologies and compares the results of each methodology in order to determine the fair value of the goodwill associated with our prior acquisitions. The impairment testing is a two-step process. Step 1 compares the fair value of the reporting unit to the carrying value. If the fair value is below the carrying value, Step 2 is performed. Step 2 involves a process similar to business combination accounting in which fair values are assigned to all assets, liabilities and

 

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other (non-goodwill) intangibles. The result of Step 2 is the implied fair value of goodwill. If the implied fair value of goodwill is below the recorded goodwill amount, an impairment charge is recorded for the difference.

The results of the third-party goodwill assessment for 2009 indicated a full impairment and therefore we recorded a $27.2 million goodwill impairment as of September 30, 2009. The impairment was primarily a result of the continuing economic downtown and its implication on bank valuations. The one-time, non-cash accounting adjustment has no impact on cash flows, liquidity, tangible capital or our ability to conduct business. Additionally, as goodwill is excluded from regulatory capital, the impairment had no impact on the regulatory capital ratios of First Security or FSGBank.

Intangible asset amortization decreased by $28 thousand, or 5.8%, in 2010 as compared to 2009 and decreased $311 thousand, or 39%, in 2009 compared to 2008. The core deposit intangible assets amortize on an accelerated basis over an estimated useful life of ten years. The following table represents our anticipated intangible asset amortization over the next five years, excluding new acquisitions, if any.

 

     2011      2012      2013      2014      2015  
     (in thousands)  

Core deposit intangible amortization expense

   $ 479       $ 382       $ 270       $ 196       $ 134   

Other expense decreased by $761 thousand, or 14.6%, for 2010 compared to 2009 and increased $1.1 million, or 28%, in 2009 compared to 2008. The decline in 2010 is primarily as a result of the $500 thousand arbitration settlement in 2009, described below, as well as decreased credit reporting fees and franchise tax expense.

On January 19, 2010, we settled the $2.3 million arbitration claim involving the April 15, 2009 termination of employment of Lloyd L. Montgomery, III, our former President and Chief Operating Officer. The settlement agreed to pay Mr. Montgomery $500 thousand. The settlement amount was accrued in other expense during 2009. Through the settlement agreement, both parties agreed to release all claims against one another and to dismiss the arbitration claim with prejudice. The settlement agreement also provides that Mr. Montgomery’s confidentiality and non-solicitation obligations under his employment agreement shall remain in effect.

Income Taxes

We recorded income tax expense of $9.7 million in 2010 compared to tax benefits of $8.3 million in 2009 and $587 thousand in 2008. During 2010, we recorded a $24.6 million deferred tax valuation allowance to reduce our net deferred tax assets to an amount that we consider realizable. The remaining deferred tax asset is anticipated to be realized through available carryback tax periods. A valuation allowance is required when it is “more likely than not” that the deferred tax assets will not be realized. The evaluation requires significant judgment and extensive analysis of all available positive and negative evidence, the forecasts of future income, applicable tax planning strategies and assessments of the current and future economic and business conditions. We identified as positive evidence the existence of taxes paid in available carryback years. Negative evidence included a cumulative loss in recent years as well as current business trends. As conditions change, we will evaluate the need to increase or decrease the valuation allowance. Currently, we anticipate increasing the valuation allowance to offset any future recorded tax benefit to result in minimal, if any, income tax expense or benefit.

For 2009, our tax-exempt income from municipal securities and bank-owned life insurance was approximately $2.6 million. The goodwill impairment included $20.2 million that was not deductible for tax purposes. Excluding these non-taxable items, our pre-tax 2009 net loss would decrease to approximately $24.1 million, resulting in an effective tax rate of approximately 34%.

At December 31, 2010, we evaluated our significant uncertain tax positions. Under the “more-likely-than-not” threshold guidelines, we believe we have identified all significant uncertain tax benefits. We evaluate, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be accrued, in

 

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accordance with Internal Revenue Service guidelines, and recorded as a component of income tax expense in our consolidated financial statements. During 2009, we accrued $1.1 million for an uncertain tax position and approximately $155 thousand in associated interest and penalties. During 2010, certain tax refunds were withheld and applied to the disputed uncertain tax position. As of December 31, 2010, the accrual for uncertain tax positions, including accumulated interest and penalties, totaled $1.0 million.

Statement of Financial Condition

Our total assets were $1.2 billion at December 31, 2010, a decrease of $184.9 million, or 14%, over 2009. The decline in assets was concentrated in our loan portfolio, which declined nearly $225 million during 2010. The decline in loans was partially offset by an increase in interest-bearing deposits in banks, primarily our cash account at the Federal Reserve Bank of Atlanta. During 2011, we anticipate that our total assets will continue to decline as brokered deposits mature and are primarily funded with our current cash reserves. Additionally, we anticipate funding prudent investment opportunities through growth in core deposits and with our existing cash reserves.

Loans

The effects of the economic recession, as well as our active efforts to reduce certain credit exposures and their related balance sheet risk, resulted in declining loan balances during 2010.

During 2010, total loans declined $224.9 million, or 24%, compared to year-end 2009. During 2010, we reduced our exposure to construction and land development loans by $68.9 million, or 45%, and commercial and industrial loans by $63.2 million, or 43%. Commercial real estate loans declined by $33.5 million, or 13%, and residential 1-4 family loans declined by $29.3 million, or 10%. All other loan categories declined as well.

During 2009, total loans declined $59.6 million, or 6%, compared to year-end 2008. During 2009, we actively reduced our exposure to construction and land development loans by $41.5 million, or 21%, and commercial leases by $11.1 million, or 36% compared to December 31, 2008. Most other loan categories declined during 2009 as a result of the economic recession. Commercial real estate loans increased by $25.2 million, or 11%, during 2009. A majority of this growth was in owner-occupied commercial real estate.

During the first quarter of 2011, we launched an advertising campaign aimed at generating loan demand and attracting new credit-worthy customers. We anticipate our loans to stabilize during 2011. However, funding of future loans may be restricted by our ability to raise core deposits, although we may use our current cash reserves, as necessary and appropriate. Loan growth may also be restricted by the necessity for us to maintain appropriate capital levels, as well as adequate liquidity.

 

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The following table presents a summary of the loan portfolio by category for the last five years.

Loans Outstanding

 

    As of December 31,  
    2010     Percent
Change
    2009     Percent
Change
    2008     Percent
Change
    2007     Percent
Change
    2006  
    (in thousands, except percentages)  

Loans secured by real estate-

                 

Residential 1-4 family

  $ 252,026        (10.4 )%    $ 281,354        (5.1 )%    $ 296,454        13.0   $ 262,373        6.7   $ 246,005   

Commercial

    226,357        (12.9 )%      259,819        10.7     234,630        10.7     211,931        29.4     163,836   

Construction

    84,232        (45.0 )%      153,144        (21.3 )%      194,603        (10.1 )%      216,583        27.7     173,652   

Multi-family and farmland

    36,393        (4.1 )%      37,960        10.8     34,273        91.6     17,887        (12.9 )%      20,544   
                                                                       
    599,008        (18.2 )%      732,277        (3.6 )%      759,960        7.2     708,774        17.3     604,037   

Commercial loans

    82,807        (43.3 )%      146,016        (7.5 )%      157,906        14.4     138,015        13.7     121,385   

Consumer loans

    33,860        (30.8 )%      48,927        (16.1 )%      58,296        (7.7 )%      63,156        (6.9 )%      67,858   

Leases, net of unearned income

    7,916        (59.9 )%      19,730        (36.1 )%      30,873        (25.8 )%      41,587        (20.1 )%      52,039   

Other

    3,500        (30.9 )%      5,068        11.4     4,549        189.2     1,573        (30.8 )%      2,274   
                                                                       

Total loans

    727,091        (23.6 )%      952,018        (5.9 )%      1,011,584        6.1     953,105        12.4     847,593   

Allowance for loan and lease losses

    (24,000     (9.4 )%      (26,492     52.4     (17,385     58.7     (10,956     9.9     (9,970
                                                                       

Net loans

  $ 703,091        (24.0 )%    $ 925,526        (6.9 )%      994,199        5.5   $ 942,149        12.5   $ 837,623   
                                                                       

Substantially all of our loans are to customers located in Georgia and Tennessee, in our immediate markets. We believe that we are not dependent on any single customer or group of customers whose insolvency would have a material adverse effect on operations. We also believe that the loan portfolio is diversified among loan collateral types, as noted by the following table.

Loans by Collateral Type

 

    As of December 31,  
    2010     % of
Loans
    2009     % of
Loans
    2008     % of
Loans
    2007     % of
Loans
    2006     % of
Loans
 
    (in thousands, expect percentages)  

Secured by real estate:

                   

Construction and land development

  $ 84,232        11.6   $ 153,144        16.1   $ 194,603        19.2   $ 216,583        22.7   $ 173,652        20.5

Farmland

    11,793        1.6     12,077        1.3     11,470        1.1     6,870        0.7     10,243        1.2

Home equity lines of credit

    81,742        11.2     88,770        9.3     88,708        8.8     80,326        8.4     76,872        9.1

Residential first liens

    161,622        22.2     181,740        19.1     196,734        19.4     172,003        18.0     159,172        18.8

Residential junior liens

    8,662        1.2     10,844        1.1     11,012        1.1     10,044        1.1     9,961        1.2

Multi-family residential

    24,600        3.4     25,883        2.7     22,803        2.3     11,017        1.2     10,301        1.2

Non-farm and non-residential

    226,357        31.1     259,819        27.3     234,630        23.2     211,931        22.3     163,836        19.3
                                                                               

Total Real Estate

    599,008        82.3     732,277        76.9     759,960        75.1     708,774        74.4     604,037        71.3
                                                                               

Other loans:

                   

Commercial—leases, net of unearned

    7,916        1.1     19,730        2.1     30,873        3.1     41,587        4.4     52,039        6.1

Commercial and industrial

    82,807        11.4     146,016        15.4     157,906        15.6     138,015        14.5     121,385        14.3

Agricultural production

    1,165        0.2     2,151        0.2     1,945        0.1     1,344        0.1     1,962        0.2

Credit cards and other revolving credit

    —          —       —          —       —          —       —          —       1,513        0.2

Consumer installment loans

    33,860        4.7     48,927        5.1     58,296        5.8     63,156        6.6     66,345        7.8

Other

    2,335        0.3     2,917        0.3     2,604        0.3     229        0.0     312        0.1
                                                                               

Total other loans

    128,083        17.7     219,741        23.1     251,624        24.9     244,331        25.6     243,556        28.7
                                                                               

Total loans

  $ 727,091        100.0   $ 952,018        100.0   $ 1,011,584        100.0   $ 953,105        100.0   $ 847,593        100.0
                                                                               

 

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The following table sets forth the maturity distribution of the loan portfolio as of December 31, 2010. Our loan policy does not permit automatic roll-over of matured loans.

 

     Less than
three
months
     Over three
months to
twelve
months
     One year
to five
years
     Over five
years
     Total  
     (in thousands)  

Construction and land development loans

   $ 40,454       $ 28,399       $ 15,379       $ —         $ 84,232   

Commercial and industrial loans

     29,267         26,295         27,188         57         82,807   

All other loans

     63,285         74,410         361,265         61,092         560,052   
                                            

Total

   $ 133,006       $ 129,104       $ 403,832       $ 61,149       $ 727,091   
                                            

Allowance for Loan and Lease Losses

Allowance—Overview

The allowance for loan and lease losses reflects our assessment and estimate of the risks associated with extending credit and our evaluation of the quality of the loan portfolio. We regularly analyze our loan portfolio in an effort to establish an allowance that we believe will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, we review the size, quality and risk of loans in the portfolio. We also consider such factors as:

 

   

our loan loss experience;

 

   

specific known risks;

 

   

the status and amount of past due and non-performing assets;

 

   

underlying estimated values of collateral securing loans;

 

   

current and anticipated economic conditions; and

 

   

other factors which we believe affect the allowance for potential credit losses.

The allowance is composed of three primary components: (1) specific impairments for substandard/nonaccrual loans and leases, (2) general allocations for classified loan pools, including special mention and substandard/accrual loans, and (3) general allocations for the remaining pools of loans. We accumulate pools based on the underlying classification of the collateral. Each pool is assigned a loss severity rate based on historical loss experience and various qualitative and environmental factors, including, but not limited to, credit quality and economic conditions.

An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan and lease losses is prepared by our accounting and credit administration departments and presented to our Board of Directors on a quarterly basis. Based on our analysis, we may determine that our provision expense needs to increase or decrease in order for us to remain adequately reserved for probable loan losses. As stated earlier, we make this determination after considering both quantitative and qualitative factors under appropriate regulatory and accounting guidelines.

Our allowance for loan and lease losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance compared to a group of peer banks. During their routine examinations of banks, the regulators may require a bank to make additional provisions to its allowance for loan losses when, in the opinion of the regulators, their credit evaluations and allowance methodology differ materially from the bank’s methodology. We believe our allowance methodology is in compliance with regulatory interagency guidance as well as applicable GAAP guidance.

 

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While it is our policy to charge-off all or a portion of certain loans in the current period when a loss is considered probable, there are additional risks of future losses that cannot be quantified precisely or attributed to particular loans or classes of loans. Because the assessment of these risks includes assumptions regarding local and national economic conditions, our judgment as to the adequacy of the allowance is necessarily approximate and imprecise.

Allowance—Loan Pools

As indicated in the Allowance—Overview above, we analyze our allowance by segregating our portfolio into three primary categories: impaired, classified and pass risk rated loans. Impaired loans are individually evaluated, as further discussed below. Classified loans are segregated first by loan risk rating and then into homogeneous pools based on loan type, collateral or purpose of proceeds. Non-classified loans are grouped into homogeneous pools based on loan type, collateral or purpose of proceeds. We believe our loan pools conform to regulatory and accounting guidelines.

Impaired loans generally include those loan relationships in excess of $500 thousand with a risk rating of substandard/nonaccrual or doubtful. For these loans, we determine the impairment based upon one of the following methods: (1) discounted cash flows, (2) observable market pricing or (3) the fair value of the collateral. The amount of the estimated loss, if any, is then specifically reserved in a separate component of the allowance unless the relationship is considered collateral dependent, in which the estimated loss is charged-off in the current period.

For classified loans, we first separate into the loan risk rating classifications of special mention and substandard. These two groups are then further segregated into homogeneous pools based on loan type, collateral or purpose of proceeds. Each of these pools is evaluated individually and is assigned a loss factor based on our best estimate of the loss that potentially could be realized in that pool of loans. The loss factor is the sum of an objectively calculated historical loss percentage and a subjectively calculated risk percentage. The actual annual historical loss factor is typically a weighted average of each period’s loss. For the historical loss factor, we utilize a migration loss analysis. Each period may be assigned a different weight depending on certain trends and circumstances. The subjectively calculated risk percentage is the sum of eight qualitative and environmental risk categories. These categories are evaluated separately for each pool. The eight risk categories are: (1) underlying collateral value, (2) lending practices and policies, (3) local and national economies, (4) portfolio volume and nature, (5) staff experience, (6) credit quality, (7) loan review and (8) competition, regulatory and legal issues.

Allowance—Loan Risk Ratings

A consistent and appropriate loan risk rating methodology is a critical component of the allowance. We classify loans as: pass, special mention, substandard, doubtful or loss. The following describes our loan classifications and the various risk indicators associated with each risk rating.

A pass rating is assigned to those loans that are performing as contractually agreed and do not exhibit the characteristics of the criticized and classified risk ratings as defined below. Pass loan pools do not include the unfunded portions of binding commitments to lend, standby letters of credit, deposit secured loans or mortgage loans originated with commitments to sell in the secondary market. Loans secured by segregated deposits held by FSGBank are not required to have an allowance reserve, nor are originated held-for-sale mortgage loans pending sale in the secondary market.

A special mention loan risk rating is considered criticized but is not considered as severe as a classified loan risk rating. Special mention loans contain one or more potential weakness(es), which if not corrected, could result in an unacceptable increase in credit risk at some future date. These loans may be characterized by the following risks and/or trends:

Loans to Businesses:

 

   

Downward trend in sales, profit levels and margins

 

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Impaired working capital position compared to industry

 

   

Cash flow strained in order to meet debt repayment schedule

 

   

Technical defaults due to noncompliance with financial covenants

 

   

Recurring trade payable slowness

 

   

High leverage compared to industry average with shrinking equity cushion

 

   

Questionable abilities of management

 

   

Weak industry conditions

 

   

Inadequate or outdated financial statements

Loans to Businesses or Individuals:

 

   

Loan delinquencies and overdrafts may occur

 

   

Original source of repayment questionable

 

   

Documentation deficiencies may not be easily correctable

 

   

Loan may need to be restructured

 

   

Collateral or guarantor offers adequate protection

 

   

Unsecured debt to tangible net worth is excessive

A substandard loan risk rating is characterized as having specifically identified weaknesses and deficiencies typically resulting from severe adverse trends of a financial, economic, or managerial nature, and may warrant non-accrual status. Substandard loans have a greater likelihood of loss and may require a protracted work-out plan. In addition to the factors listed for special mention loans, substandard loans may be characterized by the following risks and/or trends:

Loans to Businesses:

 

   

Sustained losses that have severely eroded equity and cash flows

 

   

Concentration in illiquid assets

 

   

Serious management problems or internal fraud

 

   

Chronic trade payable slowness; may be placed on COD or collection by trade creditor

 

   

Inability to access other funding sources

 

   

Financial statements with adverse opinion or disclaimer; may be received late

 

   

Insufficient documented cash flows to meet contractual debt service requirements

Loans to Businesses or Individuals:

 

   

Chronic or severe delinquency or has met the retail classification standards which is generally past dues greater than 90 days

 

   

Frequent overdrafts

 

   

Likelihood of bankruptcy exists

 

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Serious documentation deficiencies

 

   

Reliance on secondary sources of repayment which are presently considered adequate

 

   

Demand letter sent

 

   

Litigation may have been filed against the borrower

Loans with a risk rating of doubtful are individually analyzed to determine our best estimate of the loss based on the most recent assessment of all available sources of repayment. Doubtful loans are considered impaired and placed on nonaccrual. For doubtful loans, the collection or liquidation in full of principal and/or interest is highly questionable or improbable. We estimate the specific potential loss based upon an individual analysis of the relationship risks, the borrower’s cash flow, the borrower’s management and any underlying secondary sources of repayment. The amount of the estimated loss, if any, is then either specifically reserved in a separate component of the allowance or charged-off. In addition to the characteristics listed for substandard loans, the following characteristics apply to doubtful loans:

Loans to Businesses:

 

   

Normal operations are severely diminished or have ceased

 

   

Seriously impaired cash flow

 

   

Numerous exceptions to loan agreement

 

   

Outside accountant questions entity’s survivability as a “going concern”

 

   

Financial statements may be received late, if at all

 

   

Material legal judgments filed

 

   

Collection of principal and interest is impaired

 

   

Collateral/Guarantor may offer inadequate protection

Loans to Businesses or Individuals:

 

   

Original repayment terms materially altered

 

   

Secondary source of repayment is inadequate

 

   

Asset liquidation may be in process with all efforts directed at debt retirement

 

   

Documentation deficiencies not correctable

The consistent application of the above loan risk rating methodology ensures we have the ability to track historical losses and appropriately estimate potential future losses in our allowance. Additionally, appropriate loan risk ratings assist us in allocating credit and special asset personnel in the most effective manner. Significant changes in loan risk ratings can have a material impact on the allowance and thus a material impact on our financial results by requiring significant increases or decreases in provision expense.

Allowance—Analysis and Discussion

The following table presents an analysis of the changes in the allowance for loan and lease losses for the past five years. The provision for loan and lease losses in the table below does not include our provision accrual for unfunded commitments of $24 thousand, $24 thousand, $24 thousand, $40 thousand and $120 thousand for 2010, 2009, 2008, 2007 and 2006, respectively. The reserve for unfunded commitments is included in other liabilities in our consolidated balance sheets and totaled $229 thousand and $205 thousand as of December 31, 2010 and 2009, respectively.

 

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Analysis of Changes in Allowance for Loan and Lease Losses

 

    For the Years Ending December 31,  
    2010     2009     2008     2007     2006  
    (in thousands, except percentages)  

Allowance for loan and lease losses—

         

Beginning of period

  $ 26,492      $ 17,385      $ 10,956      $ 9,970      $ 10,121   

Provision for loan and lease losses

    33,589        25,380        15,729        2,115        2,064   
                                       

Sub-total

    60,081        42,765        26,685        12,085        12,185   
                                       

Charged-off loans:

         

Real estate—residential 1-4 family

    2,572        1,778        1,492        216        751   

Real estate—commercial

    2,955        1,505        —          107        1   

Real estate—construction

    10,514        1,801        982        44        24   

Real estate—multi-family and farmland

    1,150        58        —          100        12   

Commercial loans

    16,420        8,109        3,468        133        943   

Consumer installment loans and other

    1,110        1,217        2,350        575        535   

Leases, net of unearned income

    2,050        2,214        1,227        692        455   
                                       

Total charged-off

    36,771        16,682        9,519        1,867        2,721   
                                       

Recoveries of charged-off loans:

         

Real estate—residential 1-4 family

    56        35        25        103        47   

Real estate—commercial

    160        9        —          91        101   

Real estate—construction

    7        23        1        2        —     

Real estate—multi-family and farmland

    —          3        6        7        1   

Commercial loans

    326        166        15        256        83   

Consumer installment loans and other

    141        167        172        222        269   

Leases, net of unearned income

    —          6        —          57        5   
                                       

Total recoveries

    690        409        219        738        506   
                                       

Net charged-off loans

    36,081        16,273        9,300        1,129        2,215   
                                       

Allowance for loan and lease losses—end of period

  $ 24,000      $ 26,492      $ 17,385      $ 10,956      $ 9,970   
                                       

Total loans—end of period

  $ 727,091      $ 952,018      $ 1,011,584      $ 953,105      $ 847,593   

Average loans

  $ 845,945      $ 977,758      $ 997,371      $ 940,490      $ 796,866   

Net loans charged-off to average loans

    4.27     1.66     0.93     0.12     0.28

Provision for loan and lease losses to average loans

    3.97     2.60     1.58     0.22     0.25

Allowance for loan and lease losses as a
percentage of:

         

Period end loans

    3.30     2.78     1.72     1.15     1.18

Non-performing loans

    40.73     53.01     82.16     193.53     250.63

 

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The following table presents the allocation of the allowance for loan and lease losses for each respective loan category with the corresponding percent of loans in each category to total loans. The comprehensive allowance analysis jointly developed by our credit administration and accounting groups enable us to allocate the allowance based on risk elements within the portfolio. The unallocated reserve is available as a general reserve against the entire loan portfolio and is related to factors such as current economic conditions which are not directly associated with a specific loan category.

Allocation of the Allowance for Loan and Lease Losses

 

    As of December 31,  
    2010     2009     2008     2007     2006  
    Amount     Percent
of
Portfolio1
    Amount     Percent
of
Portfolio1
    Amount     Percent
of
Portfolio1
    Amount     Percent
of
Portfolio1
    Amount     Percent
of
Portfolio1
 
    (in thousands, except percentages)  

Real estate—residential 1-4 family

  $ 7,346        34.7   $ 5,037        29.6   $ 3,760        29.3   $ 2,183        27.5   $ 1,786        29.1

Real estate—commercial

    5,550        31.1     4,525        27.3     2,599        23.2     1,350        22.2     1,483        19.3

Real estate—construction

    2,905        11.6     6,706        16.0     3,919        19.2     1,594        22.7     1,613        20.5

Real estate—multi-family and farmland

    761        5.0     766        4.0     366        3.4     163        1.9     170        2.4

Commercial loans

    5,692        11.4     6,953        15.4     3,149        15.6     2,638        14.5     2,278        14.3

Consumer loans

    813        4.7     1,107        5.1     872        5.8     778        6.6     841        8.0

Leases, net of unearned income

    917        1.1     1,386        2.1     2,588        3.1     2,134        4.4     1,639        6.1

Other and unallocated

    16        0.4     12        0.5     132        0.4     116        0.2     160        0.3
                                                                               

Total

  $ 24,000        100.0   $ 26,492        100.0   $ 17,385        100.0   $ 10,956        100.0   $ 9,970        100.0
                                                                               

 

1 

Represents the percentage of loans in each category to total loans.

Over the last two years, our allowance as a percentage of total loans significantly increased due to higher levels of non-performing loans and the elevated level of charge-offs during 2010. The allowance to total loans increased to 3.30% as of December 31, 2010, compared to 2.78% as of December 31, 2009 and 1.72% as of December 31, 2008. As of December 31, 2010, $23.5 million of the allowance was associated with general reserves and $457 thousand was associated with specific reserves.

