Note 4: Investment Securities

The amortized costs and approximate fair values, together with gross unrealized gains and losses on securities, are as follows:



	March 31, 2014
		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Available for Sale Securities
Mortgage-backed securities
Government-sponsored agencies	$	110,919	$	1,821	$	(1,397)	$	111,343
Collateralized mortgage obligations
Government-sponsored agencies		107,074		1,277		(1,646)		106,705
Federal agencies		5		-		-		5
Municipal obligations		28,270		922		(33)		29,159
Corporate obligations		24,646		32		(2,784)		21,894
Total investment securities	$	270,914	$	4,052	$	(5,860)	$	269,106



	December 31, 2013
		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Available for Sale Securities
Mortgage-backed securities
Government-sponsored agencies	$	104,006	$	1,700	$	(2,189)	$	103,517
Collateralized mortgage obligations
Government-sponsored agencies		108,305		1,207		(1,934)		107,578
Federal agencies		5,005		-		(231)		4,774
Municipal obligations		27,357		257		(276)		27,338
Corporate obligations		24,648		18		(3,525)		21,141
Total investment securities	$	269,321	$	3,182	$	(8,155)	$	264,348

The amortized cost and fair value of securities available for sale at March 31, 2014, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.



	Available for Sale
Description Securities	Amortized Cost		Fair Value
Security obligations due
One to five years	$	9,722	$	9,729
Five to ten years		10,614		10,537
After ten years		32,585		30,792
		52,921		51,058
Mortgage-backed securities
Government-sponsored agencies		110,919		111,343
Collateralized mortgage obligations
Government-sponsored agencies		107,074		106,705
Totals	$	270,914	$	269,106

The carrying value of securities pledged as collateral, to secure public deposits and for other purposes, was $2.0 million at $2.1 million and March 31, 2014 and December 31, 2013, respectively.

Proceeds from sales of securities available for sale during the three months ended March 31, 2014 and 2013 were $15.5 million and $17.4 million, respectively. Gross gains of $315,000 and $339,000 for the quarter ended March 31, 2014 and 2013, respectively, were recognized on those sales. Gross losses of $165,000 and $0 for the three months ended March 310, 2014 and 2013, respectively, were recognized on those sales

All mortgage-backed securities and collateralized-mortgage obligations held by the Company as of March 31, 2014 were in government-sponsored and federal agency securities.

Certain investments in debt securities are reported in the financial statements at an amount less than their historical cost. Total fair value of these investments at March 31, 2014 and December 31, 2013 was $123.0 million and $147.8 million, which is approximately 45.7 percent and 55.9 percent of the Company’s investment portfolio at those dates.

Based on our evaluation of available evidence, including recent changes in market interest rates, management believes the declines in fair value for these securities are temporary.

Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified.

During the first quarter of 2014 and 2013, the Bank determined that its holdings in trust preferred securities were not other than temporarily impaired.

The following tables show the gross unrealized losses and fair value of the Company’s investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2014 and December 31, 2013:



	March 31, 2014
	Less than 12 Months				12 Months or More				Total
		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Available for Sale
Mortgage-backed securities
Government-sponsored agencies	$	53,895	$	(1,397)	$	-	$	-	$	53,895	$	(1,397)
Collateralized mortgage obligations										-		-
Government-sponsored agencies		48,246		(1,394)		4,442		(252)		52,688		(1,646)
Federal agencies		5		-		-		-		5		-
Municipal obligations		2,764		(8)		748		(25)		3,512		(33)
Corporate obligations		4,487		(13)		8,432		(2,771)		12,919		(2,784)
Total temporarily impaired securities	$	109,397	$	(2,812)	$	13,622	$	(3,048)	$	123,019	$	(5,860)


	December 31, 2013
	Less than 12 Months				12 Months or More				Total
		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Available for Sale
Mortgage-backed securities
Government-sponsored agencies	$	67,130	$	(2,189)	$	-	$	-	$	67,130	$	(2,189)
Collateralized mortgage obligations
Government-sponsored agencies		51,753		(1,934)		-		-	$	51,753	$	(1,934)
Federal agencies		4,769		(231)						4,769		(231)
Municipal obligations		11,264		(245)		741		(31)		12,005		(276)
Corporate obligations		8,849		(151)		3,336		(3,374)		12,185		(3,525)
Total temporarily impaired securities	$	143,765	$	(4,750)	$	4,077	$	(3,405)	$	147,842	$	(8,155)

Mortgage-Backed Securities (MBS), Collateralized Mortgage Obligations (CMO) and Federal Agencies

The unrealized losses on the Company’s investment in MBSs, CMOs and Federal Agencies were caused by interest rate changes. The Company expects to recover the amortized cost basis over the term of the securities. Because (1) the decline in market value is attributable to changes in interest rates and not credit quality, (2) the Company does not intend to sell the investments and (3) it is