 

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The following table provides the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of December 31, 2010:

 

     Pass      Special
Mention
     Substandard –
Non-impaired
     Substandard –
Impaired
     Total  
     (in thousands)  

Loans by Classification

              

Real estate: Residential 1-4 family

   $ 217,470       $ 7,378       $ 25,234       $ 1,944       $ 252,026   

Real estate: Commercial

     182,584         18,030         17,511         8,232         226,357   

Real estate: Construction

     46,305         3,970         10,048         23,909         84,232   

Real estate: Multi-family and farmland

     30,835         3,238         1,905         415         36,393   

Commercial

     54,456         4,330         20,281         3,740         82,807   

Consumer

     31,238         43         1,156         1,423         33,860   

Leases, net of unearned income

     —           2,085         3,888         1,943         7,916   

Other

     3,464         —           36         —           3,500   
                                            

Total Loans

   $ 566,352       $ 39,074       $ 80,059       $ 41,606       $ 727,091   
                                            

As of December 31, 2010, the largest components of the allowance were associated with 1-4 family residential real estate loans, commercial loans and commercial real estate loans. These classifications have higher levels of substandard, non-impaired loans. These loans are subject to general allowance allocations based on historical loss and qualitative and environmental factors. The allowance allocation associated with construction and land development loans declined by $3.8 million during 2010. This is a result of significant charge-offs during 2010 as well as an elevated level of substandard, impaired loans at year-end. During the third quarter of 2010, management, in consultation with bank regulators, identified various loan relationships that had previously been evaluated utilizing the present value of future cash flow that were more appropriately evaluated as collateral-dependent relationships. Changing the impairment method on these relationships resulted in a significant number of charge-offs during the third quarter of 2010. Additionally, the third quarter of 2010 impairment analysis of one commercial loan relationship resulted in a $9.5 million charge-off. The underlying financial condition of the borrower was unable to support the unsecured portion of this relationship and therefore, the entire unsecured portion was charged-off. The elevated level of charge-offs in 2010 will continue to impact the loss factors within the allowance during future periods.

We believe that the allowance for loan and lease losses at December 31, 2010 is sufficient to absorb losses inherent in the loan portfolio based on our assessment of the information available, including the results of extensive internal and independent reviews of our loan portfolio, as discussed in the Asset Quality and Non-Performing Asset section below. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examinations, may require additional charges to the provision for loan losses in future periods if the results of their reviews warrant.

Asset Quality and Non-Performing Assets

Asset Quality Strategic Initiatives for 2009, 2010 and Beyond

Our ability to return to profitability is largely dependent on properly addressing and improving asset quality. As of December 31, 2010, our loan portfolio was 62.2% of total assets. Over the past twelve to eighteen months, we implemented several significant strategies to further address our asset quality, including:

 

   

Hired a new Chief Credit Officer

 

   

Restructured and expanded our credit department, including special assets

 

   

Developed centralized underwriting, document preparation and collections processes

 

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Conducted a third-party loan review

 

   

Hired an experienced special assets officer

 

   

Expanded our loan review department, and

 

   

Outsourced the marketing and sales of residential OREO to market-leading real estate firms

During the fourth quarter of 2009, we began the process of restructuring our credit administration department to add additional depth and expertise. Specifically, the credit department is now aligned by line of business for commercial and retail credit with dedicated credit officers and staff supporting each of these portfolios. The chief credit officer will serve to support both senior credit officers.

With the additional depth and expertise of the restructured credit department, we have centralized our loan underwriting, document preparation and collections processes. This centralization will improve consistency, increase quality and provide higher levels of operational efficiencies. Collectively, we believe these changes will assist in reducing current and future non-performing assets.

During the fourth quarter of 2009, we engaged an independent consulting firm to conduct an extensive loan review. The primary purpose of the loan review was to evaluate individual credits for compliance with credit and underwriting standards, and to assess the potential impairment of certain credits in which we might experience additional risks of loss.

Our internal loan review department performs risk-based reviews and historically targets 60% to 70% of our portfolio over an 18-month cycle. In the last twelve months, we have added two experienced loan review employees to our loan review department. During 2010, we achieved the 60% to 70% review of our portfolio over a 12-month cycle, focusing on a risk-based approach. We anticipate similar coverage during 2011.

During the second half of 2010, we outsourced the marketing and sales process over our OREO properties to market leading real estate companies. We anticipate higher volumes of OREO sales in 2011.

We believe the above loan review and credit initiatives will enable us to improve our asset quality over time through a more timely recognition of problem relationships. Additionally, we believe the expanded special assets department will allow us to manage the problem relationships in a more efficient and effective manner to ultimately reduce future loan losses.

Asset Quality and Non-Performing Assets Analysis and Discussion

Our asset quality ratios weakened in 2010 compared to 2009. As of December 31, 2010, our allowance for loan and lease losses as a percentage of total loans was 3.30% compared to 2.78% as of December 31, 2009. Net charge-offs were 4.27% of average loans for 2010 compared to 1.66% for 2009. Non-performing loans to total loans was 8.10% as of year-end 2010 compared to 5.25% as of year-end 2009. Non-performing assets as a percentage of total assets was 6.78% at year-end 2010 compared to 4.78% at year-end 2009. The allowance as a percentage of total non-performing loans was 40.73% as of year-end 2010 compared to 53.01% for 2009.

Non-performing assets include non-accrual loans, restructured loans, OREO and repossessed assets. We place loans on non-accrual status when we have concerns related to our ability to collect the loan principal and interest, and generally when such loans are 90 days or more past due. The following table presents our non-performing assets and related ratios.

 

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Nonperforming Assets

 

     As of December 31,  
     2010     2009     2008     2007     2006  
     (in thousands, except percentages)  

Nonaccrual loans

   $ 54,082      $ 45,454      $ 18,453      $ 3,372      $ 2,653   

Loans past due 90 days and still accruing

     4,838        4,524        2,706        2,289        1,325   
                                        

Total nonperforming loans

   $ 58,920      $ 49,978      $ 21,159      $ 5,661      $ 3,978   
                                        

Other real estate owned

   $ 24,399      $ 15,312      $ 7,145      $ 2,452      $ 1,982   

Repossessed assets

     763        3,881        1,680        1,834        2,231   

Nonaccrual loans

     54,082        45,454        18,453        3,372        2,653   
                                        

Total nonperforming assets

   $ 79,244      $ 64,647      $ 27,278      $ 7,658      $ 6,866   
                                        

Nonperforming loans as a percentage of total loans

     8.10     5.25     2.09     0.59     0.47

Nonperforming assets as a percentage of total assets

     6.78     4.78     2.14     0.63     0.61

Nonperforming assets and loans 90 days past due to total assets

     7.20     5.11     2.35     0.82     0.72

The following table provides further information, including classification, for nonaccrual loans and other real estate owned for the past three years.

Non-Performing Assets—Classification and Number of Units

 

     December 31, 2010      December 31, 2009      December 31, 2008  
     Amount      Units      Amount      Units      Amount      Units  
     (in thousands, except units)  

Nonaccrual loans

                 

Construction/development loans

   $ 25,586         56       $ 13,706         36       $ 9,037         20   

Residential real estate loans

     8,906         84         6,059         52         2,649         10   

Commercial real estate loans

     10,007         30         6,156         26         1,991         9   

Commercial and industrial loans

     4,228         26         15,397         38         1,228         10   

Commercial leases

     3,459         59         2,389         20         3,523         5   

Consumer and other loans

     1,896         18         1,747         15         25         3   
                                                     

Total

   $ 54,082         273       $ 45,454         187       $ 18,453         57   
                                                     

Other real estate owned

                 

Construction/development loans

   $ 10,821         67       $ 6,023         37       $ 4,564         27   

Residential real estate loans

     8,266         63         4,647         34         1,143         9   

Commercial real estate loans

     5,312         20         4,642         14         1,438         4   
                                                     

Total

   $ 24,399         150       $ 15,312         85       $ 7,145         40   
                                                     

Nonaccrual loans totaled $54.1 million, $45.5 million and $18.5 million as of December 31, 2010, 2009 and 2008, respectively. We place loans on nonaccrual when we have concerns relating to our ability to collect the loan principal and interest, and generally when loans are 90 or more days past due. As previously described, we have individually reviewed each nonaccrual relationship in excess of $500 thousand for possible impairment. We measure impairment by adjusting the loans to either the present value of expected cash flows, the fair value of the collateral or observable market prices. As of December 31, 2010, the book value of impaired loans totaled $41.6 million. The associated unpaid principal balances of the impaired loans totaled $59.2 million. As of December 31, 2010, the book value of impaired loans reflected an approximately 30% discount through previously recorded partial charge-offs and specific reserves currently in the allowance.

 

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From year-end 2009 to year-end 2010, nonaccrual loans increased by $8.6 million, or 19%. As shown above, construction and land development nonaccrual loans increased by $11.9 million to $25.6 million comparing year-end 2009 to year-end 2010. This increase is primarily attributable to four relationships totaling $10.1 million in our Knoxville market area. Commercial and industrial nonaccrual loans declined by $11.2 million from year-end 2009 to year-end 2010. The decline is primarily associated with a $9.5 million charge-off recorded in the third quarter of 2010 on one relationship. We are actively pursuing the appropriate strategies to reduce the current level of nonaccrual loans through longer-term reworks of the credits, charge-offs and/or foreclosure.

Other real estate owned increased to $24.4 million as of December 31, 2010 compared to $15.3 million as of December 31, 2009. The $9.1 million increase from year-end 2009 to year-end 2010 is a reflection of new OREO properties exceeding the amount of properties that we have sold. For 2010, we sold 36 properties for $5.6 million, resulting in a 98% realization of the carrying value prior to sale and a 76% realization of the original loan balance. We anticipate taking a more aggressive sales approach during 2011 to dispose of our current properties, which may lead to a lower realization rate.

Loans 90 days past due and still accruing were $4.8 million as of December 31, 2010 compared to $4.5 million as of December 31, 2009. Of these past due loans as of December 31, 2010, commercial real estate loans totaled $3.3 million, or 67% of the total past dues.

As of December 31, 2010, we owned repossessed assets, which are carried at fair value less anticipated selling costs, in the amount of $763 thousand compared to $3.9 million as of December 31, 2009. The majority of our repossessions are related to our leasing portfolio that primarily includes trucking and construction equipment leases.

Our asset quality ratios are less favorable compared to our peer group. Our peer group, as defined by the Uniform Bank Performance Report (UBPR), consists of all commercial banks between $1 billion and $3 billion in total assets. The following table provides our asset quality ratios as of December 31, 2010 compared to our UBPR peer group ratios.

Asset Quality Ratios

 

     First
Security
    UBPR
Peer
Group
 

Allowance for loan and lease losses to total loans

     3.30     2.12

Non-performing loans1 as a percentage of gross loans

     8.10     3.68

Non-performing loans1 as a percentage of the allowance

     245.50     161.45

Non-performing loans1 as a percentage of equity capital

     63.10     25.25

Non-performing loans1 plus OREO as a percentage of gross loans plus OREO

     11.09     4.91

 

1 

Non-performing loans consist of nonaccrual loans and loans 90 days past due that are still accruing.

We believe the positive economic growth within our market area, as discussed in the Overview section, may stabilize and possibly increase real estate values, as well as provide increased overall economic activity in our largest region. Additionally, we believe the strategic initiatives that we are executing within our credit and underwriting functions will also positively impact our ability to reduce our current and future nonperforming assets and improve the related asset quality ratios.

Investment Securities and Other Earning Assets

The composition of our securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. Our securities portfolio also provides a

 

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balance to interest rate risk and credit risk in other categories of our consolidated balance sheet while providing a vehicle for investing available funds, furnishing liquidity and supplying securities to pledge as required collateral for certain deposits and borrowed funds. Currently, all of our investments are classified as available-for-sale. As of December 31, 2010, we had no plans to liquidate a significant amount of any securities; however, the securities classified as available-for-sale may be used for liquidity purposes should management deem it to be in our best interest.

Securities in our portfolio totaled $154.2 million at December 31, 2010, compared to $143.0 million at December 31, 2009. We believe our current level of investment securities provides an appropriate level of liquidity and provides a proper balance to our interest rate and credit risk in our loan portfolio. As of December 31, 2010, the available-for-sale securities portfolio had unrealized gains of approximately $1.9 million, net of tax, as compared to unrealized gains of $2.7 million, net of tax, at December 31, 2009. Our securities portfolio at December 31, 2010 consisted of tax-exempt municipal securities, federal agency bonds, federal agency issued Real Estate Mortgage Investment Conduits (REMICs) and federal agency issued pools. We sold our collateralized mortgage obligations during 2010 in our sale of approximately $14.8 million of investment securities.

The following table provides the amortized cost of our securities, as of December 31, 2010, by their stated maturities (this maturity schedule excludes security prepayment and call features), as well as the tax equivalent yields for each maturity range.

Maturity of AFS Investment Securities—Amortized Cost

 

     Less than
One Year
    One Year to
Five Years
    Five Years to
Ten Years
    More than
Ten Years
    Totals  
     (in thousands, except percentages)  

Municipal—tax exempt

   $ 2,169      $ 15,409      $ 12,919      $ 4,203      $ 34,700   

Agency bonds

     —          18,480        13,487        —          31,967   

Agency issued REMICs

     7,138        35,297        2,779        —          45,214   

Agency issued mortgage pools

     346        28,254        8,636        2,065        39,301   

Other

     —          —          —          127        127   
                                        

Total

   $ 9,653      $ 97,440      $ 37,821      $ 6,395      $ 151,309   
                                        

Tax equivalent yield

     5.16     3.68     3.85     5.93     3.92

The following table details our investment portfolio by type of investment.

Investment Securities by Type—Amortized Cost

 

     As of December 31,  
     2010      2009      2008  
     (in thousands)  

Securities available-for-sale

        

Debt securities—

        

Federal agencies

   $ 31,967       $ 17,226       $ 8,500   

Mortgage-backed

     84,515         80,338         85,878   

Municipals

     34,700         41,216         43,053   

Other

     127         126         125   
                          

Total

   $ 151,309       $ 138,906       $ 137,556   
                          

 

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We currently have the ability and intent to hold our available-for-sale investment securities to maturity. However, should conditions change, we may sell unpledged securities. We consider the overall quality of the securities portfolio to be high. All securities held are historically traded in liquid markets, except for one bond. This $250 thousand investment is a Qualified Zone Academy Bond (within the meaning of Section 1379E of the Internal Revenue Code of 1986, as amended) issued by The Health, Educational and Housing Facility Board of the County of Knox under the authority from the State of Tennessee.

As of December 31, 2010, we performed an impairment assessment of the securities in our portfolio that had an unrealized loss to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) we intend to sell the security, (2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis or (3) we do not expect to recover the security’s entire amortized cost basis, even if we do not intend to sell. Additionally, accounting guidance requires that for impaired securities that we do not intend to sell and/or that it is not more-likely-than-not that we

will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.

In evaluating the recovery of the entire amortized cost basis, we consider factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.

The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2010 and 2009.

 

     Less than 12 months      12 months or greater      Totals  
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 
     (in thousands)  

December 31, 2010

                 

Federal agencies

   $ 15,147       $ 339       $ —         $ —         $ 15,147       $ 339   

Mortgage-backed

     8,466         73         —           —           8,466         73   

Municipals

     4,030         110         364         37         4,394         147   

Other

     —           —           30         97         30         97   
                                                     

Totals

   $ 27,643       $ 522       $ 394       $ 134       $ 28,037       $ 656   
                                                     

December 31, 2009

                 

Federal agencies

   $ 1,982       $ 16       $ —         $ —         $ 1,982       $ 16   

Mortgage-backed

     2,375         6         3,086         471         5,461         477   

Municipals

     1,404         31         617         35         2,021         66   

Other

     —           —           82         44         82         44   
                                                     

Totals

   $ 5,761       $ 53       $ 3,785       $ 550       $ 9,546       $ 603   
                                                     

As of December 31, 2010, gross unrealized losses in the Company’s portfolio totaled $656 thousand, compared to $603 thousand as of December 31, 2009. The unrealized losses in federal agencies, mortgage-backed and municipal securities are primarily due to widening credit spreads and changes in interest rates

 

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subsequent to purchase. The unrealized losses in other securities are two trust preferred securities. The unrealized losses in the trust preferred securities are primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. Based on results of the Company’s impairment assessment, the unrealized losses at December 31, 2010 are considered temporary.

As of December 31, 2010, we owned securities from issuers in which the aggregate amortized cost from such issuers exceeded 10% of our stockholders’ equity. The following table presents the amortized cost and market value of the securities from each such issuer as of December 31, 2010.

 

     Book Value      Market Value  
     (in thousands)  

Fannie Mae

   $ 41,917       $ 38,651   

Federal Home Loan Mortgage Corporation

   $ 40,249       $ 38,489   

Ginnie Mae

   $ 24,232       $ 24,470   

At December 31, 2010 and 2009, our interest-bearing deposits in banks totaled $200.6 million and $152.6 million, respectively. We are holding our excess liquidity in our Federal Reserve cash account. The yield on the account is approximately 25 basis points.

At December 31, 2010 and 2009, we held $100 thousand in certificates of deposit at other FDIC insured financial institutions. At December 31, 2010 and 2009, we held $25.8 million and $24.9 million, respectively, in bank-owned life insurance.

Deposits and Other Borrowings

Deposits decreased by $134.0 million, or 11.3%, from year-end 2009 to year-end 2010, driven primarily by declines in retail and jumbo certificates of deposit. Core deposits decreased $54.7 million, or 8.6%, from year-end 2009 to year-end 2010. We define core deposits to include interest bearing and noninterest bearing demand deposits, savings and money market accounts, as well as retail certificates of deposit with denominations less than $100 thousand. We consider our retail certificates of deposit to be a stable source of funding because they are in-market, relationship-oriented deposits. Core deposit growth is an important tenet of our business strategy.

As discussed in Note 2 of our consolidated financial statements, the presence of a capital requirement restricts the rates that we can offer on deposit products. On December 15, 2010, we received a determination letter from the FDIC designating our market areas as “high rate” markets. As such, we may offer rates up to 75 basis points above the prevailing local market rates. We believe this pricing flexibility will enable us to maintain and possibly grow core deposits during 2011.

Brokered deposits decreased $24.9 million, or 7.3%, from year-end 2009 to year-end 2010. The decrease is primarily due to the elimination of our brokered money market account during the first quarter of 2010. In addition to brokered certificates of deposits, we are a member bank of the Certificate of Deposit Account Registry Service® (CDARS®) network. CDARS® is a network of banks that allows customers’ CDs to receive full FDIC insurance of up to $50 million. Additionally, as a member bank, we have the opportunity to sell one-way time deposits. At year-end 2010, our CDARS® balance consisted of $6.6 million in one-way buy deposits and $5.7 million in our customers’ reciprocal accounts. Brokered deposits at December 31, 2010 and 2009, were as follows:

 

     2010      2009  
     (in thousands)  

Brokered certificates of deposits

   $ 302,584       $ 239,283   

Brokered money market accounts

     —           76,749   

Brokered NOW accounts

     —           514   

CDARS®

     12,292         23,204   
                 
   $ 314,876       $ 339,750   
                 

 

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As discussed in Note 2 of our consolidated financial statements, the presence of a capital requirement in our Consent Order restricts our ability to accept, renew, or roll over brokered deposits without prior approval of the FDIC. The liquidity enhancement over the last fifteen months was in part to ensure we have adequate funding to meet our short-term contractual obligations. We believe that our current liquidity, along with maintaining or increasing core deposits, will provide for our short-term contractual obligations, including maturing brokered deposits. The table below is a maturity schedule for our certificates of deposit, including brokered CDs, in amounts of $100 thousand or more as of December 31, 2010.

 

     Less than
3 months
     Three months
to six months
     Six months to
twelve months
     Greater than
twelve months
 
     (in thousands)  

Certificates of deposit of $100 or more

   $ 36,554       $ 31,713       $ 55,805       $ 29,066   

Brokered certificates of deposit

     32,025         —           22,656         247,903   

CDARS®

     5,009         —           5,808         1,475   
                                   
   $ 73,588       $ 31,713       $ 84,269       $ 278,444   
                                   

At December 31, 2010 and 2009, we had securities sold under repurchase agreements with commercial checking customers of $5.9 million and $7.9 million, respectively. We also had a structured repurchase agreement with another financial institution of $10.0 million at December 31, 2010 and December 31, 2009. This agreement has a five-year term with a variable rate of three-month LIBOR minus 75 basis points for the first year and a fixed rate of 3.93% for the remaining term. The agreement was callable on November 6, 2008, the first anniversary, and quarterly thereafter. The stated maturity is November 2012.

As a member of the Federal Home Loan Bank of Cincinnati (FHLB), we have the ability to acquire short and long-term advances through a blanket agreement secured by our unencumbered qualifying 1-4 family first mortgage loans and by pledging investment securities or individual, qualified loans, subject to approval of the FHLB. We also use FSGBank’s borrowing capacity at the FHLB to purchase a letter of credit that we pledged to the State of Tennessee Collateral Pool. The $9 million letter of credit allows us to release investment securities from the Collateral Pool and thus improve our liquidity ratio.

The terms of the FHLB advances and other borrowing as of December 31, 2010 are as follows:

 

Maturity
Year

   Origination
Date
 

Type

   Principal      Original
Term
     Rate     Maturity  
              (in thousands)                      

2011

   6/18/1996*   FHLB fixed rate advance    $ 1         180 months         7.70     7/1/2011   

2011

   9/16/1996*   FHLB fixed rate advance    $ 1         180 months         7.50     10/1/2011   

2012

   9/9/1997*   FHLB fixed rate advance    $ 1         180 months         7.05     10/1/2012   

2015

   1/5/1995   Fixed rate mortgage    $ 74         240 months         7.50     1/5/2015   

 

* Assumed as part of the acquisition of Jackson Bank

Interest Rate Sensitivity

Financial institutions are subject to interest rate risk to the degree that their interest bearing liabilities (consisting principally of customer deposits) mature or reprice more or less frequently, or on a different basis, than their interest earning assets (generally consisting of intermediate or long-term loans, investment securities and federal funds sold). The match between the scheduled repricing and maturities of our earning assets and liabilities within defined time periods is referred to as “gap” analysis. At December 31, 2010, our cumulative one-year gap was a positive (or asset sensitive) $417.9 million, or 39% of total earning assets. At December 31, 2009, our cumulative one-year gap was a positive (or asset sensitive) $377.7 million, or 30% of total earning assets. During the fourth quarter of 2009 and first quarter of 2010, we issued $255.6 million in brokered certificates of deposits with an average maturity of approximately 2.7 years at a weighted average all-in cost of 2.80%. The issuances established a strong liquidity position that will be used to fund prudent loans and pay for future contractual obligations. At December 31, 2010, we held $200.6 million in interest-bearing cash, which was

 

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primarily held at the Federal Reserve Bank of Atlanta. The issuance combined with the retention of the cash positions us to be asset-sensitive in preparation for future increases in interest rates. We anticipate rates to begin to increase in late 2011 or early 2012, depending on economic conditions.

The following “gap” analysis provides information based the next repricing date or the maturity date. The “Interest Rate Risk Income Sensitivity Summary” table, located in Item 7A incorporates additional assumptions, including prepayments on loans and securities and reinvestments of paydowns and maturities of loans, investments, and deposits. We believe the Income Sensitivity Summary table located in Item 7A provides a more accurate analysis related to interest rate risk.

The following table reflects our rate sensitive assets and liabilities by maturity or the next repricing date as of December 31, 2010. Variable rate loans are shown in the category of due “Within Three Months” because they reprice with changes in the prime lending rate. Fixed rate loans are presented assuming all payments are made according to the loan’s contractual terms. Additionally, demand deposits and savings accounts have no stated maturity; however, it has been our experience that these accounts are not entirely rate sensitive, and accordingly the following analysis assumes 11% of interest bearing demand deposit accounts, 33% of money market deposit accounts, and 20% of savings accounts reprice within one year and the remaining accounts reprice within one to five years.

Interest Rate Gap Sensitivity

 

     As of December 31, 2010  
     Within
Three Months
     After
Three Months
but Within
One Year
    After
One Year
but Within
Five Years
    After
Five Years
and Non-Rate
Sensitive
    Total  
     (in thousands)  

Interest earning assets:

           

Interest bearing deposits

   $ 200,521       $ 100      $ —        $ —        $ 200,621   

Federal funds sold

     —           —          —          —          —     

Securities

     1,842         8,066        71,163        73,094        154,165   

Mortgage loans held for sale

     2,556         —          —          —          2,556   

Loans

     367,464         193,776        108,967        54,328        724,535   
                                         

Total interest earning assets

     572,383         201,942        180,130        127,422        1,081,877   
                                         

Interest bearing liabilities:

           

Demand deposits

     3,511         3,511        56,816        —          63,838   

MMDA deposits

     20,375         20,375        82,732        —          123,482   

Savings deposits

     3,839         3,839        30,713        —          38,391   

Time deposits

     83,834         211,194        63,785        —          358,813   

Brokered certificates of deposits

     32,025         22,656        241,136        6,767       302,584   

CDARS®

     5,009         5,808        1,475        —          12,292   

Fed funds purchased/repos

     5,933         10,000        —          —          15,933   

Other borrowings

     —           2        75        —          77   
                                         

Total interest bearing liabilities

     154,526         277,385        476,732        6,767        915,410   

Noninterest bearing sources of funds

     —           —          —          166,467        166,467   
                                         

Interest sensitivity gap

   $ 417,857       $ (75,443   $ (296,602   $ (45,812   $ —     
                                         

Cumulative sensitivity gap

   $ 417,857       $ 342,414      $ 45,812      $ —        $ —     
                                         

Liquidity

Liquidity refers to our ability to adjust our future cash flows to meet the needs of our daily operations. We rely primarily on management service fees from FSGBank to fund the liquidity needs of our daily operations.

 

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Our cash balance on deposit with FSGBank, which totaled approximately $2.5 million as of December 31, 2010, is available for funding activities for which FSGBank will not receive direct benefit, such as shareholder relations and holding company operations. As discussed in Note 2 to our consolidated financial statements, the Written Agreement with the Federal Reserve requires prior written authorization for any payment to First Security that reduces the equity of FSGBank, including management fees. We anticipate seeking quarterly management fee authorizations for 2011. Subsequent to December 31, 2010, we received authorization for the first quarter 2011 management fee. If we determine that our cash flow needs will be satisfactorily met, we may deploy a portion of the funds into FSGBank.

On January 27, 2010, to further preserve our capital resources, our Board of Directors elected to suspend the dividend on our common stock and elected to defer the dividend payment on our Series A Preferred Stock starting with the first quarter of 2010. As the payment of future dividends requires prior written consent by the Federal Reserve, we anticipate continuing to defer the dividend payments on the Preferred Stock until conditions improve.

The liquidity of FSGBank refers to the ability or financial flexibility to adjust its future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost effective basis. One of the primary sources of funds for FSGBank is cash generated by repayments of outstanding loans, interest payments on loans, and new deposits. Additional liquidity is available from the maturity and earnings on securities and liquid assets, as well as the ability to liquidate securities available-for-sale.

As of December 31, 2010, our interest bearing account at the Federal Reserve Bank of Atlanta totaled approximately $199.3 million. This cash balance was primarily funded through the issuance of brokered deposits in the fourth quarter of 2009 and first quarter of 2010. This excess liquidity is available to fund our contractual obligations and prudent investment opportunities.

As of December 31, 2010, the unused borrowing capacity (using 1-4 family residential mortgages) for FSGBank at the FHLB was $1.7 million. The FHLB is requiring individual pledging of loans for future funding. We are currently preparing the necessary documentation to increase the available funding and anticipate securing additional funding capacity during 2011.

Another source of funding is loan participations sold to other commercial banks (in which we retain the service rights). As of year-end, we had $10.1 million in loan participations sold. FSGBank may elect to sell loan participations as a source of liquidity. An additional source of short-term funding would be to pledge investment securities against a line of credit at a commercial bank. As of December 31, 2010, FSGBank had no borrowings against investment securities, except for repurchase agreements, treasury tax and loan deposits, and public-fund deposits attained in the ordinary course of business.

Historically, we have utilized brokered deposits to provide an additional source of funding. As of December 31, 2010, we had $302.6 million in brokered CDs outstanding with a weighted average remaining life of approximately 29 months, a weighted average coupon rate of 2.60% and a weighted average all-in cost (which includes fees paid to deposit brokers) of 2.85%. Our CDARS® product had $12.3 million at December 31, 2010, with a weighted average coupon rate of 1.71% and a weighted average remaining life of approximately 23 months. Our certificates of deposit greater than $100 thousand were generated in our communities and are considered relatively stable. During 2009, we were approved to use the Federal Reserve discount window. We applied to utilize the Federal Reserve window as an abundance of caution due to the economic climate. As discussed in Note 2 of our consolidated financial statements, the presence of a capital requirement in our Consent Order restricts our ability to accept, renew or roll over brokered deposits without prior approval of the FDIC.

We believe that our liquidity sources are adequate to meet our current operating needs. We continue to study our contingency funding plans and update them as needed paying particular attention to the sensitivity of our liquidity and deposit base to positive and negative changes in our asset quality.

 

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First Security also has contractual cash obligations and commitments, which included certificates of deposit, other borrowings, operating leases and loan commitments. Unfunded loan commitments and standby letters of credit totaled $127.4 million and $14.1 million at year-end, respectively. The following table illustrates our significant contractual obligations at December 31, 2010 by future payment period.

Contractual Obligations

 

     Total      Less than
One Year
     One to Three
Years
     Three to Five
Years
     More than
Five Years
 
     (in thousands)  

Certificates of deposit1

   $ 358,813       $ 295,028       $ 59,080       $ 4,705       $ —     

Brokered certificates of deposit1

     302,584         54,681         149,821         91,315         6,767   

CDARS® 1

     12,292         10,817         1,018         457         —     

Federal funds purchased and securities sold under agreements to repurchase2

     15,933         5,933         10,000         —           —     

FHLB borrowings3

     3         2         1         —           —     

Operating lease obligations4

     7,340         870         1,135         903         4,432   

Commitment to fund affordable housing investments5

     158         158         —           —           —     

Note payable6

     74         16         36         22         —     
                                            

Total

   $ 697,197       $ 367,505       $ 221,091       $ 97,402       $ 11,199   
                                            

 

1 

Time deposits give customers rights to early withdrawal. Early withdrawals may be subject to penalties. The penalty amount depends on the remaining time to maturity at the time of early withdrawal. For more information regarding certificates of deposits, see “Deposits and Other Borrowings.”

 

2 

We expect securities repurchase agreements to be re-issued and, as such, they do not necessarily represent an immediate need for cash.

 

3 

For more information regarding FHLB borrowings, see “Deposits and Other Borrowings.”

 

4 

Operating lease obligations include existing and future property and equipment non-cancelable lease commitments.

 

5 

We have commitments to certain investments in affordable housing and historic building rehabilitation projects in Tennessee. The investments entitle us to receive historic tax credits and low-income housing tax credits.

 

6 

This note payable is a mortgage on the land of our branch facility located at 2905 Maynardville Highway, Maynardville, Tennessee.

Net cash provided by operations in 2010 totaled $1.7 million compared to $6.1 million and $14.2 million for 2009 and 2008, respectively. Cash flows from operations in 2010 were reduced primarily due to a decline in net interest income. Net cash provided by investing activities totaled $119.3 million in 2010 compared to net cash used in investing activities of $117.0 million in 2009 and $83.0 million for 2009 and 2008, respectively. For 2010, loan principal collections, net of loan originations, totaled $172.9 million, compared to $23.0 million in 2009. The reduction in the loan portfolio, which was partially offset by the continued increase in interest-bearing deposits in banks, was the primary reason for the year-over-year change in investing activities. Net cash used in financing activities totaled $135.9 million in 2010 compared to net cash provided by financing activities of $110.9 million and $64.6 million in 2009 and 2008, respectively. The year-over-year change in financing activities is primarily related to the decline in retail CDs, which declined by $93.0 million from December 31, 2009. During 2009, the cash provided by financing activities included the increase of $82.7 million in brokered deposits as well the proceeds of $33.0 million associated with the issuance of Preferred Stock and common stock warrants.

 

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Capital Resources

Banks and bank holding companies, as regulated institutions, must meet required levels of capital. The OCC and the Federal Reserve, the primary federal regulators for FSGBank and First Security, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated

with various types of assets. Financial institutions are expected to maintain a level of capital commensurate with the risk profile assigned to their assets in accordance with the guidelines. The Consent Order, as described in Note 2 to our consolidated financial statements, requires FSGBank to achieve and maintain total capital to risk adjusted assets of at least 13% and a leverage ratio of at least 9%. The Order provided 120 days from the effective date of April 28, 2010 to achieve these ratios. As shown below, FSGBank was not in compliance with the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. As brokered deposits mature and are funded by available cash, we anticipate our total assets to decline. A decline in assets may cause both capital ratios to increase; however, continued losses may outpace the benefit associated with a reduction in assets. We continue to explore various strategic and capital alternatives to increase capital.

The following table compares the required capital ratios maintained by First Security and FSGBank.

Regulatory Capital Ratios

 

     FSGBank
Consent
Order(1)
    Minimum to be
Well  Capitalized
under Prompt
Corrective Action
Provisions
    Minimum
Capital
Requirements
    First
Security
    FSGBank  

As of December 31, 2010

          

Tier 1 capital to risk weighted assets

     n/a        6.0     4.0     11.2     10.9 %(3) 

Total capital to risk weighted assets

     13.0     10.0     8.0     12.5     12.2 %(3) 

Leverage ratio

     9.0     5.0 %(2)      4.0     7.3     7.1 %(3) 

As of December 31, 2009

          

Tier 1 capital to risk weighted assets

     n/a        6.0     4.0     12.7     11.5

Total capital to risk weighted assets

     n/a        10.0     8.0     13.9     12.8

Leverage ratio

     n/a        5.0 %(2)      4.0     10.6     9.6

 

(1) 

FSGBank must achieve and maintain the above capital ratios within 120 days from April 28, 2010.

 

(2) 

The Federal Reserve Board definition of well capitalized for bank holding companies does not include a leverage ratio component; accordingly, the leverage ratio requirement for well capitalized status only applies to FSGBank.

 

(3) 

Due to the capital requirement within FSGBank’s Consent Order, FSGBank is considered to be adequately capitalized.

To further preserve our capital resources, our Board of Directors elected to suspend our common stock dividend and defer the dividend on the Series A Preferred Stock for all four quarters of 2010. As described in Note 2 to our consolidated financial statements, the Written Agreement between First Security and the Federal Reserve prohibits declaring or paying dividends without prior written consent. Under applicable banking regulations, we do not anticipate declaring or paying a dividend until we return to sustained profitability.

Effect of Governmental Policies

We are affected by the policies of regulatory authorities, including the Federal Reserve Board and the OCC. An important function of the Federal Reserve Board is to regulate the national money supply.

Among the instruments of monetary policy used by the Federal Reserve Board are: purchases and sales of U.S. Government securities in the marketplace; changes in the discount rate, which is the rate any depository

 

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institution must pay to borrow from the Federal Reserve Board; and changes in the reserve requirements of depository institutions. These instruments are effective in influencing economic and monetary growth, interest rate levels and inflation.

The monetary policies of the Federal Reserve Board and other governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of changing conditions in the national and international economy and in the money market, as well as the result of actions by monetary and fiscal authorities, it is not possible to predict with certainty future changes in interest rates, deposit levels or loan demand or whether the changing economic conditions will have a positive or negative effect on operations and earnings.

Legislation from time to time is introduced in the United States Congress and the Tennessee General Assembly and other state legislatures, and regulations are proposed by the regulatory agencies that could affect our business. It cannot be predicted whether or in what form any of these proposals will be adopted or the extent to which our business may be affected thereby.

The Dodd-Frank Wall Street Reform and Consumer Protection Act. On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) which, among other things, alters the oversight and supervision of financial institutions by federal and state regulators, introduces minimum capital requirements, creates a new federal agency to supervise consumer financial products and services, and implements changes to corporate governance and compensation practices. Although the Act is particularly focused on large bank holding companies with consolidated assets of $50 billion or more, it does contain a number of provisions that may affect us, including:

 

   

Minimum Leverage and Risk-Based Capital Requirements. Under the Act, the appropriate Federal banking agencies are required to establish minimum leverage and risk-based capital requirements on a consolidated basis for all insured depository institutions and bank holding companies, which can be no less than the currently applicable leverage and risk-based capital requirements for depository institutions.

 

   

Deposit Insurance Modifications. The Act modifies the FDIC’s assessment base upon which deposit insurance premiums are calculated. The new assessment base will equal our average total consolidated assets minus the sum of our average tangible equity during the assessment period. The Act also makes permanent the increase in maximum federal deposit insurance limits from $100,000 to $250,000.

 

   

Creation of New Consumer Protection Bureau. The Act creates a new Bureau of Consumer Financial Protection within the Federal Reserve with broad powers to supervise and enforce consumer protection laws. The Bureau of Consumer Financial Protection will have broad rule-making authority for a wide range of consumer protection laws that apply to all insured depository institutions. The Bureau of Consumer Financial Protection has examination and enforcement authority over all depository institutions with more than $10 billion in assets. Depository institutions with $10 billion or less in assets, such as FSGBank, will be examined by their applicable bank regulators.

 

   

Executive Compensation and Corporate Governance Requirements. The Act includes provisions that may impact our corporate governance, including a grant of authority to the SEC to issue rules that allow shareholders to nominate directors by using the company’s proxy solicitation materials. The Act further requires the SEC to adopt rules that prohibit the listing of any equity security of a company that does not have an independent compensation committee and require all exchange-traded companies to adopt clawback policies for incentive compensation paid to executive officers in the event of accounting restatements based on material non-compliance with financial reporting requirements.

Many provisions of the Act will require our regulators to adopt additional rules in order to implement the mandates included in the Act. In addition, the Act requires multiple studies which could result in additional legislative action. Governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operations.

 

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Off-Balance Sheet Arrangements

We are party to credit-related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

Our exposure to credit loss is represented by the contractual amount of these commitments. We follow the same credit policies in making commitments as we do for on-balance-sheet instruments.

Our maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at December 31, 2010 and 2009, was as follows:

Unfunded Loan Commitments

 

     2010      2009  
     (in thousands)  

Commitments to Extend Credit

   $ 127,377       $ 185,639   

Standby Letters of Credit

   $ 14,090       $ 16,077   

Commitments to extend credit are agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

Recent Accounting Developments

The following items represent accounting changes that have been issued but are not currently effective. Refer to the Notes to our consolidated financial statements for accounting changes that became effective during the current periods.

In January 2011, the FASB issued Accounting Standards Update 2011-01, “Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in ASU 2010-20.” This update defers the effective date of reporting TDR credit quality disclosures until the additional guidance is issued that clarifies what constitutes a TDR.

In April 2011, the FASB issued Accounting Standards Update 2011-02, “The Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” This update provides additional guidance in determining what is considered a troubled debt restructuring (“TDR”). The update clarifies the two criteria that are required in determining a TDR. The update is effective for interim or annual periods beginning after June 15, 2011. We are currently evaluating the impact of this update to our consolidated financial statements.

 

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Market risk, with respect to First Security, is the risk of loss arising from adverse changes in interest rates and prices. The risk of loss can result in either lower fair market values or reduced net interest income. We manage several types of risk, such as credit, liquidity and interest rate. We consider interest rate risk to be a significant risk that could potentially have a large material effect on our financial condition. Further, we process hypothetical scenarios whereby we shock our balance sheet up and down for possible interest rate changes, we

 

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analyze the potential change (positive or negative) to net interest income, as well as the effect of changes in fair market values of assets and liabilities. We do not deal in international instruments, and therefore are not exposed to the risks inherent to foreign currency. Additionally, as of December 31, 2010, we had no trading assets that exposed us to the risks in market changes.

Our interest rate risk management is the responsibility of our Board of Directors’ Asset/Liability Committee (ALCO). The committee has established policies and limits for management to monitor, measure and coordinate our sources, uses, and pricing of funds.

Interest rate risk represents the sensitivity of earnings to changes in interest rates. As interest rates change, the interest income and expense associated with our interest sensitive assets and liabilities also change, thereby impacting net interest income, the primary component of our earnings. ALCO utilizes the results of both a static and dynamic gap report, as well as an income simulation report, to quantify the estimated exposure of net interest income to a sustained change in interest rates.

We monitor and forecast potential interest rate changes based on market data. In a falling interest rate environment, we closely monitor our funding sources and pricing to minimize the impact to our net interest margin for our asset sensitive balance sheet.

The income simulation analysis projects net interest income based on both a rise and fall in interest rates of 200 basis points (i.e. 2.00%) over a twelve-month period. The model is based on actual repricing dates of interest sensitive assets and interest sensitive liabilities. The model incorporates assumptions regarding the impact of changing interest rates on the prepayment rates of certain assets.

We measure this exposure based on an immediate change in interest rates of 200 basis points up or down. Given this scenario, we had, at year-end, an exposure to falling rates and a benefit from rising rates. More specifically, the model forecasts a decline in net interest income of $7.2 million, or 21%, as a result of a 200 basis point decline in rates. The model also predicts a $6.0 million increase in net interest income, or 17%, as a result of a 200 basis point increase in rates. The forecasted results of the model for the 200 basis point increase are within the limits specified by our guidelines. The forecasted results for a decline in rates is not within our policy limit, however, a 200 basis point decline in rates is not anticipated. The following chart reflects First Security’s sensitivity to changes in interest rates as of December 31, 2010. The model is based on a static balance sheet and assumes that paydowns and maturities of both assets and liabilities are reinvested in similar instruments at current interest rates, rates down 200 basis points, and rates up 200 basis points.

Interest Rate Risk

Income Sensitivity Summary

 

     As of December 31, 2010  
     Down 200 BP     Current     Up 200 BP  
     (in thousands, except percentages)  

Net interest income

   $ 27,484      $ 34,681      $ 40,713   

$ change net interest income

     (7,197     —          6,032   

% change net interest income

     (20.75 )%      0.00     17.39

The preceding sensitivity analysis is a modeling analysis, which changes periodically and consists of hypothetical estimates based upon numerous assumptions including interest rate levels, shape of the yield curve, prepayments on loans and securities, rates on loans and deposits, reinvestments of paydowns and maturities of loans, investments and deposits, and other assumptions. In addition, there is no input for growth or a change in asset mix. While assumptions are developed based on the current economic and market conditions, management cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.

 

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As market conditions vary from those assumed in the sensitivity analysis, actual results will differ. Also, the sensitivity analysis does not reflect actions that management might take in responding to or anticipating changes in interest rates.

We use the Sendero Vision Asset/Liability system which is a comprehensive interest rate risk measurement tool that is widely used in the banking industry. Generally, it provides the user with the ability to more accurately model both static and dynamic gap, economic value of equity, duration, and income simulations using a wide range of scenarios including interest rate shocks and rate ramps. The system also has the capability to model derivative instruments, such as interest rate swap contracts.

 

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Item 8. Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page  

Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements

     88   

Consolidated Balance Sheets as of December 31, 2010 and 2009

     89   

Consolidated Statements of Income for the Years Ended December 31, 2010, 2009 and 2008

     90   

Consolidated Statements of Stockholders’ Equity for the Years Ended December  31, 2010, 2009 and 2008

     91   

Consolidated Statements of Cash Flows for the Years Ended December 31, 2010, 2009 and 2008

     93   

Notes to Consolidated Financial Statements

     95   

 

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DECOSIMO

CERTIFIED PUBLIC ACCOUNTANTS

 

Joseph Decosimo and Company, PLLC

Suite 1100—Two Union Square

Chattanooga, Tennessee 37402

www.decosimo.com

Report of Independent Registered Public Accounting Firm

On the Consolidated Financial Statements

Board of Directors and Stockholders

First Security Group, Inc.

Chattanooga, Tennessee

We have audited the accompanying consolidated balance sheets of First Security Group, Inc. and subsidiary (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2010. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Security Group, Inc. and subsidiary as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has incurred losses from operations for the past two years. The Company is also operating under formal supervisory agreements (the Agreements) with the Federal Reserve Bank of Atlanta and the Office of the Comptroller of the Currency and is not in compliance with all provisions of the Agreements. Failure to achieve all of the Agreements’ requirements may lead to additional regulatory actions. These matters raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), First Security Group, Inc. and subsidiary’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated April 15, 2011, expressed an adverse opinion on the effectiveness of First Security Group, Inc. and subsidiary’s internal control over financial reporting.

/s/ Joseph Decosimo and Company, PLLC

Chattanooga, Tennessee

April 15, 2011

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31, 2010 and 2009

 

             2010                     2009          
     (in thousands, except share data)  
ASSETS   

Cash and Due from Banks

   $ 8,298      $ 23,220   

Federal Funds Sold and Securities Purchased under Agreements to Resell

     —          —     
                

Cash and Cash Equivalents

     8,298        23,220   
                

Interest Bearing Deposits in Banks

     200,621        152,616   
                

Securities Available-for-Sale

     154,165        143,045   
                

Loans Held for Sale (at fair value)

     2,556        1,225   

Loans and Leases

     724,535        950,793   
                

Total Loans

     727,091        952,018   

Less: Allowance for Loan and Lease Losses

     24,000        26,492   
                
     703,091        925,526   
                

Premises and Equipment, net

     30,814        33,157   
                

Intangible Assets

     1,461        1,918   
                

Other Assets

     70,098        73,917   
                

TOTAL ASSETS

   $ 1,168,548      $ 1,353,399   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

LIABILITIES

    

Deposits—

    

Noninterest Bearing Demand

   $ 149,323      $ 151,174   

Interest Bearing Demand

     63,838        62,429   

Savings and Money Market Accounts

     161,873        177,543   

Certificates of Deposit of less than $100 thousand

     205,675        244,312   

Certificates of Deposit of $100 thousand or more

     153,138        207,465   

Brokered Deposits

     314,876        339,750   
                

Total Deposits

     1,048,723        1,182,673   

Federal Funds Purchased and Securities Sold under Agreements to Repurchase

     15,933        17,911   

Security Deposits

     732        1,376   

Other Borrowings

     77        94   

Other Liabilities

     9,709        10,181   
                

Total Liabilities

     1,075,174        1,212,235   
                

STOCKHOLDERS’ EQUITY

    

Preferred Stock—no par value—10,000,000 shares authorized; 33,000 issued as of December 31, 2010 and December 31, 2009

     31,718        31,339   

Common Stock—$.01 par value—150,000,000 shares authorized as of December 31, 2010, 50,000,000 shares authorized as of December 31, 2009; 16,418,327 shares issued for December 31, 2010 and December 31, 2009

     114        114   

Paid-In Surplus

     111,344        111,964   

Common Stock Warrants

     2,006        2,006   

Unallocated ESOP Shares

     (5,218     (6,193

Accumulated Deficit

     (50,629     (4,258

Accumulated Other Comprehensive Income

     4,039        6,192   
                

Total Stockholders’ Equity

     93,374        141,164   
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,168,548      $ 1,353,399   
                

The accompanying notes are an integral part of the financial statements.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2010, 2009 and 2008

(in thousands, except per share amounts)

 

     2010     2009     2008  

INTEREST INCOME

      

Loans, including fees

   $ 49,118      $ 57,772      $ 69,846   

Debt Securities—taxable

     3,870        4,555        4,588   

Debt Securities—non-taxable

     1,411        1,608        1,605   

Other

     517        72        49   
                        

Total Interest Income

     54,916        64,007        76,088   
                        

INTEREST EXPENSE

      

Interest Bearing Demand Deposits

     186        190        327   

Savings Deposits and Money Market Accounts

     1,417        1,668        2,285   

Certificates of Deposit of less than $100 thousand

     4,673        7,183        10,549   

Certificates of Deposit of $100 thousand or more

     4,049        6,265        9,310   

Brokered Deposits

     9,429        5,970        4,809   

Other

     481        522        3,581   
                        

Total Interest Expense

     20,235        21,798        30,861   
                        

NET INTEREST INCOME

     34,681        42,209        45,227   

Provision for Loan and Lease Losses

     33,613        25,404        15,753   
                        

NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES

     1,068        16,805        29,474   
                        

NONINTEREST INCOME

      

Service Charges on Deposit Accounts

     3,912        4,642        5,284   

Gain on Sales of Available-for-Sale Securities

     57        —          146   

Other

     5,534        5,693        6,252   
                        

Total Noninterest Income

     9,503        10,335        11,682   
                        

NONINTEREST EXPENSES

      

Salaries and Employee Benefits

     18,926        20,246        21,577   

Expense on Premises and Equipment, net of rental income

     5,525        5,891        6,564   

Impairment of Goodwill

     —          27,156        —     

Other

     20,783        15,554        12,241   
                        

Total Noninterest Expenses

     45,234        68,847        40,382   
                        

(LOSS) INCOME BEFORE INCOME TAX PROVISION (BENEFIT)

     (34,663     (41,707     774   

Income Tax Provision (Benefit)

     9,679        (8,252     (587
                        

NET (LOSS) INCOME

     (44,342     (33,455     1,361   

Preferred Stock Dividends

     1,650        1,609        —     

Accretion of Preferred Stock Discount

     379        345        —     
                        

NET (LOSS) INCOME AVAILABLE TO COMMON STOCKHOLDERS

   $ (46,371   $ (35,409   $ 1,361   
                        

NET (LOSS) INCOME PER SHARE:

      

Net (Loss) Income Per Share—Basic

   $ (2.95   $ (2.28   $ 0.08   

Net (Loss) Income Per Share—Diluted

   $ (2.95   $ (2.28   $ 0.08   

Dividends Declared Per Common Share

   $ —        $ 0.08      $ 0.20   

The accompanying notes are an integral part of the financial statements.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Years Ended December 31, 2010, 2009 and 2008

(in thousands)

 

    Preferred
Stock
    Common Stock     Paid-In
Surplus
    Stock
Warrants
    Retained
Earnings
(Accumulated
Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
    Unallocated
ESOP
Shares
    Total
Stockholders’
Equity
    Total
Comprehensive
Income (Loss)
 
    Shares     Amount                

BALANCE—December 31, 2007

  $ —          16,775      $ 116      $ 114,631        —        $ 34,279      $ 2,977      $ (4,310   $ 147,693     

Issuance of Common Stock

      4          —                  —       

Comprehensive income—

                   

Net Income

              1,361            1,361      $ 1,361   

Change in Net Unrealized Gain:

                   

Securities Available-for-Sale, net of tax and reclassification adjustments

                598          598        598   

Fair value of Derivatives, net of tax and reclassification adjustments

                2,335          2,335        2,335   
                         

Total Comprehensive income

                    $ 4,294   
                         

Dividends Paid

              (3,253         (3,253  

Stock-based Compensation

          584                584     

ESOP Allocation

          (637           1,399        762     

ESOP Purchases of Common Stock

                  (3,033     (3,033  

Repurchase and Retirement of Common Stock (358,495 shares)

      (359     (2     (2,801             (2,803  
                                                                         

BALANCE—December 31, 2008

    —          16,420        114        111,777        —          32,387        5,910        (5,944     144,244     

Issuance of Common Stock

          —                  —       

Comprehensive loss—

                   

Net Loss

              (33,455         (33,455   $ (33,455

Change in Net Unrealized Gain:

                   

Securities Available-for-Sale, net of tax and reclassification adjustments

                1,575          1,575        1,575   

Fair value of Derivatives, net of tax and reclassification adjustments

                (1,293       (1,293     (1,293
                         

Total Comprehensive loss

                    $ (33,173
                         

Issuance of Preferred Stock

    30,994              2,006              33,000     

Accretion of Discount associated with Preferred Stock

    345                (345         —       

Preferred Stock Dividends Paid

              (1,609         (1,609  

Common Stock Dividends Paid

              (1,236         (1,236  

Stock-based Compensation

      (2       344                344     

ESOP Allocation

          (157           774        617     

ESOP Purchases of Common Stock

                  (1,023     (1,023  
                                                                         

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY—(Continued)

Years Ended December 31, 2010, 2009 and 2008

(in thousands)

 

    Preferred
Stock
    Common Stock     Paid-In
Surplus
    Stock
Warrants
    Retained
Earnings
(Accumulated
Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
    Unallocated
ESOP
Shares
    Total
Stockholders’
Equity
    Total
Comprehensive
Income (Loss)
 
    Shares     Amount                

BALANCEDecember 31, 2009

    31,339        16,418        114        111,964        2,006        (4,258     6,192        (6,193     141,164     

Comprehensive loss—

                   

Net Loss

              (44,342         (44,342   $ (44,342

Change in Net Unrealized Gain:

                   

Securities Available-for-Sale, net of tax and reclassification adjustments

                (847       (847     (847

Fair value of Derivatives, net of tax and reclassification adjustments

                (1,306       (1,306     (1,306
                         

Total Comprehensive Loss

                    $ (46,495
                         

Accretion of Discount associated with Preferred Stock

    379                (379         —       

Preferred Stock Dividends

              (1,650         (1,650  

Stock-based Compensation

          24                24     

ESOP Allocation

          (644           975        331     
                                                                         

BALANCEDecember 31, 2010

  $ 31,718        16,418      $ 114      $ 111,344      $ 2,006      $ (50,629   $ 4,039      $ (5,218   $ 93,374     
                                                                         

The accompanying notes are an integral part of the financial statements.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2010, 2009 and 2008

(in thousands)

 

     2010     2009     2008  

CASH FLOWS FROM OPERATING ACTIVITIES

      

Net (Loss) Income

   $ (44,342   $ (33,455   $ 1,361   

Adjustments to Reconcile Net (Loss) Income to Net Cash Provided by Operating Activities—

      

Provision for Loan and Lease Losses

     33,613        25,404        15,753   

Amortization, net

     1,095        679        829   

Impairment of Goodwill

     —          27,156        —     

Stock-Based Compensation

     24        344        584   

401(k) and ESOP Match Compensation

     331        617        762   

Depreciation

     1,795        2,076        2,450   

Loss (Gain) on Sale of Premises and Equipment, net

     199        (6     (7

Loss (Gain) on Sale of Other Real Estate and Repossessions and Leased Equipment, net

     710        222        (195

Write-down of Other Real Estate and Repossessions

     3,539        1,334        985   

Gain on the Sale of Available-for-Sale Securities

     (57     —          (146

Accretion of Fair Value Adjustment, net

     (89     (175     (334

Accretion of Cash Flow Swaps

     —          (528     (1,340

Accretion of Terminated Cash Flow Swaps

     (2,022     (1,783     (597

Deferred Income Taxes

     12,457        (7,498     (3,224

Changes in Operating Assets and Liabilities—

      

Decrease (Increase) in—

      

Loans Held for Sale

     (1,303     357        2,787   

Interest Receivable

     1,084        284        1,152   

Other Assets

     (3,753     (7,522     (1,912

(Decrease) Increase in—

      

Interest Payable

     (1,462     (2,836     (1,076

Other Liabilities

     (139     1,452        (3,599
                        

Net Cash Provided by Operating Activities

     1,680        6,122        14,233   
                        

CASH FLOWS FROM INVESTING ACTIVITIES

      

Net Change in Interest Bearing Deposits in Banks

     (48,005     (151,698     (622

Activity in Available-for-Sale Securities—

      

Maturities, Prepayments and Calls

     61,794        31,368        17,304   

Sales

     14,762        —          13,126   

Purchases

     (89,540     (32,915     (36,868

Loan Originations and Principal Collections, net

     172,893        22,983        (78,320

Proceeds from Interim Settlements of Cash Flow Swaps, net

     —          938        955   

Proceeds from Termination of Cash Flow Swaps

     —          5,778        —     

Proceeds from Sale of Premises and Equipment

     25        16        113   

Proceeds from Sale of Other Real Estate Owned and Repossessions

     9,045        8,321        3,208   

Additions to Premises and Equipment

     (200     (1,466     (1,613

Capital Improvements to Repossessions and Other Real Estate

     (1,431     (363     (310
                        

Net Cash Provided by (Used in) Investing Activities

     119,343        (117,038     (83,027
                        

The accompanying notes are an integral part of the financial statements.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS—(Continued)

Years Ended December 31, 2010, 2009 and 2008

(in thousands)

 

     2010     2009     2008  

CASH FLOWS FROM FINANCING ACTIVITIES

      

Net (Decrease) Increase in Deposits

     (133,950     106,383        173,643   

Net Decrease in Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

     (1,978     (22,125     (22,250

Net Decrease of Other Borrowings

     (17     (2,683     (77,682

Proceeds from Issuance of Preferred Stock and Common Stock Warrants

     —          33,000        —     

Repurchase and Retirement of Common Stock

     —          —          (2,803

Purchase of ESOP Shares

     —          (1,023     (3,033

Dividends Paid on Preferred Stock

     —          (1,402     —     

Dividends Paid on Common Stock

     —          (1,236     (3,253
                        

Net Cash (Used in) Provided by Financing Activities

     (135,945     110,914        64,622   
                        

NET DECREASE IN CASH AND CASH EQUIVALENTS

     (14,922     (2     (4,172

CASH AND CASH EQUIVALENTS—beginning of year

     23,220        23,222        27,394   
                        

CASH AND CASH EQUIVALENTS—end of year

   $ 8,298      $ 23,220      $ 23,222   
                        

SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES

      

Foreclosed Properties and Repossessions

   $ 22,309      $ 24,759      $ 10,128   

SUPPLEMENTAL SCHEDULE OF CASH FLOWS

      

Interest Paid

   $ 21,697      $ 24,634      $ 31,937   

Income Taxes Paid

   $ 128      $ 552      $ 5,548   

The accompanying notes are an integral part of the financial statements.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

First Security Group, Inc. is a bank holding company organized for the principal purpose of acquiring, developing and managing banks. The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry.

The significant accounting policies and practices followed by the Company are as follows:

BASIS OF CONSOLIDATION—The consolidated financial statements include the accounts of First Security Group, Inc. and its wholly-owned subsidiary, FSGBank, National Association (the Bank) (collectively referred to as the Company in the accompanying notes to the consolidated financial statements). All significant intercompany balances and transactions have been eliminated in consolidation.

NATURE OF OPERATIONS—The Company is headquartered in Chattanooga, Tennessee, and provides banking services through the Bank to the various communities in eastern and middle Tennessee and northern Georgia. The Bank’s commercial banking operations are primarily retail-oriented and aimed at individuals and small to medium-sized local businesses. The Bank provides traditional banking services, which include obtaining demand and time deposits and the making of secured and unsecured consumer and commercial loans, as well as trust and investment management, mortgage banking, financial planning and Internet banking (www.FSGBank.com) services.

CASH AND CASH EQUIVALENTS—For the purpose of presentation in the statements of cash flows, the Company considers all cash and amounts due from depository institutions to be cash equivalents. The Bank is required to maintain noninterest bearing average reserve balances with the Federal Reserve Bank of Atlanta.

INTEREST BEARING DEPOSITS IN BANKS—Interest bearing deposits in banks mature within one year and are carried at cost.

SECURITIES—Securities that management does not have the intent or ability to hold to maturity are classified as available-for-sale and recorded at fair value. Unrealized gains and losses are excluded from earnings and reported in other comprehensive income, net of tax. Purchase premiums and discounts are recognized in interest income using methods approximating the interest method over the terms of the securities. Gains and losses on sale of securities are determined using the specific identification method.

The Company reviews available-for-sale securities for impairment on a quarterly basis. A security is reviewed for impairment if the fair value is less than its amortized cost basis at the measurement date. The Company determines whether a decline in fair value below the amortized cost is other-than-temporary. Prior to April 1, 2009, a security that the Company had the intent and ability to hold to recovery and for which it was probable that the Company would receive all cash flows were considered not to be other-than-temporarily impaired. Available-for-sale securities which had an other-than-temporary impairment were written down to fair value through a realized loss in the Consolidated Statements of Income.

After April 1, 2009, the applicable authoritative guidance for other-than-temporary impairment was updated and the Company adopted the new guidance. Subsequent to April 1, 2009, the Company determines whether it has the intent to sell the security or whether it is more likely than not that it will not be required to sell the security before the recovery of its amortized cost. If either condition is met, the Company will recognize a full impairment and write the available-for-sale security down to fair value though the Consolidated Income Statement. For securities that the Company does not expect to recover the entire amortized cost and do not meet

 

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either of the above conditions, the Company records an other-than-temporary loss for the credit loss portion of the impairment through earnings and the temporary impairment related to all other factors through other comprehensive income.

LOANS—Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans.

The Company also engages in direct lease financing through two wholly owned subsidiaries of the Bank. The net investment in direct financing leases is the sum of all minimum lease payments and estimated residual values, less unearned income. Unearned income is added to interest income over the term of the leases to produce a level yield.

A loan or lease is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are measured based on one of three methods: (1) the present value of expected future cash flows discounted at the loan’s effective interest rate, (2) the loan’s observable market price or (3) the fair value of the collateral if the loan is collateral-dependent. When the fair value of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a specific reserve allocation which is a component of the allowance for loan losses unless the loan is collateral-dependent, in which case the impairment is recorded through a charge-off.

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well collateralized and in the process of renewal or collection. If a loan or a portion of a loan is classified as doubtful or is partially charged off, the loan is generally classified as nonaccrual. At management’s discretion, loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.

When a loan is placed on nonaccrual status, unpaid interest and fees are reversed against interest income. Interest income on nonaccrual loans, if recognized, is either recorded using the cash basis method of accounting or recognized after the loan is returned to accrual status.

A troubled-debt restructuring (TDR) is a loan that the Company has granted a concession to the borrower, which would not otherwise be considered due to the borrower experiencing financial difficulty. If a loan is in nonaccrual status before it is determined to be a TDR, then the loan remains in nonaccrual status. TDR loans in nonaccrual status may be returned to accrual status if there has been at least a six month sustained period of repayment performance by the borrower. When the Company modifies the terms of an existing loan that is not considered a TDR, the Company accounts for the loan modification as a new loan if the terms of the new loan resulting from the refinancing or restructuring are at least as favorable to the Company as the terms for comparable loans to other customers with similar risk characteristics who are not undergoing a refinancing or restructuring and the modifications are more than minor.

LOANS HELD FOR SALE—Loans held for sale include residential mortgage loans originated for sale into the secondary market. Loans held for sale are carried at fair value. Fair value is determined from observable current market prices.

LOAN ORIGINATION FEES—Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield over the lives of the related loans.

INTEREST INCOME ON LOANS—Interest on loans is accrued and credited to income based on the principal amount outstanding. The accrual of interest on loans is discontinued when, in the opinion of management, there is an indication that the borrower may be unable to meet payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed.

 

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ALLOWANCE FOR LOAN AND LEASE LOSSES—The allowance for loan and lease losses is the amount the Company considers adequate to absorb probable losses within the portfolio based on management’s evaluation of the size and risk characteristics of the loan portfolio. The Company’s methodology is based on authoritative accounting guidance and applicable guidance from regulatory agencies.

The allowance is increased by charges to income (provision for loan and lease losses) and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the allowance is based on the Company’s past loan loss experience, known and inherent risks in the portfolio, strength of credit risk management systems, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral and current economic conditions. Although management uses available information to recognize losses on loans, because of uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that a material change could occur in the allowance in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

The allowance for loan and lease losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Company periodically analyzes the commercial loan and lease portfolios in an effort to establish an allowance that it believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, the Company reviews the size, quality and risk of loans and leases in the portfolio. The Company also, on at least a quarterly basis, considers such factors as:

 

   

the Company’s loan loss experience;

 

   

the amount of past due and nonperforming loans;

 

   

specific known risks;

 

   

the status of nonperforming assets;

 

   

underlying estimated values of collateral securing loans;

 

   

current economic conditions; and

 

   

other factors which management believes affect the allowance for potential credit losses.

An analysis of the credit quality of the loan portfolio and the adequacy of the allowance is prepared by the Company and is presented to the board of directors on a regular basis.

In addition to the allowance, the Company also estimates probable losses related to unfunded commitments, such as letters of credit and binding unfunded loan commitments. The reserve for unfunded commitments is reported on the Consolidated Balance Sheet in other liabilities and the provision associated with changes in the unfunded commitment reserve is reported as a component of the provision for loan and lease losses in the Consolidated Statements of Income.

PREMISES AND EQUIPMENT—Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Expenditures for repairs, maintenance and minor improvements are charged to expense as incurred and additions and improvements that significantly extend the lives of assets are capitalized. Upon sale or other retirement of depreciable property, the cost and related accumulated depreciation are removed from the related accounts and any gain or loss is reflected in operations.

Depreciation is provided using the straight-line method over the estimated lives of the depreciable assets. Buildings are depreciated over a period of forty years. Land and building improvements are depreciated over a ten year period. Leasehold improvements are depreciated over the lesser of the term of the related lease or the estimated useful life of the improvement. Furniture, fixtures and equipment and autos are depreciated over an estimated life of three to seven years. Deferred income taxes are provided for differences in the computation of depreciation for book and tax purposes.

 

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GOODWILL AND OTHER INTANGIBLE ASSETS—Goodwill represents the cost in excess of the fair value of the net assets acquired. Other intangible assets represent identified intangible assets including premiums paid for acquisitions of core deposits (core deposit intangibles), which are amortized over a 10 year period.

Management evaluates whether events or circumstances have occurred that indicate the remaining useful life or carrying value of amortizing intangibles should be revised. On an annual basis or earlier if an event or circumstances warrant, the Company tests goodwill for impairment. For additional information, refer to Note 8, “Goodwill and Other Intangible Assets,” to the consolidated financial statements.

FORECLOSED PROPERTIES AND REPOSSESSIONS—Foreclosed properties are comprised principally of residential and commercial real estate properties obtained in partial or total satisfaction of nonperforming loans. Repossessions are primarily comprised of heavy equipment and other machinery, obtained in partial or total satisfaction of loans or leases. Foreclosed properties and repossessions are recorded at their estimated fair value less anticipated selling costs based upon the property’s or item’s appraised value at the date of transfer, with any difference between the fair value of the property and the carrying value of the loan charged to the allowance for loan and lease losses. Subsequent changes in values are reported as adjustments to the carrying amount, not to exceed the initial carrying value of the assets at the time of transfer. Gains or losses not previously recognized resulting from the sale of foreclosed properties or other repossessed items are recognized on the date of sale. At December 31, 2010 and 2009, the Company had $24,399 thousand and $15,312 thousand of foreclosed properties, respectively, and $763 thousand and $3,881 thousand of other repossessed items, respectively.

INCOME TAXES—The consolidated financial statements have been prepared on the accrual basis. When income and expenses are recognized in different periods for financial reporting purposes and for purposes of computing income taxes currently payable, deferred taxes are provided on such temporary differences. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes in the period in which the change was enacted. Additionally, the Company does not recognize an income tax expense or benefit on permanent differences, such as tax-exempt income and tax credits. Tax years 2007 through 2010 remain open for the Company’s federal tax returns. Tax years 2005 through 2010 remain open for the Company’s Tennessee tax returns.

A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. In determining whether a valuation allowance is necessary, the Company considers the level of taxable income in prior years to the extent that carrybacks are permitted under current tax laws, as well as estimates of future pre-tax and taxable income and tax planning strategies that may be utilized.

In computing the income tax provision (benefit), the Company evaluates the technical merits of its income tax positions based on current legislative, judicial and regulatory guidance. The Company classifies interest and penalties related to its tax positions as a component of income tax expense (benefit). For additional information, refer to Note 13 “Income Taxes.”

FINANCIAL INSTRUMENTS—In the ordinary course of business, the Company has entered into off-balance-sheet financial instruments consisting of commitments to extend credit, commercial letters of credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

ADVERTISING COSTS—Advertising costs are charged to expense when incurred. The Company expensed $155 thousand, $278 thousand and $372 thousand in 2010, 2009 and 2008, respectively.

STOCK-BASED COMPENSATION—The Company accounts for stock-based compensation under the fair value recognition provision whereby fair value of the award at the date of grant is expensed over the vesting period of the award. The required disclosures related to the Company’s stock-based employee compensation plans are included in Note 15 “Long-Term Incentive Plan,” to the consolidated financial statements.

 

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ESTIMATES AND UNCERTAINTIES—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

PER SHARE DATA—Basic net income per share represents net income divided by the weighted average number of shares outstanding during the period. Diluted net income per share reflects additional shares that would have been outstanding if dilutive potential shares had been issued, as well as any adjustment to income that would result from the assumed issuance.

COMPREHENSIVE INCOME—Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities and cash flow derivatives, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. Note 3 provides further information.

SEGMENT REPORTING—The Company identifies reportable segments based on the authoritative accounting guidance. Reportable segments are determined on the basis of discrete business units and their financial information to the extent such units are reviewed by an entity’s chief decision maker (which can be an individual or group of management persons). The statement permits aggregation or combination of segments that have similar characteristics. The operations of First Security Group, Inc. and the Bank have similar economic characteristics and are similar in each of the following areas: the nature of products and services, the nature of production processes, the type of customers, the methods of distribution, and the nature of their regulatory environment. Accordingly, the Company’s consolidated financial statements reflect the presentation of segment information on an aggregated basis in one reportable segment.

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES—The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of December 31, 2010, the Company has not entered into a transaction in a dealer capacity.

When a derivative is intended to be a qualifying hedged instrument, the Company prepares written hedge documentation that designates the derivative as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or (2) a hedge of a forecasted transaction, such as, the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).

The written documentation includes identification of, among other items, the risk management objective, hedging instrument, hedged item, and methodologies for assessing and measuring hedge effectiveness and ineffectiveness, along with support for management’s assertion that the hedge will be highly effective. Methodologies related to hedge effectiveness and ineffectiveness include (1) statistical regression analysis of changes in the cash flows of the actual derivative and a perfectly effective hypothetical derivative, (2) statistical regression analysis of changes in fair values of the actual derivative and the hedged item and (3) comparison of the critical terms of the hedged item and the hedging derivative. Changes in fair value of a derivative that is highly effective and that has been designated and qualifies as a fair value hedge are recorded in current period earnings, along with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. Changes in the fair value of a derivative that is highly effective and that has been designed and qualifies as a cash flow hedge are initially recorded in other comprehensive income and reclassified to earnings in conjunction with the recognition of the earnings impacts of the hedged item; any ineffective portion is recorded in current period earnings. Designated hedge transactions are reviewed at least quarterly for ongoing effectiveness. Transactions that are no longer deemed to be effective are removed from hedge accounting

 

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classification and the recorded impacts of the hedge are recognized in current period income or expense in conjunction with the recognition of the income or expense on the originally hedged item.

The Company’s derivatives are based on underlying risks, primarily interest rates. The Company has previously utilized cash flow swaps to reduce the risks associated with interest rates. Swaps are contracts in which a series of net cash flows, based on a specific notional amount that is related to an underlying risk, are exchanged over a prescribed period.

Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk is equal to the fair value gain of the derivative. The credit exposure for swaps is the replacement cost of contracts that have become favorable. Credit risk is minimized by entering into transactions with high quality counterparties that are initially approved by the Board of Directors and reviewed periodically by the Asset Liability Committee. It is the Company’s policy to require that all derivatives be governed by an International Swap and Derivatives Associations Master Agreement (ISDA). Bilateral collateral agreements may also be required.

FAIR VALUE—The Company determines fair value based on applicable accounting guidance. The guidance establishes a fair value hierarchy, which requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance describes three levels of inputs that may be used to measure the fair value, which are provided in Note 18.

RECLASSIFICATIONS—Certain reclassifications have been made to the prior years’ financial statements to conform to the current year presentation.

ACCOUNTING POLICIES RECENTLY ADOPTED—In April 2011, the FASB issued Accounting Standards Update 2011-02, “The Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” This update provides additional guidance in determining what is considered a troubled debt restructuring (“TDR”). The update clarifies the two criteria that are required in determining a TDR. The update is effective for interim or annual periods beginning after June 15, 2011. The Company is currently evaluating the impact of this update to its consolidated financial statements.

Effective December 31, 2010, the Company adopted the provisions of the FASB Accounting Standards Update 2010-20, “Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses” (ASU 2010-20). The update requires additional disclosures about the credit quality of financing receivables, which include loans, lease receivables, and other long-term receivables, and the associated credit allowances. The disclosure requirements as of December 31, 2010 are included in Note 6, “Loans and Allowance for Loan and Lease Losses,” to the consolidated financial statements. Disclosures about activity that occurs during a reporting period will be effective in the interim reporting period ended March 31, 2011.

Effective January 1, 2010, the Company adopted the provisions of the FASB Accounting Standards Update 2010-06, “Improving Disclosures about Fair Value Measurements” (ASU 2010-06), which updates ASC 820 to require disclosure of significant transfers into and out of Level 1 and Level 2 of the fair value hierarchy, as well as disclosure of an entity’s policy for determining when transfers between all levels of the hierarchy are recognized. ASC 820, as amended, also provides enhanced disclosure requirements regarding purchases, sales, issuances, and settlements related to recurring Level 3 measurements, and requires separate disclosure in the Level 3 reconciliation of total gains and losses recognized in other comprehensive income. The updated provisions of ASC 820 require that fair value measurement disclosures be provided by each “class” of assets and liabilities, and that disclosures providing a description of the valuation techniques and inputs used to measure fair value be included for both recurring and nonrecurring fair value measurements classified as either Level 2 or Level 3. The provisions of ASU 2010-06 are effective for periods beginning after December 15, 2009, except for the requirement to provide the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis which will be effective for periods beginning after December 15, 2010. Comparative disclosures are required only for periods ending subsequent to initial adoption. The Company revised its disclosures accordingly.

 

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Effective January 1, 2010, the Company adopted the provisions of the FASB Accounting Standards Update 2009-16, “Accounting for Transfers of Financial Assets” (ASU 2009-16). ASU 2009-16 updates ASC 860 to provide for the removal of the qualifying special purpose entity (“QSPE”) concept from GAAP, resulting in the evaluation of all former QSPEs for consolidation on and after January 1, 2010 in accordance with ASC 810. The amendments to ASC 860 modify the criteria for achieving sale accounting for transfers of financial assets and define the term participating interest to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale. The updated provisions of ASC 860 also provide that a transferor should recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. ASC 860, as amended, requires enhanced disclosures which are generally consistent with, and supersede, the disclosures previously required by the Codification update to ASC 810 and ASC 860 which was effective for periods ending after December 15, 2008. The provisions of ASU 2009-16 are effective prospectively for new transfers of financial assets occurring in fiscal years beginning after November 15, 2009, and in interim periods within those fiscal years. ASC 860’s amended disclosure requirements should be applied to transfers that occurred both before and after the effective date of the Codification update, with comparative disclosures required only for periods subsequent to initial adoption for those disclosures not previously required under the Codification update to ASC 810 and ASC 860 which was effective for periods ending after December 15, 2008. The adoptions did not impact the Company’s consolidated financial statements.

Effective December 31, 2009, the Company adopted the provisions of FASB Accounting Standards Update (ASU) 2009-05, “Measuring Liabilities at Fair Value” (ASU 2009-05) to the FASB Accounting Standards Codification (ASC or Codification). ASU 2009-05 updates ASC 820 to clarify that a quoted price for the identical liability, when traded as an asset in an active market, is a Level 1 measurement for that liability when no adjustment to the quoted price is required. ASU 2009-05 further amends ASC 820 to provide that if a quoted price for an identical liability does not exist in an active market, the fair value of the liability should be measured using an approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. Under the updated provisions of ASC 820, for such liabilities fair value will be measured using either a valuation technique that uses the quoted price of the identical liability when traded as an asset, a valuation technique that uses the quoted price for similar liabilities or similar liabilities when traded as an asset, or another valuation technique that is consistent with the principles of ASC 820. The adoption had no significant impact on the Company’s consolidated financial statements.

Effective September 30, 2009, the Company adopted the provisions of the FASB Accounting Standard Codification 105-10, “Generally Accepted Accounting Principles.” This standard establishes the FASB Accounting Standards Codification as the single source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP, other than guidance issued by the SEC. Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority, with this Statement superseding all then-existing non-SEC accounting and reporting standards as of its effective date. Following this Statement, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standard Updates that will serve only to update the Codification. In conjunction with the adoption of this Statement, all references to pre-Codification Statements have either been removed or updated to reflect the new Codification reference. The adoption of this Statement did not have a significant impact on the Company’s consolidated financial statements.

Effective June 30, 2009, the Company adopted the FASB ASC 855, “Subsequent Events.” ASC 855 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In February 2010, the FASB issued ASU 2010-09, an update to ASC 855-10, “Subsequent Events.” This update amends the guidance to remove the requirement for SEC filers to disclose the date through which subsequent events have been evaluated. The amendment was effective and was adopted by the Company upon issuance.

 

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Effective June 30, 2009, the Company adopted ASC 825-10, “Financial Instruments.” This update requires disclosures about the fair value of financial instruments in interim financial statements. The guidance requires that disclosures be included in both interim and annual financial statements of the methods and significant assumptions used to estimate the fair value of financial instruments. Comparative disclosures are required only for periods ending subsequent to initial adoption. The additional required disclosures are presented in Note 12 of the Company’s consolidated financial statements.

Effective March 31, 2009, the Company adopted the FASB Codification update ASC 320-10-35 which replaces the “intent and ability to hold to recovery” indicator of other-than-temporary impairment in ASC 320-10-35 for debt securities. The guidance, issued in April 2009, establishes a new method of recognizing and reporting other-than-temporary impairments of debt securities as well as requiring additional disclosures related to debt and equity securities. Under the new guidance, an impairment is other-than-temporary if any of the following conditions exist: (1) the entity intends to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis or (3) the entity does not expect to recover the security’s entire amortized cost basis, even if the entity does not intend to sell. Additionally, the guidance requires that for impaired securities that an entity does not intend to sell that it is not more-likely-than-not that it will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. The guidance discusses the proper interaction with other authoritative guidance, including the additional factors that must be considered in an other-than-temporary impairment analysis. The additional disclosure requirements include a roll-forward of amounts recognized in earnings for debt securities for which an other-than-temporary impairment has been recognized and the noncredit portion of the other-than-temporary impairment that has been recognized in other comprehensive income. The adoption did not impact the Company’s consolidated financial statements.

Effective March 31, 2009, the Company first applied the provisions of the FASB ASC 820-10, “Fair Value Measurements and Disclosures,” that was issued in April 2009. The update provides factors that an entity should consider when determining whether a market for an asset is not active. If, after evaluating the relevant factors, the evidence indicates that a market is not active, the guidance provides an additional list of factors that an entity must consider when determining whether events and circumstances indicate that a transaction which occurred in an inactive market is orderly. The guidance requires that entities place more weight on observable transactions determined to be orderly and less weight on transactions for which there is insufficient information to determine whether the transaction is orderly when determining the fair value of an asset or liability under applicable authoritative guidance. The guidance also requires enhanced disclosures, including disclosure of a change in valuation technique that results from its application and disclosure of fair value measurements for debt and equity securities by major security types. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of the Codification update to ASC 815-10-50 which requires expanded disclosures about an entity’s derivative instruments and hedging activities, but does not change previous authoritative guidance on scope or accounting. This updated guidance requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under GAAP and its related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. To meet those objectives, this guidance requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures in a tabular format about fair value amounts and gains and losses on derivative instruments including specific disclosures regarding the location and amounts of derivative instruments in the financial statements, and disclosures about credit-risk-related contingent features in derivative agreements. The guidance also clarifies derivative instruments that are subject to the concentration of credit-risk disclosures. The adoption did not impact the Company’s consolidated financial statements.

 

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Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 805. This update establishes principles and requirements for how an acquirer in a business combination: recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and discloses information to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 805, which requires that an acquirer recognize at fair value as of the acquisition date an asset acquired or liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of the asset or liability can be determined during the measurement period. The guidance provides that if the acquisition-date fair value of an asset acquired or liability assumed in a business combination that arises from a contingency cannot be determined during the measurement period, the asset or liability should be recognized at the acquisition date if information available before the end of the measurement period indicates that it is probable that an asset existed or a liability had been incurred at the acquisition date and the amount of the asset or liability can be reasonably estimated. Additionally, the guidance requires enhanced disclosures regarding assets and liabilities arising from contingencies which are recognized at the acquisition date of a business combination, including the nature of the contingencies, the amounts recognized at the acquisition date and the measurement basis applied. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 810, as amended. The update establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This guidance clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be clearly reported as equity in the consolidated financial statements. Additionally, the guidance requires that the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated income statement. The adoptions did not impact the Company’s consolidated financial statements.

NOTE 2—GOING CONCERN AND REGULATORY MATTERS

The Company continues to operate in a difficult environment and has been significantly impacted by the unprecedented credit and economic market turmoil, as well as the recessionary economy. Deterioration in the Tennessee and Georgia commercial and residential real estate markets and related declined in property values in those markets has had a negative impact on the Company’s operating results since the latter half of 2008.

Operational Matters

The Company’s financial statements are presented on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has experienced losses from operations during the last two years that raise substantial doubt as to its ability to continue as a going concern. The Company’s ability to continue as a going concern is contingent upon its ability to devise and successfully execute a management plan to develop profitable operations, satisfy the requirements of the regulatory actions detailed below, and lower the level of problem assets to an acceptable level.

Management has developed strategic and capital plans, which include, but are not limited to: (1) reorganizing management into a line of business structure, (2) restructuring credit and lending functions with new policies and centralized processes, (3) reducing adversely classified assets, (4) maintaining an adequate allowance for loan losses, (5) actively working to maintain appropriate liquidity while reducing reliance on non-core sources of funding and (6) evaluating strategic and capital opportunities.

 

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The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the possible inability of the Company to continue as a going concern.

Regulatory Matters

First Security Group, Inc.

On September 7, 2010, the Company entered into a Written Agreement (Agreement) with the Federal Reserve Bank of Atlanta (Federal Reserve Bank), the Company’s primary regulator. The Agreement is designed to enhance the Company’s ability to act as a source of strength to the Bank.

The Agreement prohibits the Company from declaring or paying dividends without prior written consent of the Federal Reserve Bank. The Company is also prohibited from taking dividends, or any other form of payment representing a reduction of capital, from the Bank without prior written consent.

Within 60 days of the Agreement, the Company was required to submit to the Federal Reserve Bank a written plan designed to maintain sufficient capital at the Company and the Bank. The Company submitted a copy of the Bank’s capital plan that had previously been submitted to the OCC. Neither the Federal Reserve Bank nor the OCC have accepted that capital plan.

The Company is currently deemed not in compliance with several provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve Bank. Management believes the successful execution of the strategic initiatives discussed above will ultimately result in full compliance with the Agreement and position the Company for long-term growth and a return to profitability.

On September 14, 2010, the Company filed a current report on Form 8-K describing the Agreement. The Form 8-K also provides the final, executed Agreement.

FSGBank, N.A.

On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order (Order), FSGBank, the Company’s wholly-owned subsidiary, consented and agreed to the issuance of a Consent Order by the Office of the Comptroller of the Currency (OCC), the Bank’s primary regulator.

The Bank and the OCC agreed as to the areas of the Bank’s operations that warrant improvement and a plan for making those improvements. The Order required the Bank to develop and submit written strategic and capital plans covering at least a three-year period. The Board is required to ensure that competent management is in place in all executive officer positions to manage the Bank in a safe and sound manner. The Bank is also required to review and revise various policies and procedures, including those associated with concentration management, the allowance for loan and lease losses, liquidity management, criticized asset, loan review and credit administration. The Bank is continuing to work with the OCC to correct identified deficiencies in these policies.

Within 120 days of the effective date of the Order, the Bank was required to achieve and thereafter maintain total capital at least equal to 13 percent of risk-weighted assets and Tier 1 capital at least equal to 9 percent of adjusted total assets. As of December 31, 2010, the second financial reporting period subsequent to the 120 day requirement, the Bank’s total capital to risk-weighted assets was 12.2 percent and the Tier 1 capital to adjusted total assets was 7.1 percent. The Bank has notified the OCC of the non-compliance.

During the third quarter of 2010, the OCC requested additional information and clarifications to the Bank’s submitted strategic and capital plans as well as the management assessments. At this time, the Bank has not submitted updated strategic and capital plans. However, the Bank anticipates submitting these updates as soon as they are available.

 

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Because the Order established specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Order. As an adequately capitalized institution, the Bank may not pay interest on deposits that are more than 75 basis points above the rate applicable to the applicable market of the bank as determined by the FDIC. Additionally, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.

The Bank is currently deemed not in compliance with the provisions of the Order, including the capital requirements. Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. Management believes the successful execution of the strategic initiatives discussed above will ultimately result in full compliance with the Order and position the Bank for long-term growth and a return to profitability.

On April 29, 2010, the Company filed a current report on Form 8-K describing the Order. The Form 8-K also provides the final, executed Order.

NOTE 3—COMPREHENSIVE INCOME

Comprehensive income is a measure of all changes in equity, not only reflecting net income but certain other changes as well. The following table presents the comprehensive income for the years ended December 31, 2010, 2009 and 2008, respectively:

 

     2010     2009     2008  
     (in thousands)  

Net (loss) income

   $ (44,342   $ (33,455   $ 1,361   
                        

Other comprehensive (loss) income:

      

Available-for-sale securities:

      

Unrealized net (loss) gain on securities arising during the period

     (1,226     2,390        1,051   

Tax benefit (expense) related to unrealized net gain

     417        (815     (357

Reclassification adjustments for realized gain included in net income

     (57     —          (146

Tax expense related to gain realized in net income

     19        —          50   
                        

Unrealized (loss) gain on securities, net of tax

     (847     1,575        598   
                        

Derivative cash flow hedges:

      

Unrealized gain on derivatives arising during the period

     42        353        5,474   

Tax expense related to unrealized gain

     (14     (121     (1,861

Reclassification adjustments for realized gain included in net income

     (2,022     (2,310     (1,936

Tax expense related to gain realized in net income

     688        785        658   
                        

Unrealized (loss) gain on derivatives, net of tax

     (1,306     (1,293     2,335   
                        

Other comprehensive (loss) income, net of tax

     (2,153     282        2,933   
                        

Comprehensive (loss) income, net of tax

   $ (46,495   $ (33,173   $ 4,294   
                        

 

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NOTE 4—EARNINGS PER SHARE

The difference in basic and diluted weighted average shares is due to the assumed conversion of outstanding stock options, restricted stock awards and common stock warrants using the treasury stock method. The computation of basic and diluted earnings per share is as follows:

 

     2010     2009     2008  
    

(in thousands, except

per share amounts)

 

Numerator:

      

Net (loss) income available to common stockholders

   $ (46,371   $ (35,409   $ 1,361   
                        

Denominator:

      

Weighted average basic common shares outstanding

     15,740        15,550        16,021   

Effect of diluted securities:

      

Equivalent shares issuable upon exercise of stock options, stock warrants and restricted stock awards

     —          —          122   
                        

Weighted average diluted common shares outstanding

     15,740        15,550        16,143   
                        

Net (loss) income per share:

      

Basic

   $ (2.95   $ (2.28   $ 0.08   

Diluted

   $ (2.95   $ (2.28   $ 0.08   

On January 9, 2009, as part of the Capital Purchase Program (CPP) administered by the U.S. Department of the Treasury (Treasury) under the Troubled Asset Relief Program (TARP), the Company issued a ten-year warrant to purchase up to 823,627 shares of the Company’s common stock, $0.01 par value, at an exercise price of $6.01 per share. Note 16 discusses the transaction in further detail. The common stock warrants are treated as outstanding options under the treasury stock method for calculating the weighted average diluted shares outstanding. For the years ended December 31, 2010 and 2009, the common stock warrants were anti-dilutive.

As of December 31, 2010, 2009 and 2008, the outstanding stock options and restricted stock awards that were anti-dilutive totaled 1,013 thousand, 1,273 thousand and 757 thousand, respectively. Anti-dilutive options and awards are not included in the computation of diluted earnings per share under the treasury stock method. Under authoritative accounting guidance, options with an exercise price less than the average price can be anti-dilutive due to the inclusion of unamortized compensation. The anti-dilutive options expire between 2011 and 2020.

 

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NOTE 5—SECURITIES

Investment Securities by Type

The amortized cost and fair value of securities, with gross unrealized gains and losses, are as follows:

 

     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Fair Value  
     (in thousands)  

Securities available-for-sale

           

December 31, 2010

           

Debt securities—

           

Federal agencies

   $ 31,967       $ 199       $ 339       $ 31,827   

Mortgage-backed

     84,515         2,366         73         86,808   

Municipals

     34,700         947         147         35,500   

Other

     127         —           97         30   
                                   
   $ 151,309       $ 3,512       $ 656       $ 154,165   
                                   

Securities available-for-sale

           

December 31, 2009

           

Debt securities—

           

Federal agencies

   $ 17,226       $ 144       $ 16       $ 17,354   

Mortgage-backed

     80,338         3,225         477         83,086   

Municipals

     41,216         1,373         66         42,523   

Other

     126         —           44         82   
                                   
   $ 138,906       $ 4,742       $ 603       $ 143,045   
                                   

Proceeds from sales of securities available-for-sale totaled $14,762 thousand and $13,126 thousand for the years ended December 31, 2010 and 2008, respectively. There were no sales of securities during the year ended December 31, 2009. Gross realized gains from sales of securities were $368 thousand and $146 thousand for the years ended December 31, 2010 and 2008, respectively. Gross realized losses were $311 thousand from sales of securities available-for-sale for the year ended December 31, 2010.

At December 31, 2010 and 2009, federal agencies, municipals and mortgage-backed securities with a carrying value of $21,572 thousand and $12,600 thousand, respectively, were pledged to secure public deposits. At December 31, 2010 and 2009, the carrying amount of securities pledged to secure repurchase agreements was $30,254 thousand and $26,472 thousand, respectively. At December 31, 2010, securities of $5,756 thousand were pledged to the Federal Reserve Bank of Atlanta to secure the Company’s daytime correspondent transactions.

Maturity of Securities

The amortized cost and fair value of debt securities by contractual maturity at December 31, 2010, are as follows:

 

     Amortized
Cost
     Fair
Value
 
     (in thousands)  

Within 1 year

   $ 2,169       $ 2,204   

Over 1 year through 5 years

     33,889         34,404   

5 years to 10 years

     26,406         26,624   

Over 10 years

     4,330         4,125   
                 
     66,794         67,357   

Mortgage-backed securities

     84,515         86,808   
                 
   $ 151,309       $ 154,165   
                 

 

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Impairment Analysis

The following table shows the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2010 and 2009.

 

     Less than 12 months      12 months or greater      Totals  
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 
     (in thousands)  

December 31, 2010

                 

Federal agencies

   $ 15,147       $ 339       $ —         $ —         $ 15,147       $ 339   

Mortgage-backed

     8,466         73         —           —           8,466         73   

Municipals

     4,030         110         364         37         4,394         147   

Other

     —           —           30         97         30         97   
                                                     

Totals

   $ 27,643       $ 522       $ 394       $ 134       $ 28,037       $ 656   
                                                     

December 31, 2009

                 

Federal agencies

   $ 1,982       $ 16       $ —         $ —         $ 1,982       $ 16   

Mortgage-backed

     2,375         6         3,086         471         5,461         477   

Municipals

     1,404         31         617         35         2,021         66   

Other

     —           —           82         44         82         44   
                                                     

Totals

   $ 5,761       $ 53       $ 3,785       $ 550       $ 9,546       $ 603   
                                                     

As of December 31, 2010, the Company performed an impairment assessment of the securities in its portfolio that had an unrealized loss to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) the Company intends to sell the security, (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized costs basis or (3) the Company does not expect to recover the security’s entire amortized cost basis, even if the Company does not intend to sell. Additionally, accounting guidance requires that for impaired securities that the Company does not intend to sell and/or that it is not more-likely-than-not that the Company will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.

In evaluating the recovery of the entire amortized cost basis, the Company considers factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.

As of December 31, 2010, gross unrealized losses in the Company’s portfolio totaled $656 thousand, compared to $603 thousand as of December 31, 2009. The unrealized losses in federal agencies (consisting of five securities), mortgage-backed (consisting of three securities) and municipal (consisting of twelve securities) securities are primarily due to widening credit spreads and changes in interest rates subsequent to purchase. The unrealized losses in other securities are two trust preferred securities. The unrealized losses in the trust preferred securities are primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. The Company does not intend to sell the investments with unrealized losses and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity. Based on results of the Company’s impairment assessment, the unrealized losses at December 31, 2010 are considered temporary.

 

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NOTE 6—LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES

Loans by type are summarized as follows:

 

     2010     2009  
     (in thousands)  

Loans secured by real estate—

    

Residential 1-4 family

   $ 252,026      $ 281,354   

Commercial

     226,357        259,819   

Construction

     84,232        153,144   

Multi-family and farmland

     36,393        37,960   
                
     599,008        732,277   

Commercial loans

     82,807        146,016   

Consumer installment loans

     33,860        48,927   

Leases, net of unearned income

     7,916        19,730   

Other

     3,500        5,068   
                

Total loans

     727,091        952,018   

Allowance for loan and lease losses

     (24,000     (26,492
                

Net loans

   $ 703,091      $ 925,526   
                

The loan portfolio includes lease financing receivables consisting of direct financing leases on equipment. The components of the investment in lease financing were as follows:

 

     2010     2009  
     (in thousands)  

Lease payments receivable

   $ 8,850      $ 22,422   

Estimated residual value of leased assets

     188        714   
                

Gross investment in lease financing

     9,038        23,136   

Unearned income

     (1,122     (3,406
                

Net investment in lease financing

   $ 7,916      $ 19,730   
                

At December 31, 2010, the minimum future lease payments to be received were as follows:

 

     Amount  
     (in thousands)  

2011

   $ 6,196   

2012

     2,087   

2013

     500   

2014

     67   

2015 and after

     —     
        

Total lease payments receivable

   $ 8,850   
        

The allowance for loan and lease losses is composed of three primary components: (1) specific impairments for substandard/nonaccrual loans and leases, (2) general allocations for classified loan pools, including special mention and substandard/accrual loans, and (3) general allocations for the remaining pools of loans. The Company accumulates pools based on the underlying classification of the collateral. Each pool is assigned a loss severity rate based on historical loss experience and various qualitative and environmental factors, including, but not limited to, credit quality and economic conditions. Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may materially change in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

 

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The following table presents an analysis of the allowance for loan and lease losses for the year ended December 31, 2010. The provisions for loan and lease losses in the table below do not include the Company’s provision accrual for unfunded commitments of $24 thousand, $24 thousand and $24 thousand as of December 31, 2010, 2009 and 2008, respectively. The reserve for unfunded commitments is included in other liabilities in the consolidated balance sheets and totaled $229 thousand and $205 thousand at December 31, 2010 and 2009, respectively.

Allowance for Loan and Lease Losses

For the Year Ended December 31, 2010

 

    Real estate:
Residential
1-4 family
    Real estate:
Commercial
    Real estate:
Construction
    Real estate:
Multi-
family and
farmland
    Commercial     Consumer     Leases     Other     Unallocated     Total  
    (in thousands)  

Allowance for loan and lease losses:

                   

Beginning balance, December 31, 2009

  $ 5,037      $ 4,525      $ 6,706      $ 766      $ 6,953      $ 1,107      $ 1,386      $ 12      $ —        $ 26,492   

Charge-offs

    (2,572     (2,955     (10,514     (1,150     (16,420     (1,061     (2,050     (49     —          (36,771

Recoveries

    56        160        7        —          326        138        —          3        —          690   

Provision

    4,825        3,820        6,706        1,145        14,833        629        1,581        50        —          33,589   
                                                                               

Ending balance, December 31, 2010

  $ 7,346      $ 5,550      $ 2,905      $ 761      $ 5,692      $ 813      $ 917      $ 16      $ —        $ 24,000   
                                                                               

Ending balance: Individually evaluated for impairment

  $ —        $ —        $ 148      $ —        $ 309      $ —        $ —        $ —          $ 457  
                                                                         

Ending balance: Collectively evaluated for impairment

  $ 7,346      $ 5,550      $ 2,757     $ 761      $ 5,383     $ 813      $ 917      $ 16      $ —        $ 23,543  
                                                                               

Ending balance: Loans acquired with deteriorated credit quality

  $ —        $ —        $ —        $ —        $ —        $ —        $ —        $ —        $ —        $ —     
                                                                               

Loans and Leases:

                   

Ending balance, December 31, 2010

  $ 252,026      $ 226,357      $ 84,232      $ 36,393      $ 82,807      $ 33,860      $ 7,916      $ 3,500        $ 727,091   
                                                                         

Ending balance: Individually evaluated for impairment

  $ 1,944      $ 8,232      $ 23,909      $ 415      $ 3,600      $ 1,423      $ 2,083      $ —          $ 41,606   
                                                                         

Ending balance: Collectively evaluated for impairment

  $ 249,619      $ 218,028      $ 60,323      $ 35,978      $ 79,207      $ 32,341      $ 5,833      $ 3,486        $ 684,815   
                                                                         

Ending balance: Loans acquired with deteriorated credit quality

  $ 463      $ 97      $ —        $ —        $ —        $ 96      $ —        $ 14        $ 670   
                                                                         

The following table presents an analysis of the allowance for loan and lease losses for the years ended December 31, 2009 and 2008.

 

     2009     2008  

Allowance for loan and lease losses—beginning of year

   $ 17,385      $ 10,956   

Provision expense for loan and lease losses

     25,380        15,729   

Loans charged off

     (16,682     (9,519

Loan loss recoveries

     409        219   
                

Allowance for loan and lease losses—end of year

   $ 26,492      $ 17,385   
                

The Company utilizes a risk rating system to evaluate the credit risk of its loan portfolio. The Company classifies loans as: pass, special mention, substandard, doubtful or loss. The Company assigns a pass rating to loans that are performing as contractually agreed and do not exhibit the characteristics of heightened credit risk. The Company assigns a special mention risk rating to loans that are criticized but not considered as severe as a classified loan. Special mention loans generally contain one or more potential weaknesses, which if not corrected, could result in an unacceptable increase in the credit risk at some future date. The Company assigns a substandard risk rating to loans that have specifically identified weaknesses and deficiencies typically resulting from severe adverse trends of a financial, economic or managerial nature and may require nonaccrual status. Substandard loans have a greater likelihood of loss.

 

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The Company segregates substandard loans into two classifications based on the Company’s allowance methodology for impaired loans. The Company defines an impaired loan as a substandard loan relationship in excess of $500 thousand that is also on nonaccrual status. The Company individually reviews these relationships on a quarterly basis to determine the required allowance or loss, as applicable.

For the allowance analysis, the Company’s primary categories are: pass, special mention, substandard – non-impaired, and substandard – impaired. Loans in the substandard and doubtful loan categories are combined and impaired loans are segregated from non-impaired loans. The following table presents the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of December 31, 2010:

 

     Pass      Special
Mention
     Substandard –
Non-impaired
     Substandard –
Impaired
     Total  
     (in thousands)  

Loans by Classification

              

Real estate: Residential 1-4 family

   $ 217,470       $ 7,378       $ 25,234       $ 1,944       $ 252,026   

Real estate: Commercial

     182,584         18,030         17,511         8,232         226,357   

Real estate: Construction

     46,305         3,970         10,048         23,909         84,232   

Real estate: Multi-family and farmland

     30,835         3,238         1,905         415         36,393   

Commercial

     54,553         4,338         20,316         3,600         82,807   

Consumer

     31,238         43         1,156         1,423         33,860   

Leases

     —           2,036         3,797         2,083         7,916   

Other

     3,464         —           36         —           3,500   
                                            

Total Loans

   $ 566,449       $ 39,033       $ 80,003       $ 41,606       $ 727,091   
                                            

The Company classifies a loan as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans were $41,606 thousand and $40,118 thousand at December 31, 2010 and 2009, respectively. For impaired loans, the Company generally applies all payments directly to principal. Accordingly, the Company did not recognize any significant amount of interest for impaired loans during the years ended December 31, 2008, 2009 or 2010. The following table presents additional information on the Company’s impaired loans as of December 31, 2010:

 

     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
 

Impaired loans with no related allowance recorded:

        

Real estate: Residential 1-4 family

   $ 1,944       $ 2,265       $ —     

Real estate: Commercial

     8,232         9,210         —     

Real estate: Construction

     18,644         24,886         —     

Real estate: Multi-family and farmland

     415         415         —     

Commercial

     2,658         12,634         —     

Consumer

     1,423         1,423         —     

Leases

     2,083         2,198         —     

Other

     —           —           —     
                          

Total

   $ 35,399       $ 53,031       $ —     
                          

 

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     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
 

Impaired loans with an allowance recorded:

        

Real estate: Residential 1-4 family

   $ —         $ —         $ —     

Real estate: Commercial

     —           —           —     

Real estate: Construction

     5,265         5,400         148   

Real estate: Multi-family and farmland

     —           —           —     

Commercial

     942         977         309   

Consumer

     —           —           —     

Leases

     —           —           —     

Other

     —           —           —     
                          

Total

   $ 6,207       $ 6,377       $ 457   
                          

Nonaccrual loans were $54,082 thousand and $45,454 thousand at December 31, 2010 and 2009, respectively. The following table provides nonaccrual loans by type:

 

     As of December 31,
2010
     As of December 31,
2009
 

Nonaccrual Loans by Classification

     

Real estate: Residential 1-4 family

   $ 8,906       $ 6,059   

Real estate: Commercial

     9,181         5,043   

Real estate: Construction

     25,586         13,706   

Real estate: Multi-family and farmland

     826         1,113   

Commercial

     4,228         15,379   

Consumer and other

     1,896         1,765   

Leases

     3,459         2,389   
                 

Total Loans

   $ 54,082       $ 45,454   
                 

The Company monitors loans by past due status. The following table provides the past due status for all loans. Nonaccrual loans are included in the applicable classification.

 

    30-89
Days
Past Due
    Greater than
90 Days Past
Due
    Total
Past Due
    Current     Total     Greater than
90 Days Past
Due and
Accruing
 

Loans by Classification

           

Real estate: Residential 1-4 family

  $ 3,629      $ 5,855      $ 9,484      $ 242,542      $ 252,026      $ 403   

Real estate: Commercial

    5,185        5,905        11,090        215,267        226,357        2,271   

Real estate: Construction

    3,732        15,371        19,103        65,129        84,232        3   

Real estate: Multi-family and farmland

    53        1,757        1,810        34,583        36,393        985   
                                               

Subtotal of real estate secured loans

    12,599        28,888        41,487        557,521        599,008        3,662   

Commercial

    1,726        2,955        4,681        78,126        82,807        409   

Consumer

    384        2,430        2,814        31,046        33,860        679   

Leases

    2,725        3,055        5,780        2,136        7,916        82   

Other

    80        6        86        3,414        3,500        6   
                                               

Total Loans

  $ 17,514      $ 37,334      $ 54,848      $ 672,243      $ 727,091      $ 4,838   
                                               

At December 31, 2010, the Company had $161,622 thousand of loans pledged to secure borrowings from the Federal Home Loan Bank of Cincinnati. The loans pledged included all residential first mortgage loans.

 

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The Company has entered into transactions with certain directors, executive officers and significant stockholders and their affiliates. Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features. The aggregate amount of loans to such related parties at December 31, 2010 and 2009 was $1,050 thousand and $3,841 thousand, respectively. New loans made to such related parties amounted to $206 thousand and principal and interest payments amounted to $2,280 thousand for 2010. Additionally, new directors for 2010 had loans totaling $746 thousand as of their appointment dates and resigning directors during 2010 had loans totaling $1,426 thousand as of their resignation dates. New loans made to such related parties amounted to $253 thousand and principal and interest payments amounted to $920 thousand for 2009. At December 31, 2010, unused lines of credit to these related parties totaled $26 thousand.

NOTE 7—PREMISES AND EQUIPMENT

Premises and equipment consist of the following:

 

     2010     2009  
     (in thousands)  

Land and improvements

   $ 10,188      $ 10,649   

Buildings and improvements

     25,236        25,770   

Equipment

     14,193        14,164   
                

Premises and equipment-gross

     49,617        50,583   

Accumulated depreciation

     (18,803     (17,426
                

Premises and equipment-net

   $ 30,814      $ 33,157   
                

The amount charged to operating expenses for depreciation was $1,795 thousand for 2010, $2,076 thousand for 2009 and $2,450 thousand for 2008.

NOTE 8—GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill and Related Impairment Analysis

The changes in the carrying amounts of goodwill are as follows:

 

     2010      2009  
     (in thousands)  

Balance—beginning of year

   $ —         $ 27,156   

Goodwill acquired

     —           —     

Goodwill impairment

     —           (27,156
                 

Balance—end of year

   $ —         $ —     
                 

The Company’s policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount as required by authoritative accounting guidance. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The impairment testing is a two-step process. Step 1 compares the fair value of the reporting unit to the carrying value. If the fair value is below the carrying value, Step 2 is performed. Step 2 involves a process similar to business combination accounting in which fair value is assigned to all assets, liabilities and other (non-goodwill) intangibles. The result of Step 2 is the implied fair value of goodwill. If the implied fair value of goodwill is below the recorded goodwill amount, an impairment charge is recorded for the difference.

 

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The Company engaged an independent valuation firm to assist in computing the fair value estimate for the goodwill impairment assessment as of September 30, 2009. The firm utilized two separate valuation methodologies for Step 1 and compared the results of each to determine the fair value of the goodwill associated with the Company’s prior bank acquisitions. The valuation methodologies utilized included a discounted cash flow valuation technique and a comparison of the average price to book value of comparable bank acquisitions. Both methods indicated a valuation below the book value of the Company. The firm conducted Step 2, which assigned fair values to all assets, liabilities and other (non-goodwill) intangibles. The results of Step 2 indicated a full goodwill impairment of $27,156 thousand that is recorded in non-interest expense in the Consolidated Statements of Income for the year ended December 31, 2009. The impairment was primarily a result of the continuing economic downturn and its implications on bank valuations.

The Company’s goodwill was associated with six prior acquisitions. Three acquisitions were taxable asset purchases and three were non-taxable stock purchases. The goodwill impairment that is deductible for tax is $6,953 thousand, which added $2,394 thousand to the tax benefit recognized in the third quarter of 2009. The remaining $20,203 thousand goodwill impairment is not deductible for taxes and thus no tax benefit was recognized.

Other Intangible Assets

The Company has other intangible assets in the form of core deposit intangibles. The core deposit intangibles are amortized on an accelerated basis over their estimated useful lives of 10 years. A summary of other intangible assets is as follows:

 

     2010      2009  
     (in thousands)  

Gross carrying amount

   $ 7,041       $ 7,041   

Less: Accumulated amortization and impairment

     5,580         5,123   
                 

Balance

   $ 1,461       $ 1,918   
                 

Amortization expense on other intangible assets was $457 thousand for 2010, $485 thousand for 2009 and $796 thousand in 2008. For 2008, the amortization expense was associated with core deposit intangibles, a non-compete agreement and a license fee. Amortization expense for the Company’s core deposit intangibles for the next five years is as follows:

 

     Year  
     (in thousands)  

2011

   $ 479   

2012

     382   

2013

     270   

2014

     196   

2015

     134   
        
   $ 1,461   
        

 

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NOTE 9—DEPOSITS

The aggregate amount of time deposits of $100 thousand or more was $153,138 thousand and $207,465 thousand at December 31, 2010 and 2009, respectively. Brokered deposits were $314,876 thousand and $339,750 thousand at December 31, 2010 and 2009, respectively, as follows:

 

     2010      2009  
     (in thousands)  

Brokered certificates of deposits

   $ 302,584       $ 239,283   

Brokered money market accounts

     —           76,749   

Brokered NOW accounts

     —           514   

CDARS®

     12,292         23,204   
                 
   $ 314,876       $ 339,750   
                 

Brokered certificates of deposits issued in denominations of $100 thousand or more are participated out by the deposit brokers in shares of $100 thousand or less. CDARS® includes $6,582 thousand one-way buy deposits and $5,710 thousand in First Security customers’ reciprocal accounts as of December 31, 2010.

Scheduled maturities of time deposits as of December 31, 2010, are as follows:

 

     Time
Deposits
     Brokered
CDs
     CDARS®      Totals  
     (in thousands)  

2011

   $ 295,028       $ 54,681       $ 10,817       $ 360,526   

2012

     52,751         59,403         1,018         113,172   

2013

     6,329         90,418         —           96,747   

2014

     2,801         70,254         457         73,512   

2015 and thereafter

     1,904         27,828         —           29,732   
                                   
   $ 358,813       $ 302,584       $ 12,292       $ 673,689   
                                   

NOTE 10—FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

At December 31, 2010, the Company had no lines of credit to purchase federal funds with correspondent banks. At December 31, 2009, the Company had lines of credit to purchase federal funds totaling $50,000 thousand with correspondent banks for short-term liquidity needs. The terms of each line of credit varied with respect to borrowing capacity and the duration of time for which the borrowing can be outstanding. At December 31, 2009, the Company had full access to the $50,000 thousand in overnight federal funds purchased.

Securities sold under agreements to repurchase represent the purchase of interests in securities by commercial checking customers. The Company may also enter into structured repurchase agreements with other financial institutions. Repurchase agreements with commercial checking customers are settled the following business day, while structured repurchase agreements with other financial institutions will have varying terms.

At December 31, 2010 and 2009, the Company had securities sold under agreements to repurchase of $5,933 thousand and $7,911 thousand, respectively, by commercial checking customers. The Company had a structured repurchase agreement with another financial institution of $10,000 thousand at December 31, 2010 and 2009. Securities sold under agreements to repurchase are held in safekeeping for the Company and had a carrying value of approximately $30,254 thousand and $26,472 thousand at December 31, 2010 and 2009, respectively. These agreements averaged $18,435 thousand and $20,828 thousand during 2010 and 2009, respectively. The maximum amounts outstanding at any month end during 2010 and 2009 were $20,507 thousand and $23,564 thousand, respectively. Interest expense on repurchase agreements totaled $474 thousand, $498 thousand and $835 thousand for the years ended 2010, 2009 and 2008, respectively.

 

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The structured repurchase agreement with another financial institution provides for a variable rate of three-month LIBOR minus 75 basis points for the first year ending November 6, 2008 and a fixed rate of 3.93% for the remaining term, and is callable on a quarterly basis after the first year. The maturity date is November 6, 2012.

NOTE 11—OTHER BORROWINGS

Other borrowings at December 31, 2010, consist of long-term fixed rate advances from the Federal Home Loan Bank of Cincinnati (FHLB) totaling $3 thousand and a mortgage note totaling $74 thousand. Additionally, the Company had an FHLB letter of credit totaling $9,000 thousand which reduces the FHLB borrowing capacity. The letter of credit was not in use as of December 31, 2010. Other borrowings at December 31, 2009, consist of long-term fixed rate advances from the FHLB totaling $5 thousand and a mortgage note totaling $89 thousand. Additionally, the Company had an FHLB letter of credit totaling $9,000 thousand which reduces the FHLB borrowing capacity. The letter of credit was not in use as of December 31, 2009.

Pursuant to the blanket agreement for advances and security agreements with the FHLB, advances as of December 31, 2010 and 2009 are secured by the Company’s unencumbered qualifying 1-4 family first mortgage loans subject to varying limitations determined by the FHLB. Advances for both years are also secured by the FHLB stock owned by the Company. As of December 31, 2010, for additional borrowing capacity, the FHLB required the Company to pledge investment securities or individual, qualifying loans, subject to approval of the FHLB. As of December 31, 2010 and 2009, the Company had loans totaling $161,622 thousand and $181,740 thousand, respectively, pledged as collateral at the FHLB. At December 31, 2010, the Company’s remaining available borrowing capacity with the FHLB was approximately $1,664 thousand.

As a member of FHLB, the Company must own FHLB stock. The amount of FHLB stock required to be held is subject the Company’s asset size and outstanding FHLB advances. At December 31, 2010 and 2009, the Company owned FHLB stock totaling $2,276 thousand and $2,276 thousand, respectively.

The terms of the FHLB advances and other borrowing as of December 31, 2010 are as follows:

 

Maturity
Year

   Origination
Date
 

Type

   Principal      Original
Term
     Rate     Maturity  
              (in thousands)                      

2011

   6/18/1996*   FHLB fixed rate advance    $ 1         180 months         7.70     7/1/2011   

2011

   9/16/1996*   FHLB fixed rate advance    $ 1         180 months         7.50     10/1/2011   

2012

   9/9/1997*   FHLB fixed rate advance    $ 1         180 months         7.05     10/1/2012   

2015

   1/5/1995   Fixed rate mortgage    $ 74         240 months         7.50     1/5/2015   

 

* Assumed as part of the acquisition of Jackson Bank

NOTE 12—LEASES

The Company leases bank branches and equipment under operating lease agreements. Minimum lease commitments with remaining noncancelable lease terms in excess of one year as of December 31, 2010, are as follows:

 

     Amount  
     (in thousands)  

2011

   $ 870   

2012

     606   

2013

     529   

2014

     456   

2015

     447   

Thereafter

     4,432   
        

Total minimum lease commitments

   $ 7,340   
        

 

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Rent expense totaled $986 thousand, $954 thousand and $1,000 thousand for the years ended 2010, 2009 and 2008, respectively.

NOTE 13—INCOME TAXES

The Company accounts for income taxes in accordance with ASC 740, which requires an asset and liability approach for the financial accounting and reporting of income taxes. Under this method, deferred income taxes are recognized for the expected future tax consequences of differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. These balances are measured using the enacted tax rates expected to apply in the year(s) in which these temporary differences are expected to reverse. The effect on deferred income taxes of a change in tax rates is recognized in income in the period when the change is enacted.

In accordance with ASC 740, the Company is required to establish a valuation allowance for deferred tax assets when it is “more likely than not” that a portion or all of the deferred tax assets will not be realized. The evaluation requires significant judgment and extensive analysis of all available positive and negative evidence, the forecasts of future income, applicable tax planning strategies and assessments of the current and future economic and business conditions.

During 2010, the Company established a $24,550 thousand deferred tax asset valuation allowance after evaluating all available positive and negative evidence. Positive evidence included the existence of taxes paid in available carryback years. Negative evidence included a cumulative loss in recent years and general business and economic trends. As business and economic conditions change, the Company will re-evaluate the valuation allowance.

For 2010, the Company recognized an income tax expense of $9,679 thousand compared to income tax benefits of $8,252 thousand and $587 thousand for 2009 and 2008, respectively. The following reconciles the income tax provision (benefit) to statutory rates:

 

     For the Years Ended  
     2010     2009     2008  
     (in thousands)  

Federal taxes at statutory tax rate

   $ (11,785   $ (14,180   $ 263   

Increase (decrease) resulting from:

      

Non-deductible goodwill impairment

     —          6,869        —     

Low income housing and historical tax credits

     (895     —          —     

Tax exempt earnings from securities

     (480     (547     (546

Tax exempt earnings on bank owned life insurance

     (351     (342     (329

Increase in unrecognized tax benefits for prior year tax positions

     —          1,096        —     

Other, net

     126        (270     267   

State tax (benefit) provision, net of federal effect

     (1,486     (878     (242

Changes in the deferred tax asset valuation allowance

     24,550        —          —     
                        

Income tax provision (benefit)

   $ 9,679      $ (8,252   $ (587
                        

The income tax (benefit) provision consists of the following:

 

     For the Years Ended  
     2010     2009     2008  
     (in thousands)  

Current (benefit) provision

   $ (2,778   $ (754   $ 2,637   

Deferred provision (benefit)

     12,457        (7,498     (3,224
                        

Income tax provision (benefit)

   $ 9,679      $ (8,252   $ (587
                        

 

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The deferred tax asset valuation allowance of $24,550 thousand fully offset the income tax benefits recognized during 2010. The benefit recognized before the valuation allowance primarily related to increases in deferred tax assets, including the allowance for loan and lease losses and the year-to-date operating loss. The benefit recognized during 2009 primarily relates to increase in deferred tax assets including the increase associated with the temporary difference of the allowance for loan and lease losses, the tax-deductible portion of the goodwill impairment and the net operating loss.

The Company recognized a goodwill impairment of $27,156 thousand in the third quarter of 2009. Approximately $6,953 thousand of the impairment was deductible for taxes, which represents $2,394 thousand of the total 2009 income tax benefit. The remaining $20,203 thousand of the impairment was not deductible for taxes. As shown above, this non-deductible portion significantly impacts the effective tax rate for 2009.

The components of the net deferred tax asset and liability included in other assets and liabilities consist of the following:

 

     2010     2009  
     (in thousands)  

Deferred tax assets

    

Net operating loss carryforward

   $ 12,553      $ —    

Allowance for loan and lease losses

     8,821        9,478   

Federal tax credits

     1,933        —     

Other real estate owned

     1,667        1,354   

Goodwill and other intangible assets

     1,125        1,481   

Salary continuation plan

     874        686   

Acquisition fair value adjustments

     78        80   

Deferred loan fees

     73        128   

Other assets

     979        75   
                

Total deferred tax assets

     28,103        13,282   
                

Deferred tax liabilities

    

Premises and equipment

     1,682        1,930   

Core deposit intangibles

     253        390   

Leasing activities

     223        613   

Securities available-for-sale

     971        1,407   

FHLB stock

     305        307   

Gain on business combination

     40        67   

Other

     79        1,189   
                

Total deferred tax liabilities

     3,553        5,903   
                

Net deferred tax asset before valuation allowance

     24,550        7,379   

Deferred tax asset valuation allowance

     (24,550     —    
                

Net deferred tax asset after valuation allowance

   $ —       $ 7,379   
                

During 2010, the Company entered into a net operating loss carryforward position for federal tax purposes. The net operating loss and federal tax credits as disclosed above can be carried forward for a 20 year period and if not utilized, will expire in 2030.

The Company evaluated its material tax positions as of December 31, 2010. Under the “more-likely-than-not” threshold guidelines, the Company believes it has identified all significant uncertain tax benefits. The Company evaluates, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be accrued, in accordance with Internal Revenue Service guidelines, and recorded as a component of

 

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income tax expense in the Company’s consolidated financial statements. The roll-forward of unrecognized tax benefits is as follows:

 

     Amount  
     (in thousands)  

Balance at January 1, 2010

   $ 1,146   

Increases related to prior year tax positions

     —     

Increases related to current year tax positions

     192   

Lapse of statute

     —     
        

Balance at December 31, 2010

   $ 1,338   
        

NOTE 14—RETIREMENT PLANS

401(k) and ESOP Plan

The Company has a 401(k) and employee stock ownership plan (the Plan) covering employees meeting certain age and service requirements. Employees may contribute up to 75% of their compensation subject to certain limits based on federal tax laws. From January 1, 2008 to June 30, 2010, the Company made matching contributions equal to 100% of the employee’s contribution up to 6% of the employee’s compensation. Effective July 1, 2010, the Company’s matching contribution was reduced to 1% of the employee’s compensation. The employer contribution is made in the form of Company common stock on a quarterly basis. The employee and employer contributions and earnings thereon are vested immediately. In its sole discretion at the end of the Plan year, the Company may make supplemental matching contributions or profit sharing contributions.

The Company recognized $331 thousand, $617 thousand and $762 thousand in expense under the Plan for 2010, 2009 and 2008, respectively, which has been included in salaries and employee benefits in the accompanying consolidated statements of income.

The employee stock ownership (ESOP) portion of the Plan purchased shares of common stock with proceeds from advances of a loan from the Company. The loan between the Company and the Plan enabled the Plan to borrow up to $12,745 thousand until December 31, 2009, as amended on January 28, 2009. The loan has a term of 30 years, bears interest at 6.25% and requires annual payments. The loan is secured by the stock purchased by the Plan that has not been allocated to participant accounts. The Company may make discretionary profit sharing contributions to the ESOP. The ESOP contribution will first be used to repay the loan. As the loan is repaid, shares are released from collateral based on the proportion of the payment in relation to total payments required to be made on the loan, and those shares are allocated to the ESOP accounts of participants on a quarterly or annual basis. Cash dividends on financed shares will first be used to repay the acquisition loan. Cash dividends on allocated shares are payable to the participants in cash or reinvested in Company stock no later than 90 days from the end of the Plan year.

 

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Compensation expense is determined by multiplying the per share market price of the common stock by the number of shares to be released. The number of unallocated, committed to be released and allocated shares are as follows:

 

     Unallocated
shares
    Committed
to be
released
shares
     Allocated
shares
     Compensation
Expense
 
                         (in thousands)  

Shares as of December 31, 2007

     377,389        —           122,611      

Shares purchased by ESOP during 2008

     451,876        —           —        

Shares allocated for match during 2008

     (119,102     —           119,102       $ 762   
                                  

Shares as of December 31, 2008

     710,163        —           241,713      

Shares purchased by ESOP during 2009

     248,800        —           —        

Shares allocated for match during 2009

     (190,176     —           190,176       $ 617   
                                  

Shares as of December 31, 2009

     768,787        —           431,889      

Shares allocated for match during 2010

     (191,064     —           191,064       $ 331   
                                  

Shares as of December 31, 2010

     577,723        —           622,953      
                            

The cost of the shares not yet committed to be released from collateral is shown as a reduction of stockholders’ equity. Unallocated shares are not considered outstanding for earnings per share purposes. At December 31, 2010, the market value of the 577,723 unallocated shares outstanding totaled $520 thousand. At December 31, 2009, the market value of the 768,787 unallocated shares outstanding totaled $1,830 thousand.

NOTE 15—LONG-TERM INCENTIVE PLAN

As of December 31, 2010, the Company has two stock-based compensation plans, the 2002 Long-Term Incentive Plan (2002 LTIP) and the 1999 Long-Term Incentive Plan (1999 LTIP). The plans are administered by the Compensation Committee of the Board of Directors (the Committee), which selects persons eligible to receive awards and determines the number of shares and/or options subject to each award, the terms, conditions and other provisions of the award. The plans are described in further detail below.

The 2002 Long-Term Incentive Plan was approved by the stockholders of the Company at the 2002 annual meeting and subsequently amended twice by the stockholders of the Company. The first amendment was approved at the 2004 annual meeting to increase the number of shares available for issuance under the 2002 LTIP to 768 thousand shares. The second amendment at the 2008 annual meeting increased the number of shares available for issuance under the 2002 LTIP to 1,518 thousand shares. Eligible participants include eligible employees, officers, consultants and directors of the Company or any affiliate. Pursuant to the 2002 LTIP, the total number of shares of stock authorized for awards was 1,518 thousand, of which not more than 20% may be granted as awards of restricted stock. The exercise price per share of a stock option granted may not be less than the fair market value as of the grant date. The exercise price must be at least 110% of the fair market value at the grant date for options granted to individuals, who at grant date, are 10% owners of the Company’s voting stock (10% owner). Restricted stock may be awarded to participants with terms and conditions determined by the Committee. The term of each award is determined by the Committee, provided that the term of any incentive stock option may not exceed ten years (five years for 10% owners) from its grant date. Each option award vests in approximately equal percentages each year over a period of not less than three years from the date of grant as determined by the Committee subject to accelerated vesting under terms of the 2002 LTIP or as provided in any award agreement.

The Company’s 1999 Long-Term Incentive Plan (1999 LTIP) is limited to eligible employees. The total number of shares of stock authorized for awards was 936 thousand, of which not more than 10% could be granted as awards of restricted stock. Under the terms of the 1999 LTIP, incentive stock options to purchase shares of the Company’s common stock were granted at a price not less than the fair market value of the stock as

 

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of the date of the grant. Options were to be exercised within ten years from the date of grant subject to conditions specified by the plan. Restricted stock could also be awarded by the committee in accordance with the 1999 LTIP. Each award vested in approximately equal percentages each year over a period of not less than three years (with the exception of five grants for a total of 168 thousand shares which previously vested in approximately equal percentages at 6 months, 18 months and 30 months) and vest from the date of grant as determined by the committee subject to accelerated vesting under terms of the 1999 LTIP or as provided in any award agreement.

Stock Options

The Company uses the Black-Scholes option pricing model to estimate fair value of stock-based awards, which uses the assumptions indicated in the table below. Expected volatility is based on the implied volatility of the Company’s stock price. The Company uses historical data to estimate option exercise and employee terminations used in the model. The expected term of options granted is derived using the “simplified” method as permitted under the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 and represents the period of time options granted are expected to be outstanding. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The table below provides the weighted average assumptions used to determine the fair value of stock option grants during the years indicated.

 

     2010     2009     2008  

Expected dividend yield

     —          0.98     2.30

Expected volatility

     46     36     21

Risk-free interest rate

     2.42     3.06     3.39

Expected life of option

     6.5 years        6.5 years        6.5 years   

Grant date fair value

   $ 0.79      $ 1.44      $ 1.79   

There were no stock options exercised during 2010, 2009 or 2008. At December 31, 2010, there was $27 thousand unrecognized compensation expense related to share-based payments, which is expected to be recognized over a weighted average period of 17 months.

 

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The following is a summary of the status of stock options as of December 31, 2010, 2009, and 2008, and changes during the years then ended:

 

     Shares     Weighted-
Average
Exercise
Price
     Weighted-
Average
Remaining
Contractual
Term
     Aggregate
Intrinsic
Value
 
     (in thousands)            (in years)      (in thousands)  

Outstanding—January 1, 2008

     1,379      $ 8.19         

Granted

     112        8.75         

Exercised

     —          —           

Forfeited

     (26     10.31         
                                  

Outstanding—December 31, 2008

     1,465      $ 8.20         5.35       $ —   1 
                                  

Exercisable—December 31, 2008

     1,244      $ 7.87         4.77       $ —   1 
                                  

Outstanding—January 1, 2009

     1,465      $ 8.20         

Granted

     45        3.83         

Exercised

     —          —           

Forfeited

     (239     8.20         
                                  

Outstanding—December 31, 2009

     1,271      $ 8.04         4.50       $ —   1 
                                  

Exercisable—December 31, 2009

     1,155      $ 8.14         4.09       $ —   1 
                                  

Outstanding—January 1, 2010

     1,271      $ 8.04         

Granted

     31        1.66         

Exercised

     —          —           

Forfeited

     (283     8.10         
                                  

Outstanding—December 31, 2010

     1,019      $ 7.83         3.51       $ 2   
                                  

Exercisable—December 31, 2010

     953      $ 8.05         3.17       $ 2   
                                  

 

1 

At December 31, 2009 and 2008, the strike price of all outstanding options exceeded the share price resulting in no intrinsic value.

The Company recorded compensation expense of $14 thousand, $270 thousand and $472 thousand related to stock options for the years ended December 31, 2010, 2009 and 2008, respectively. As of December 31, 2010, shares available for future grants to employees and directors under existing plans were zero shares and 874 thousand shares for the 1999 LTIP and 2002 LTIP, respectively.

Restricted Stock

The plans described above allow for the issuance of restricted stock awards that may not be sold or otherwise transferred until certain restrictions have lapsed. The unearned stock-based compensation related to these awards is amortized to compensation expense over the period the restrictions lapse. The share-based expense for these awards was determined based on the market price of the Company’s stock at the grant date applied to the total number of shares that were anticipated to fully vest and then amortized over the vesting period.

The Company recognized $10 thousand, $74 thousand and $112 thousand in stock-based compensation for 2010, 2009 and 2008, respectively, net of forfeitures related to restricted stock. As of December 31, 2010, unearned stock-based compensation of less than $1 thousand was associated with these awards. This cost is expected to be recognized over a weighted-average period of 2 months. The total fair value of shares vested during 2010 and 2009 was $2 thousand and $15 thousand, respectively.

 

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The following table summarizes the restricted stock activity:

 

     2010      2009      2008  
     Shares     Weighted-
Average
Grant
Date Fair
Value
     Shares     Weighted-
Average
Grant
Date Fair
Value
     Shares     Weighted-
Average
Grant
Date Fair
Value
 

Nonvested—beginning of period

     1,910      $ 9.08         9,090      $ 10.44         15,310      $ 10.80   

Granted

     —          —           —          —           3,650      $ 9.08   

Vested

     (942   $ 9.08         (5,624   $ 10.86         (9,870   $ 9.87   

Forfeited

     (186   $ 9.08         (1,556   $ 10.57         —          —     
                                                  

Nonvested—end of period

     782      $ 9.08         1,910      $ 9.08         9,090      $ 10.44   
                                                  

The restricted stock awards granted during 2008 vest in equal installments on each of the first three anniversaries of the date of grant.

NOTE 16—STOCKHOLDERS’ EQUITY

Common Stock and ESOP Activity

On January 27, 2010, the Company’s Board of Directors elected to suspend the dividend on the Company’s common stock. The Company may not pay dividends on common stock unless all Preferred Stock dividends have been paid.

On July 22, 2010, the Company filed with the State of Tennessee, Articles of Amendment to the Charter of Incorporation to increase the number of authorized shares of common stock from 50 million to 150 million, in accordance with shareholder approval obtained on June 30, 2010.

During 2009, the Board of Directors declared the following dividends:

 

Declaration Date

   

Dividend Per Share

   

        Date of Record        

   

Total Amount

   

Payment Date

 
                  (in thousands)        
  January 28, 2009      $ 0.05        March 2, 2009      $ 761        March 16, 2009   
  April 22, 2009      $ 0.01        June 1, 2009      $ 156        June 16, 2009   
  July 22, 2009      $ 0.01        September 1, 2009      $ 155        September 16, 2009   
  October 28, 2009      $ 0.01        December 1, 2009      $ 164        December 16, 2009   

On July 23, 2008, the Board of Directors approved a loan, which was subsequently amended on January 28, 2009, in the amount of $12,745 thousand from First Security Group, Inc. to the First Security Group, Inc. 401(k) and Employee Stock Ownership Plan (401(k) and ESOP plan). The purpose of the loan was to purchase Company shares in open market transactions through December 31, 2009. The shares will be used for future Company matching contributions with the 401(k) and ESOP plan. From January 1, 2009 to December 31, 2009, the Company purchased 248,800 shares at an average cost of $4.11. As of December 31, 2009, the cumulative purchases total 700,676 shares at a total cost of $4,056 thousand, or an average of $5.79 per share. No shares were purchased by the 401(k) and ESOP plan during 2010.

Preferred Stock

On December 29, 2008, the Company filed with the State of Tennessee Articles of Amendment to the Charter of Incorporation to authorize a class of ten million (10,000,000) shares of preferred stock, no par value. The Articles of Amendment were approved by the shareholders of the Company at a shareholders’ meeting held December 18, 2008, pursuant to a proxy statement filed by the Company on November 24, 2008.

 

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On January 9, 2009, as part of the Capital Purchase Program (CPP) administered by the U.S. Department of the Treasury (Treasury), the Company agreed to issue and sell, and the Treasury agreed to purchase (1) 33,000 shares (Preferred Stock) of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, having a liquidation preference of $1,000 per share, and (2) an immediately exercisable ten-year warrant to purchase up to 823,627 shares of the Company’s common stock, $0.01 par value, at an exercise price of $6.01 per share, for an aggregate purchase price of $33,000 thousand in cash. As a participant in the CPP, the Company is subject to limitations on the payments of dividends to common stockholders (other than a regular cash dividend of not more than $0.05 per share of common stock).

The Preferred Stock qualifies as tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Dividends are payable quarterly on February 15, May 15, August 15 and November 15 of each year or the following business day.

The total purchase price of $33,000 thousand was allocated between the Preferred Stock and the warrants based on the respective fair values of each. The warrants are valued at $2,006 thousand. The Preferred Stock original discount was $2,006 thousand. This discount is being expensed over the expected life of the Preferred Stock, or five years, utilizing the effective interest method. For the years ended December 31, 2010 and 2009, the Company recognized $379 thousand and $345 thousand, respectively, in Preferred Stock discount accretion.

The Company’s Board of Directors elected to defer payment on the February 15, 2010, May 15, 2010, August 15, 2010, November 15, 2010 and February 15, 2011 dividends of the Preferred Stock. Dividends for the Preferred Stock are cumulative. If the Company misses six quarterly Preferred Stock dividend payments, whether or not consecutive, the Treasury will have the right to appoint two directors to the Company’s Board of Directors until all accrued but unpaid dividends have been paid on the Preferred Stock. The Treasury has requested, and the Company anticipates agreeing to permit, an observer employed by the Treasury to attend meetings of the Company’s Board of Directors.

On September 7, 2010, the Company entered into a Written Agreement with the Federal Reserve Bank of Atlanta. As part of the Written Agreement, the Company is prohibited from declaring or paying dividends without prior written consent from the Federal Reserve. Note 2 provides additional information on the Written Agreement.

The Company recognized $1,650 thousand and $1,609 thousand for the Preferred Stock dividend for the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, $1,865 thousand was accrued for the Preferred Stock dividends and is included in other liabilities in the Company’s consolidated balance sheet.

NOTE 17—MINIMUM REGULATORY CAPITAL REQUIREMENTS

FSGBank and the Company, as regulated institutions, are subject to various regulatory capital requirements administered by the OCC and Federal Reserve, respectively. Failure to meet minimum capital requirements can result in certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios (set forth in the following table) of total and tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of tier 1 capital (as defined) to the average assets (as defined).

 

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The Consent Order, as described in Note 2, requires FSGBank to achieve and maintain total capital to risk adjusted assets of at least 13% and a leverage ratio of at least 9%. The Order provided 120 days from the effective date of April 28, 2010 to achieve these ratios. Due to the capital requirement within the Order, FSGBank is considered adequately capitalized. As shown below, FSGBank was not in compliance with the capital requirements contained in the order.

The following table provides the regulatory capital ratios as of December 31, 2010 and 2009:

 

    Actual     FSGBank
Consent  Order
    Minimum
Capital
Requirements
    Minimum to be
Well Capitalized
under Prompt
Corrective Action
Provisions
 
    Amount     Ratio     Amount     Ratio     Amount     Ratio     Amount     Ratio  

December 31, 2010

               

Total capital to risk-weighted assets-

               

First Security Group, Inc. and subsidiary

  $ 97,839        12.5     n/a        n/a      $ 62,757        8.0     n/a        n/a   

FSGBank, N.A.

  $ 95,339        12.2   $ 101,783        13.0   $ 62,636        8.0   $ 78,295        10.0

Tier 1 capital to risk-weighted assets-

               

First Security Group, Inc. and subsidiary

  $ 87,874        11.2     n/a        n/a      $ 31,378        4.0     n/a        n/a   

FSGBank, N.A.

  $ 85,374        10.9     n/a        n/a      $ 31,318        4.0   $ 46,977        6.0

Tier 1 capital to average assets-

               

First Security Group, Inc. and subsidiary

  $ 87,874        7.3     n/a        n/a      $ 48,356        4.0     n/a        n/a   

FSGBank, N.A.

  $ 85,374        7.1   $ 108,794        9.0   $ 48,353        4.0   $ 60,441        5.0
    Actual     FSGBank
Consent Order
    Minimum
Capital
Requirements
    Minimum to be
Well Capitalized
under Prompt
Corrective Action
Provisions
 
    Amount     Ratio     Amount     Ratio     Amount     Ratio     Amount     Ratio  
                   

December 31, 2009

               

Total capital to risk-weighted assets-

               

First Security Group, Inc. and subsidiary

  $ 146,318        13.9     n/a        n/a      $ 83,945        8.0     n/a        n/a   

FSGBank, N.A.

  $ 134,063        12.8     n/a        n/a      $ 83,782        8.0   $ 104,727        10.0

Tier 1 capital to risk-weighted assets-

               

First Security Group, Inc. and subsidiary

  $ 133,054        12.7     n/a        n/a      $ 41,973        4.0     n/a        n/a   

FSGBank, N.A.

  $ 120,804        11.5     n/a        n/a      $ 41,891        4.0   $ 62,836        6.0

Tier 1 capital to average assets-

               

First Security Group, Inc. and subsidiary

  $ 133,054        10.6     n/a        n/a      $ 50,267        4.0     n/a        n/a   

FSGBank, N.A.

  $ 120,804        9.6     n/a        n/a      $ 50,262        4.0   $ 62,827        5.0

NOTE 18—FAIR VALUE MEASUREMENTS

The authoritative accounting guidance for fair value measurements defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market

 

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for the asset or liability. Authoritative guidance establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 and 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the hierarchy. In such cases, the fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 and 2009.

 

     Balance as of
December 31,
2010
     Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
     (in thousands)  

Financial assets

           

Securities available-for-sale

   $ 154,165       $ —         $ 153,915       $ 250   

Loans held for sale

     2,556         —           2,556         —     

Forward loan sales contracts

     84         —           84         —     
     Balance as of
December 31,
2009
     Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
     (in thousands)  

Financial assets

           

Securities available-for-sale

   $ 143,045       $ —         $ 142,795       $ 250   

Loans held for sale

     1,225         —           1,225         —     

Forward loan sales contracts

     41         —           41         —     

For the three years ended December 31, 2010, the Company did not recognize any realized or unrealized gains or losses on Level 3 fair value assets or liabilities. Additionally, the Company did not purchase, sell or transfer any assets into or out of the Level 3 classification. At December 31, 2010, the $250 thousand Level 3 investment is a Qualified Zone Academy Bond (within the meaning of Section 1379E of the Internal Revenue Code of 1986, as amended) issued by the Health, Educational and Housing Facility Board of the County of Knox under the authority of the State of Tennessee. The Company did not transfer any assets between the Level 1 and Level 2 classifications.

At December 31, 2010, the Company also had assets and liabilities measured at fair value on a non-recurring basis. Items measured at fair value on a non-recurring basis include other real estate owned (OREO), repossessions and collateral-dependent impaired loans, as well as assets and liabilities acquired in prior business combinations, including loans, goodwill, core deposit intangible assets, and time deposits. Such measurements were determined utilizing Level 2 and Level 3 inputs.

Upon initial recognition, OREO and repossessions are measured at fair value, which becomes the cost basis. The cost basis is subsequently re-measured at fair value when events or circumstances occur that indicate the

 

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initial fair value has declined. The fair value is generally determined using appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace. Fair value adjustments for OREO and repossessions have generally been classified as Level 2.

The Company records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of these loans. Nonrecurring adjustments also include certain impairment amounts for collateral-dependent loans when establishing the allowance for loan and lease losses. If the recorded investment in the impaired loan exceeds the measure of fair value, a valuation allowance may be established as a component of the allowance for loan and lease losses or the expense is recognized as a partial charge-off. The fair value of collateral-dependent loans is generally determined using appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally available in the marketplace. These measurements have generally been classified as Level 2.

The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis, for which impairment was recognized for the year ended December 31, 2010 and 2009.

 

    Carrying
Value as of
December 31,
2010
    Level 1 Fair
Value
Measurement
    Level 2 Fair
Value
Measurement
    Level 3 Fair
Value
Measurement
    Valuation
Allowance as
of December 31,
2010
 
    (in thousands)  

Other real estate owned

  $ 16,533      $ —        $ 16,533      $ —        $ (5,927

Repossessions

  $ 477      $ —        $ 477      $ —        $ (579

Collateral-dependent impaired loans

  $ 30,865      $ —        $ 30,865      $ —        $ (17,631
    Carrying
Value as of
December 31,
2009
    Level 1 Fair
Value
Measurement
    Level 2 Fair
Value
Measurement
    Level 3 Fair
Value
Measurement
    Valuation
Allowance as
of December 31,
2009
 
    (in thousands)  

Other real estate owned

  $ 7,572      $ —        $ 7,572      $ —        $ (2,211

Repossessions

  $ 2,846      $ —        $ 2,846      $ —        $ (2,080

Collateral-dependent impaired loans

  $ 13,722      $ —        $ 13,722      $ —        $ (4,466

The estimated fair values of the Company’s financial instruments are as follows:

 

     December 31, 2010      December 31, 2009  
     Carrying
Amount
     Fair Value      Carrying
Amount
     Fair Value  
     (in thousands)  

Financial assets

           

Cash and cash equivalents

   $ 8,298       $ 8,298       $ 23,220       $ 23,220   

Interest bearing deposits in banks

   $ 200,621       $ 200,621       $ 152,616       $ 152,616   

Securities available-for-sale

   $ 154,165       $ 154,165       $ 143,045       $ 143,045   

Loans held for sale

   $ 2,556       $ 2,556       $ 1,225       $ 1,225   

Loans

   $ 724,535       $ 736,232       $ 950,793       $ 959,689   

Allowance for loan and lease losses

   $ 24,000       $ 24,000       $ 26,492       $ 26,492   

Financial liabilities

           

Deposits

   $ 1,048,723       $ 1,052,784       $ 1,182,673       $ 1,187,263   

Federal funds purchased and securities sold under agreements to repurchase

   $ 15,933       $ 15,933       $ 17,911       $ 17,911   

Other borrowings

   $ 77       $ 77       $ 94       $ 94   

 

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The following methods and assumptions were used by the Company in estimating fair value of each class of financial instruments for which it is practicable to estimate that value:

 

   

Cash and cash equivalents—The carrying value of cash and cash equivalents approximates fair value.

 

   

Interest bearing deposits in banks—The carrying amounts of interest bearing deposits in banks approximate fair value.

 

   

Securities—The Company’s securities are valued utilizing Level 2 inputs with the exception of one $250 thousand bond. Level 2 inputs are based on quoted prices for similar assets in active markets.

 

   

Loans held for sale—Fair value for loans held for sale is based on quoted prices for similar assets in active markets.

 

   

Loans—For variable-rate loans that reprice frequently and have no significant changes in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans and other consumer loans are estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans and leases is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers of similar credit ratings quality. Fair value for impaired loans and leases is estimated using discounted cash flow analysis or underlying collateral values, where applicable.

 

   

Deposit liabilities—The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value for fixed-rate certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregate expected maturities on time deposits.

 

   

Federal funds purchased and securities sold under agreements to repurchase—These borrowings generally mature in 90 days or less and, accordingly, the carrying amount reported in the balance sheet approximates fair value.

 

   

Other borrowings—Other borrowings carrying amount reported in the consolidated balance sheets approximates fair value.

NOTE 19—FAIR VALUE OPTION

Authoritative accounting guidance provides a fair value option election (FVO) that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. The guidance permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.

The Company records all newly-originated loans held for sale under the fair value option. Origination fees and costs are recognized in earnings at the time of origination. The servicing value is included in the fair value of the loan and recognized at origination of the loan. The Company uses derivatives to hedge changes in servicing value as a result of including the servicing value in the fair value of the loan. The estimated impact from recognizing servicing value, net of related hedging costs, as part of the fair value of the loan is captured in the mortgage loan and related fee component of noninterest income.

As of December 31, 2010 and 2009, there were $2,556 thousand and $1,225 thousand, respectively, in loans held for sale recorded at fair value. For the years ended December 31, 2010 and 2009, approximately $909 thousand and $1,025 thousand, respectively, in loan origination and related fee income was recognized in noninterest income, and an insignificant amount of origination and related fee expense, respectively, was recognized in noninterest expense utilizing the fair value option.

For the year ended December 31, 2010 and 2009, the Company recognized a loss of $47 thousand and $285 thousand, respectively, due to changes in fair value for loans held-for-sale in which the fair value option was

 

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elected. This amount does not reflect the change in fair value attributable to the related hedges the Company used to mitigate the interest rate risk associated with loans held for sale. The changes in the fair value of the hedges were also recorded in the mortgage loan and related fee component of non-interest income, and offset approximately $4 thousand in 2010 and $244 thousand in 2009 of the change in fair value of loans held for sale.

The following table provides the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale for which the fair value option has been elected as of December 31, 2010.

 

     Aggregate Fair
Value
     Aggregate Unpaid
Principal Balance
under FVO
     Fair Value Carrying
Amount Over /
(Under) Unpaid
Principal
 
     (in thousands)  

Loans held for sale

   $ 2,556       $ 2,640       $ (84

NOTE 20—DERIVATIVE FINANCIAL INSTRUMENTS

The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of December 31, 2010, the Company had not entered into a transaction in a dealer capacity.

When a derivative is intended to be a qualifying hedged instrument, the Company prepares written hedge documentation that designates the derivative as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or (2) a hedge of a forecasted transaction, such as, the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).

The written documentation includes identification of, among other items, the risk management objective, hedging instrument, hedged item, and methodologies for assessing and measuring hedge effectiveness and ineffectiveness, along with support for management’s assertion that the hedge will be highly effective.

Methodologies related to hedge effectiveness and ineffectiveness include (1) statistical regression analysis of changes in the cash flows of the actual derivative and a perfectly effective hypothetical derivative, (2) statistical regression analysis of changes in fair values of the actual derivative and the hedged item and (3) comparison of the critical terms of the hedged item and the hedging derivative. Changes in fair value of a derivative that is highly effective and that has been designated and qualifies as a fair value hedge are recorded in current period earnings, along with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. Changes in the fair value of a derivative that is highly effective and that has been designed and qualifies as a cash flow hedge are initially recorded in other comprehensive income and reclassified to earnings in conjunction with the recognition of the earnings impacts of the hedged item; any ineffective portion is recorded in current period earnings. Designated hedge transactions are reviewed at least quarterly for ongoing effectiveness. Transactions that are no longer deemed to be effective are removed from hedge accounting classification and the recorded impacts of the hedge are recognized in current period income or expense in conjunction with the recognition of the income or expense on the originally hedged item.

The Company’s derivatives are based on underlying risks, primarily interest rates. The Company has utilized cash flow swaps to reduce the risks associated with interest rates. Swaps are contracts in which a series of net cash flows, based on a specific notional amount that is related to an underlying risk, are exchanged over a prescribed period. The Company utilizes forward contacts on the held for sale loan portfolio. The forward contracts hedge against change in fair value of the held for sale loans.

Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk is equal to the fair value gain of the derivative. The credit exposure for swaps is the replacement cost of contracts that have

 

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become favorable. Credit risk is minimized by entering into transactions with high quality counterparties that are initially approved by the Board of Directors and reviewed periodically by the Asset Liability Committee. It is the Company’s policy to require that all derivatives be governed by an International Swap and Derivatives Associations Master Agreement (ISDA). Bilateral collateral agreements may also be required.

On August 28, 2007, the Company elected to terminate a series of seven interest rate swaps with a total notional value of $150 million. At termination, the swaps had a market value of $2.0 million. The gain is being accreted into interest income over the remaining expected terms of the hedged variable rate loans. The Company recognized $394 thousand, $534 thousand and $597 thousand in interest income for the years ended December 31, 2010, 2009 and 2008, respectively.

On March 26, 2009, the Company elected to terminate two interest rate swaps with a total notional value of $50 million. At termination, the swaps had a market value of $5.8 million. The Company terminated the swaps to eliminate increasing credit risk with the counterparty. The gain is being accreted into interest income over the remaining life of the originally hedged items. The Company recognized $1,628 thousand for the year ended December 31, 2010. The Company recognized $528 thousand in interest income through the termination date in 2009 and an additional $1,249 thousand through December 31, 2009.

The following table presents the accretion of the remaining gain for the terminated swaps.

 

     2011      2012      Total  
     (in thousands)  

Accretion of gain from 2007 terminated swaps

   $ 219       $ 62       $ 281   

Accretion of gain from 2009 terminated swaps

   $ 1,629       $ 1,272       $ 2,901   

The following are the cash flow hedges as of December 31, 2010:

 

     Notional
Amount
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Accumulated
Other
Comprehensive
Income
     Maturity Date  
     (in thousands)         

Asset hedges

              

Cash flow hedges:

              

Forward contracts

   $ 2,556       $ 84       $ —         $ 55         various   
                                      

Total

   $ 2,556       $ 84       $ —         $ 55      
                                      

Terminated asset hedges

              

Cash flow hedges:1

              

Interest rate swap

   $ 25,000       $ —         $ —         $ 35         June 28, 2011   

Interest rate swap

     20,000         —           —           26         June 28, 2011   

Interest rate swap

     35,000         —           —           124         June 28, 2012   

Interest rate swap

     25,000         —           —           957         October 15, 2012   

Interest rate swap

     25,000         —           —           957         October 15, 2012   
                                      

Total

   $ 130,000       $ —         $ —         $ 2,099      
                                      

 

1 

The $2,099 thousand of gains, net of taxes, recorded in accumulated other comprehensive income as of December 31, 2010 will be reclassified into earnings as interest income over the original life of the respective hedged items.

 

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The following are the cash flow hedges as of December 31, 2009:

 

     Notional
Amount
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Accumulated
Other
Comprehensive
Income
     Maturity Date  
     (in thousands)         

Asset hedges

              

Cash flow hedges:

              

Forward contracts

   $ 1,225       $ 41       $ —         $ 27         various   
                                      

Total

   $ 1,225       $ 41       $ —         $ 27      
                                      

Terminated asset hedges

              

Cash flow hedges:1

              

Interest rate swap

   $ 25,000       $ —         $ —         $ 36         June 28, 2010   

Interest rate swap

     25,000         —           —           106         June 28, 2011   

Interest rate swap

     14,000         —           —           15         June 28, 2010   

Interest rate swap

     20,000         —           —           80         June 28, 2011   

Interest rate swap

     35,000         —           —           208         June 28, 2012   

Interest rate swap

     25,000         —           —           1,494         October 15, 2012   

Interest rate swap

     25,000         —           —           1,494         October 15, 2012   
                                      

Total

   $ 169,000       $ —         $ —         $ 3,433      
                                      

 

1 

The $3,433 thousand of gains, net of taxes, recorded in accumulated other comprehensive income as of December 31, 2009 will be reclassified into earnings as interest income over the original life of the respective hedged items.

For the year ended December 31, 2010 and 2009, no significant amounts were recognized for hedge ineffectiveness.

NOTE 21—COMMITMENTS AND CONTINGENCIES

The Company is party to credit related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and the issuance of financial guarantees in the form of financial and performance standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as they do for on-balance-sheet instruments.

The Company’s maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at December 31, 2010 and 2009, was as follows:

 

     2010      2009  
     (in thousands)  

Commitments to extend credit

   $ 127,377       $ 185,639   

Standby letters of credit

   $ 14,090       $ 16,077   

Commitments to extend credit are agreements to lend to customers. Standby letters of credit are contingent commitments issued by the Company to guarantee performance of a customer to a third party under a contractual non-financial obligation for which it receives a fee. Financial standby letters of credit represent a commitment to guarantee customer repayment of an outstanding loan or debt instrument. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The

 

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amount of collateral obtained, if deemed necessary by the Company on extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. Additionally, in the ordinary course of business, the Company is subject to regulatory examinations, information gathering requests, inquiries, and investigations. The Company establishes accruals for litigation and regulatory matters when those matters present loss contingencies that the Company determines to be both probable and reasonably estimable. Based on current knowledge, advice of counsel and available insurance coverage, management does not believe that liabilities arising from legal claims, if any, will have a material adverse effect on the Company’s consolidated financial condition, results of operations, or cash flows. However, in light of the significant uncertainties involved in these matters, the early stage of various legal proceedings, and the indeterminate amount of damages sought in some of these matters, it is possible that the ultimate resolution of these matters, if unfavorable, could be material to the Company’s results of operations for any particular period.

The Company intends to vigorously pursue all available defenses to these claims. There are significant uncertainties involved in any litigation. Although the ultimate outcome of these lawsuits cannot be ascertained at this time, based upon information that presently is available to it, management is unable to predict the outcome of these cases and cannot determine the probability of an adverse result or reasonably estimate a range of potential loss, if any. In addition, management is unable to estimate a range of reasonably possible losses with respect to these claims.

As of December 31, 2009, the Company was a defendant in an arbitration claim, in which Lloyd L. Montgomery, III, the Company’s former President and Chief Operating Officer, claimed that the Company wrongfully terminated his employment. On January 19, 2010, the Company settled the $2,300 thousand arbitration claim for $500 thousand. The settlement is reflected in non-interest expense and other liabilities on the Company’s financial statements as of and for the year ended December 31, 2009.

NOTE 22—OTHER ASSETS AND OTHER LIABILITIES

Other assets and other liabilities consist of the following:

 

     2010      2009  
     (in thousands)  

Other assets:

     

Cash surrender value of bank-owned life insurance

   $ 25,806       $ 24,896   

Other real estate owned and repossessions

     25,162         19,193   

Equity securities

     8,208         5,812   

Interest receivable

     3,369         4,453   

Prepaid FDIC expense

     2,389         6,029   

Prepaid expenses

     2,102         2,127   

Federal income tax receivable

     2,776         1,955   

Deferred tax assets

     —           7,379   

Other

     286         2,073   
                 

Total other assets

   $ 70,098       $ 73,917   
                 

Other liabilities:

     

Accrued interest payable

   $ 2,722       $ 4,184   

Accrued expenses

     1,662         2,895   

Accrued preferred stock dividend

     1,856         206   

Supplemental executive retirement plan accrual

     2,048         1,516   

Other

     1,421         1,380   
                 

Total other liabilities

   $ 9,709       $ 10,181   
                 

 

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NOTE 23—SUPPLEMENTAL FINANCIAL DATA

Components of other noninterest income or other noninterest expense in excess of 1% of the aggregate of total interest income and noninterest income are shown in the following table.

 

     2010      2009     2008  
     (in thousands)  

Noninterest income—

       

Point-of-service fees

   $ 1,270       $ 1,126      $ 1,050   

Mortgage loan and related fees

     909         1,025        1,443   

Bank-owned life insurance income

     1,032         1,006        967   

Trust fees

     771         —   1      —   1 

All other items

     1,552         2,536        2,792   
                         

Total other noninterest income

   $ 5,534       $ 5,693      $ 6,252   
                         

Noninterest expense—

       

Professional fees

   $ 3,144       $ 2,127      $ 1,744   

FDIC insurance

     3,803         1,866        —   1 

Data processing

     1,462         1,445        1,463   

Losses on other real estate owned, repossessions and fixed assets

     1,162         603        349   

Write-downs on other real estate owned and repossessions

     3,539         1,321        985   

OREO and repossession holding costs

     1,637         1,104        —   1 

All other items

     6,036         7,088        7,700   
                         

Total other noninterest expense

   $ 20,783       $ 15,554      $ 12,241   
                         

 

1 

Amounts less than 1% of the aggregate of total interest income plus noninterest income for each year shown are represented by a hyphen and included in “All Other Items” for the applicable year.

NOTE 24—CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY

Financial information pertaining only to First Security Group, Inc. is as follows:

CONDENSED BALANCE SHEET

 

     2010      2009  
     (in thousands)  
ASSETS      

Cash and due from bank subsidiary

   $ 2,472       $ 1,376   

Investment in common stock of subsidiary

     90,874         128,914   

Loan to subsidiary

     —           8,000   

Other assets

     2,110         3,514   
                 

TOTAL ASSETS

   $ 95,456       $ 141,804   
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY      

LIABILITIES

   $ 2,082       $ 640   

STOCKHOLDERS’ EQUITY

     93,374         141,164   
                 

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 95,456       $ 141,804   
                 

 

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CONDENSED STATEMENT OF OPERATIONS

 

     2010     2009     2008  
     (in thousands)  

INCOME

      

Management fees

   $ 7,400      $ 7,800      $ 7,800   

Dividends from subsidiary

     —          1,178        6,500   

Interest income from loan to subsidiary

     145        1,514        —     

Other

     —          18        16   
                        

Total income

     7,545        10,510        14,316   
                        

EXPENSES

      

Salaries and employee benefits

     5,828        5,652        5,896   

Other

     2,427        2,164        1,735   
                        

Total expenses

     8,255        7,816        7,631   
                        

(LOSS) INCOME BEFORE INCOME TAXES AND EQUITY IN UNDISTRIBUTED EARNINGS IN SUBSIDIARY

     (710     2,694        6,685   

Income tax (benefit) expense

     (254     584        84   
                        

INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS IN SUBSIDIARY

     (456     2,110        6,601   

Equity in undistributed loss in subsidiary

     (43,886     —          —     

Distributions in excess of earnings of subsidiary

     —          (35,565     (5,240
                        

NET (LOSS) INCOME

     (44,342     (33,455     1,361   

Preferred stock dividends

     1,650        1,609        —     

Accretion on preferred stock discount

     379        345        —     
                        

NET (LOSS) INCOME AVAILABLE TO COMMON STOCKHOLDERS

   $ (46,371   $ (35,409   $ 1,361   
                        

 

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CONDENSED STATEMENT OF CASH FLOWS

 

     2010     2009     2008  
     (in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES

      

Net (loss) income

   $ (44,342   $ (33,455   $ 1,361   

Adjustments to reconcile net (loss) income to net cash provided by operating activities—

      

Equity in undistributed loss of subsidiary

     43,886        —          —     

Distributions in excess of earnings of subsidiary

     —          35,565        5,240   

Amortization of deferred compensation

     24        344        584   

ESOP compensation

     331        617        762   

Decrease (increase) in other assets

     1,404        531        (2,044

(Decrease) increase in other liabilities

     (207     152        (1,640
                        

Net cash provided by operating activities

     1,096        3,754        4,263   
                        

CASH FLOWS FROM INVESTING ACTIVITIES

      

Equity investment in subsidiary

     (8,000     (25,000     —     

Loan to subsidiary, net of payments

     8,000        (8,000     —     
                        

Net cash used in investing activities

     —          (33,000     —     
                        

CASH FLOWS FROM FINANCING ACTIVITIES

      

Proceeds from issuance of preferred stock and common stock warrants

     —          33,000        —     

Repurchase and retirement of common stock

     —          —          (2,803

Purchase of ESOP shares

     —          (1,023     (3,033

Dividends paid on preferred stock

     —          (1,402     —     

Dividends paid on common stock

     —          (1,236     (3,253
                        

Net cash provided by (used in) financing activities

     —          29,339        (9,089
                        

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

     1,096        93        (4,826

CASH AND CASH EQUIVALENTS—beginning of year

     1,376        1,283        6,109   
                        

CASH AND CASH EQUIVALENTS—end of year

   $ 2,472      $ 1,376      $ 1,283   
                        

SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES

      

Income taxes paid

   $ 128      $ 552      $ 5,548   

NOTE 25—RELATED PARTY TRANSACTIONS

From January 1, 2010 to June 30, 2010 and the years ended December 31, 2009 and 2008, the Company was party to an agreement with Alpha Antiques, whose sole proprietor, Judy Holley, is the spouse of Rodger Holley, the Company’s Chairman and Chief Executive Officer. Under the agreement, Alpha Antiques provided design and procurement services relating to the design and construction of the Bank’s branches and the management of OREO properties, for which it paid $23 thousand in 2010, $40 thousand in 2009 and $40 thousand in 2008. During 2009 and the first half of 2010, the use of a Company car was provided to assist in managing the increased OREO properties.

During 2010 and 2009, the Company entered into certain sale transactions with Ray Marler, a director of the Company. The Company sold repossessed assets to companies owned by Mr. Marler. Gross proceeds to the Company during 2010 totaled $67 thousand. During 2009, companies owned by Mr. Marler purchased repossessed assets through a dealer. The proceeds for the 2009 purchases totaled $20 thousand. The Company also utilized Mr. Marler’s companies for certain services associated with other real estate owned. Payments for these services totaled $6 thousand and $7 thousand for the years ended December 31, 2010 and 2009, respectively.

 

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In connection with the acquisition of Premier National Bank of Dalton in 2003, the Bank assumed a lease with First Plaza, L.L.C. J.C. Harold Anders, a director of the Company through March 25, 2010, is a 14.3% owner of First Plaza. As a result of the agreement, the Bank leases property located at 715 S Thornton Avenue, Dalton, Georgia 30721. The Bank owns a full service branch facility located on this property. From January 1, 2010 through March 25, 2010, the Company recognized $13 thousand of lease expense. The Company recognized lease expense of $54 thousand and $51 thousand for 2009 and 2008, respectively.

Additionally, the Company has entered into loan transactions with certain directors, executive officers and significant stockholders and their affiliates. Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features. The aggregate amount of loans to such related parties at December 31, 2010 and 2009 was $1,050 thousand and $3,841 thousand, respectively. At December 31, 2010, unused lines of credit to these related parties totaled $26 thousand.

NOTE 26—QUARTERLY SUMMARIZED FINANCIAL INFORMATION (UNAUDITED)

 

     First
Quarter
2010
    Second
Quarter
2010
    Third
Quarter
2010
    Fourth
Quarter
2010
 
     (in thousands, except per share amounts)  

Interest income

   $ 15,041      $ 14,290      $ 13,202      $ 12,383   

Interest expense

     5,366        5,329        5,067        4,473   
                                

Net interest income

     9,675        8,961        8,135        7,910   

Provision for loan and lease losses

     4,375        3,634        18,415        7,189   
                                

Net interest income (loss) after provision for loan and lease losses

     5,300        5,327        (10,280     721   

Noninterest income

     2,304        2,558        2,404        2,237   

Noninterest expense

     9,872        11,780        12,512        11,070   
                                

Income loss before income taxes

     (2,268     (3,895     (20,388     (8,112

Income tax (benefit) provision

     (1,154     (1,769     9,384        3,218   
                                

Net loss

     (1,114     (2,126     (29,772     (11,330

Dividends and accretion on preferred stock

     505        506        508        510   
                                

Net loss available to common stockholders

   $ (1,619   $ (2,632   $ (30,280   $ (11,840
                                

Net loss per share

        

Net loss per share—basic

   $ (0.10   $ (0.17   $ (1.92   $ (0.75
                                

Net loss per share—diluted

   $ (0.10   $ (0.17   $ (1.92   $ (0.75
                                

Shares outstanding

        

Basic1

     15,649        15,715        15,785        15,808   

Diluted1

     15,649        15,715        15,785        15,808   

 

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     First
Quarter
2009
    Second
Quarter
2009
    Third
Quarter
2009
    Fourth
Quarter
2009
 
     (in thousands, except per share amounts)  

Interest income

   $ 16,475      $ 16,099      $ 15,958      $ 15,475   

Interest expense

     6,238        5,599        5,058        4,903   
                                

Net interest income

     10,237        10,500        10,900        10,572   

Provision for loan and lease losses

     4,993        6,196        9,280        4,935   
                                

Net interest income after provision for loan and lease losses

     5,244        4,304        1,620        5,637   

Noninterest income

     2,451        2,644        2,737        2,503   

Noninterest expense

     9,460        9,892        37,363        12,132   
                                

Loss before income taxes

     (1,765     (2,944     (33,006     (3,992

Income tax benefit

     (913     (1,536     (4,877     (926
                                

Net loss

     (852     (1,408     (28,129     (3,066

Dividends and accretion on preferred stock

     448        500        502        504   
                                

Net loss available to common stockholders

   $ (1,300   $ (1,908   $ (28,631   $ (3,570
                                

Net loss per share

        

Net loss per share—basic

   $ (0.08   $ (0.12   $ (1.84   $ (0.23
                                

Net loss per share—diluted

   $ (0.08   $ (0.12   $ (1.84   $ (0.23
                                

Shares outstanding

        

Basic

     15,573        15,503        15,543        15,582   

Diluted

     15,573        15,503        15,543        15,584   

 

1 

The sum of the 2010 and 2009 quarterly net loss per share (basic and diluted) differs from the annual net loss per share (basic and diluted) because of the differences in the weighted average number of common shares outstanding and the common shares used in the quarterly and annual computations as well as differences in rounding.

NOTE 27—BANK-OWNED LIFE INSURANCE

The Company’s Board of Directors approved the purchase of bank-owned life insurance (BOLI) on January 26, 2005. The Company is the owner and beneficiary of these life insurance contracts. The Company invested a total of $17,250 thousand in nine bank-owned life insurance policies during the first half of 2005. In conjunction with the acquisitions of First State Bank and Jackson Bank, the Company assumed $362 thousand and $3,348 thousand, respectively, in bank-owned life insurance. The Company’s investment in bank-owned life insurance is as follows:

 

     2010      2009  
     (in thousands)  

Cash surrender value—beginning of year

   $ 24,896       $ 24,012   

Increase in cash surrender value, net of expenses

     910         884   
                 

Cash surrender value—end of year

   $ 25,806       $ 24,896   
                 

The cash surrender value of these policies is reported in other assets in the Company’s consolidated balance sheets. The Company reports income and expenses from the policies as other income and other expense, respectively, in the consolidated statements of operations and expenses. The income is not subject to tax and the expenses are not deductible for tax.

 

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NOTE 28—CONCENTRATIONS OF CREDIT RISK

The Company offers a variety of loan products with payment terms and rate structures that have been designed to meet the needs of its customers within an established framework of acceptable credit risk. Payment terms range from fully amortizing loans that require periodic principal and interest payments to terms that require periodic payments of interest-only with principal due at maturity. Interest-only loans are a typical characteristic in commercial and home equity lines-of-credit and construction loans (residential and commercial). At December 31, 2010, the Company had approximately $279,459 thousand of interest-only loans, which primarily consist of construction and land development real estate loans (23%), commercial and industrial loans (18%) and home equity loans (29%). The loans have an average maturity of approximately eighteen months or less, with the exception of home equity lines-of-credit which have an average maturity of approximately six and a half years. The interest only loans are properly underwritten loans and are within the Company’s lending policies.

The Company has branch locations in Dalton, Georgia where the local economy is generally dependent upon the carpet industry. The Company’s loan portfolio within the Dalton market totals $84,705 thousand.

At December 31, 2010 and 2009, the Company did not offer, hold or service option adjustable rate mortgages that may expose the borrowers to future increases in repayments in excess of changes resulting solely from increases in the market rate of interest (loans subject to negative amortization).

NOTE 29—SUBSEQUENT EVENTS

On April 4, 2011, the Company received a notice from the NASDAQ Stock Market (“Nasdaq”) that its stock had closed below $1.00 per share for 30 consecutive business days, and was therefore not in compliance with Nasdaq Marketplace Rule 5450(a)(1) (the “Bid Price Rule”). In accordance with Marketplace Rule 5810(c)(3)(A), the Company may regain compliance with the Bid Price Rule if its stock closes at or above $1.00 for 10 consecutive business days by October 3, 2011. The notification has no effect on the listing of the Company’s stock at this time.

On April 11, 2011, the Company increased the size of its Board of Directors and elected Kelly P. Kirkland to serve on the Board of First Security Group, Inc. Ms. Kirkland was in private practice with a Chattanooga law firm for 27 and a half years prior to retiring at the end of 2010.

 

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Index to Financial Statements
Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Annual Report on Form 10-K, our principal executive officer and principal financial officer have evaluated the effectiveness of our “disclosure controls and procedures” (“Disclosure Controls”). Disclosure Controls, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Our management, including the CEO and CFO, does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

As a result of the material weakness in our internal control over financial reporting discussed below, our CEO and CFO have concluded that our Disclosure Controls were not effective at a reasonable assurance level as of December 31, 2010.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Our internal control over financial reporting is a process designed to provide reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, transactions are executed in accordance with appropriate management authorization and accounting records are reliable for the preparation of financial statements in accordance with generally accepted accounting principles.

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

Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2010. Management based this assessment on criteria for effective internal control over financial reporting described in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included an evaluation of the design of our internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting. Management reviewed the results of its assessment with the Audit Committee of our Board of Directors.

Based on this assessment, management identified a material weakness in the Company’s entity level controls and therefore concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2010.

 

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Index to Financial Statements

Specifically, during 2010, the Company did not maintain an effective control environment. The control environment sets the tone of the organization, influences the control consciousness of its people, and is the foundation for all other components of internal control over financial reporting. A significant element of the control environment is the establishment of a "tone at the top" culture which is an ethical atmosphere created by the Company’s leadership. An effective “tone at the top” related to internal control over financial reporting was not embedded in our culture. Specific weaknesses included: lack of communication regarding the “tone at the top” to evidence management’s commitment to a sound internal control environment; a failure to establish a culture of integrity and high ethical standards, including ineffective internal communication of what constitutes proper business practices, compliance with the code of conduct, and ethical behavior generally; lack of compliance with procedures surrounding related party transactions; inadequate communication of reporting lines; and management override of existing policies and procedures.

These control deficiencies did not result in any audit adjustments to the 2010 annual consolidated financial statements, but could result in a material misstatement to our financial statements that would not be prevented or detected. Accordingly, management has determined that these control deficiencies constitute a material weakness.

As of the filing of this Annual Report on Form 10-K, the Company has not remediated the material weaknesses in our internal control over financial reporting. The Company will explore and consider options available to us to remediate the material weakness. The remediation measures we ultimately implement may include revisions to policies, additional training and education and potential changes in management structure.

Joseph Decosimo and Company, PLLC, an independent registered public accounting firm, has issued a report on the effectiveness of internal control over financial reporting as of December 31, 2010, which is included herein.

 

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Index to Financial Statements

Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting

Board of Directors and Stockholders

First Security Group, Inc.

Chattanooga, Tennessee

We have audited First Security Group, Inc. and subsidiary’s (the Company) internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

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

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

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim consolidated financial statements will not be prevented or detected on a timely basis. In its assessment, management identified a material weakness due to the Company not maintaining an effective “tone at the top” in the control environment. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2010 consolidated financial statements and this report does not affect our report dated April 15, 2011, on those consolidated financial statements.

In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the COSO criteria, First Security Group, Inc. and subsidiary has not maintained effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010, of First Security Group, Inc. and subsidiary and our report dated April 15, 2011, expressed an unqualified opinion on those consolidated financial statements and included an explanatory paragraph relating to the existence of substantial doubt about the Company’s ability to continue as a going concern.

/s/ Joseph Decosimo and Company, PLLC

Chattanooga, Tennessee

April 15, 2011

 

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Index to Financial Statements

Changes in Internal Controls

There have been no changes in our internal controls over financial reporting during our fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

On February 23, 2011, William L. Lusk, Jr. resigned as Chief Financial Officer. The Board of Directors appointed John R. Haddock, the Company’s Controller, as acting interim Chief Financial Officer on February 23, 2011. The Company is currently conducting a search for a new Controller. In the interim, the Company has taken steps to ensure the internal controls over financial reporting have not been impacted by one person serving in both the Chief Financial Officer and Controller roles.

 

Item 9B. Other Information

There is no information required to be disclosed in a report on Form 8-K during the fourth quarter of 2010 that has not been reported.

 

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Index to Financial Statements

PART III

 

Item 10. Directors, Executive Officers and Corporate Governance

We have adopted a Code of Business Conduct and Ethics (the “Code”) that applies to all of our directors, officers and employees. We believe the Code is reasonably designed to deter wrongdoing and to promote honest and ethical conduct, including: the ethical handling of conflicts of interest; full, fair and accurate disclosure in filings and other public communications made by us; compliance with applicable laws; prompt internal reporting of violations of the Code; and accountability for adherence to the Code. We have posted a copy of our Code on our website at www.FSGBank.com.

The remaining information for this Item will be included in an amendment to this Annual Report on Form 10-K, to be filed no later than April 30, 2011.

 

Item 11. Executive Compensation

The response to this Item will be included in an amendment to this Annual Report on Form 10-K, to be filed no later than April 30, 2011.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The following table sets forth information regarding our equity compensation plans under which shares of our common stock are authorized for issuance. The only equity compensation plans maintained by us are the First Security Group, Inc. Second Amended and Restated 1999 Long-Term Incentive Plan and the First Security Group, Inc. 2002 Long-Term Incentive Plan, as amended. All data is presented as of December 31, 2010.

 

    Number of securities to be
issued upon exercise of
outstanding options and
vesting of restricted awards
    Weighted-average
exercise price of
outstanding options
    Number of shares
remaining available for
future issuance under
the Plans (excludes
outstanding options)
 

Equity compensation plans approved by security holders

    1,019,301      $ 7.83        874,254   

Equity compensation plans not approved by security holders

    —          —          —     

Total

    1,019,301      $ 7.83        874,254   

The remaining information for this Item will be included in an amendment to this Annual Report on Form 10-K, to be filed no later than April 30, 2011.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence

The response to this Item will be included in an amendment to this Annual Report on Form 10-K, to be filed no later than April 30, 2011.

 

Item 14. Principal Accountant Fees and Services

The response to this Item will be included in an amendment to this Annual Report on Form 10-K, to be filed no later than April 30, 2011.

 

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Index to Financial Statements

PART IV

 

Item 15. Exhibits and Financial Statement Schedules

 

(a)   (1)  

The list of all financial statements is included at Item 8.

  (2)  

The financial statement schedules are either included in the financial statements or are not applicable.

  (3)  

Exhibits Required by Item 601. The following exhibits are attached hereto or incorporated by reference herein (numbered to correspond to Item 601(a) of Regulation S-K, as promulgated by the Securities and Exchange Commission):

 

Exhibit
Number

  

Description

  3.1    Amended and Restated Articles of Incorporation.1
  3.4    Bylaws.2
  4.1    Form of Common Stock Certificate.2
  4.2    Form of Series A Preferred Stock Certificate.3
  4.3    Warrant to Purchase up to 823,627 shares of Common Stock, dated January 9, 2009.4
10.1*    First Security’s Second Amended and Restated 1999 Long-Term Incentive Plan.2
10.2*    First Security’s Amended and Restated 2002 Long-Term Incentive Plan.5
10.3*    Form of Incentive Stock Option Award under the Second Amended and Restated 1999 Long-Term Incentive Plan.6
10.4*    Form of Incentive Stock Option Award under the 2002 Long-Term Incentive Plan.6
10.5*    Form of Non-qualified Stock Option Award under the 2002 Long-Term Incentive Plan.6
10.6*    Form of Restricted Stock Award under the 2002 Long-Term Incentive Plan.6
10.7*    Form of Restricted Stock Award under the 2002 Long-Term Incentive Plan with TARP restrictions.
10.8*    Employment Agreement Dated as of May 16, 2003 by and between First Security and Rodger B. Holley.7
10.9*    Salary Continuation Agreement Dated as of December 21, 2005 by and between First Security, FSGBank and Rodger B. Holley.8
10.10*    Employment Agreement Dated as of September 20, 2010 and Executed November 24, 2010 by and between First Security and Ralph E. “Gene” Coffman, Jr.9
10.11*    Employment Agreement Dated as of May 16, 2003 by and between First Security and William L. Lusk, Jr.7
10.12*    Salary Continuation Agreement Dated as of December 21, 2005 by and between First Security, FSGBank and William L. Lusk, Jr.8
10.13*    First Security Group, Inc. Non-Employee Director Compensation Policy.10
10.14*    Form of First Amendment to Employment Agreements, Dated as of December 18, 2008 (executed by Messrs. Holley and Lusk).10
10.15*    Form of Senior Executive Officer Agreement, Dated as of January 9, 2009 (executed by Messrs. Holley and Lusk). 11
10.16    Letter Agreement, Dated January 9, 2009, including Securities Purchase Agreement—Standard Terms, incorporated by reference therein, between the Company and the United States Department of the Treasury.12

 

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Exhibit
Number

  

Description

10.17*    Form of TARP Restricted Employee Agreement, Dated as of December 10, 2009 (executed by Messrs. Holley and Lusk).13
10.18    Consent Order, Dated April 28, 2010, between FSGBank and the Office of the Comptroller of the Currency.14
10.19    Stipulation and Consent to the Issuance of a Consent Order, Dated April 28, 2010, between FSGBank and the Office of the Comptroller of the Currency.15
10.20    Written Agreement, Dated September 7, 2010, between First Security Group, Inc. and the Federal Reserve Bank of Atlanta. 16
21.1    Subsidiaries of the Registrant.17
23.1    Consent of Joseph Decosimo and Company, PLLC.
31.1    Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities and Exchange Act of 1934.
31.2    Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities and Exchange Act of 1934.
32.1    Certification of Chief Executive Officer pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934.
32.2    Certification of Chief Financial Officer pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934.
99.1    Certification of Chief Executive Officer pursuant to EESA.
99.2    Certification of Chief Financial Officer pursuant to EESA.

 

1 

Incorporated by reference to First Security’s Quarterly Report on Form 10-Q for the period ended June 30, 2010.

2 

Incorporated by reference to First Security’s Registration Statement on Form S-1 dated April 20, 2001, File No. 333-59338.

3 

Incorporated by reference to the Exhibit 4.1 to the Current Report on Form 8-K filed January 9, 2009.

4 

Incorporated by reference to the Exhibit 4.2 to the Current Report on Form 8-K filed January 9, 2009.

5 

Incorporated by reference from Appendix A to First Security’s Proxy Statement filed April 30, 2007.

6 

Incorporated by reference to First Security’s Annual Report on Form 10-K for the year ended December 31, 2004.

7 

Incorporated by reference to First Security’s Quarterly Report on Form 10-Q for the period ended June 30, 2003.

8 

Incorporated by reference to First Security’s Annual Report on Form 10-K for the year ended December 31, 2005.

9 

Incorporated by reference to the Exhibit 10.1 to the Current Report on Form 8-K filed December 1, 2010.

10 

Incorporated by reference to First Security’s Annual Report on Form 10-K for the year ended December 31,2009.

11 

Incorporated by reference to the Exhibit 10.3 to the Current Report on Form 8-K filed January 9, 2009.

12

Incorporated by reference to the Exhibit 10.1 to the Current Report on Form 8-K filed January 9, 2009.

13 

Incorporated by reference to First Security’s Annual Report on Form 10-K for the year ended December 31, 2009.

14 

Incorporated by reference to the Exhibit 10.1 to the Current Report on Form 8-K filed April 29, 2010.

15 

Incorporated by reference to the Exhibit 10.2 to the Current Report on Form 8-K filed April 29, 2010.

16 

Incorporated by reference to the Exhibit 10.1 to the Current Report on Form 8-K filed September 14, 2010.

17 

Incorporated by Reference to First Security’s Annual Report on Form 10-K for the year ended December 31, 2003.

* The indicated exhibit is a compensatory plan required to be filed as an exhibit to this Form 10-K.

 

(b) The Exhibits not incorporated by reference herein are submitted as a separate part of this report.

 

(c) The financial statement schedules are either included in the financial statements or are not applicable.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

FIRST SECURITY GROUP, INC.

BY:    /S/    RODGER B. HOLLEY        
  Rodger B. Holley
  Chief Executive Officer and
Chairman of the Board of Directors

DATE: April 15, 2011

Pursuant to the requirements of the Securities and Exchange Act of 1934, the report has been signed by the following persons on behalf of the registrant and in the capacities indicated on April 15, 2011.

 

Signature

  

Title

/S/    RODGER B. HOLLEY        

Rodger B. Holley

(Principal Executive Officer)

  

Chief Executive Officer and

Chairman of the Board of Directors

/S/    JOHN R. HADDOCK        

John R. Haddock

(Principal Financial and Accounting Officer)

  

Chief Financial Officer,

Controller and Secretary

/S/    RALPH E. COFFMAN, JR.        

Ralph E. Coffman, Jr.

  

President, Chief Operating

Officer and Director

/S/    WILLIAM C. HALL        

William C. Hall

   Director

/S/    CAROL H. JACKSON        

Carol H. Jackson

   Director

/S/    RALPH L. KENDALL        

Ralph L. Kendall

   Director

/S/    KELLY P. KIRKLAND        

Kelly P. Kirkland

   Director

/S/    D. RAY MARLER        

D. Ray Marler

   Director

/S/    RALPH E. MATHEWS, JR.        

Ralph E. Mathews, Jr.

   Director

 

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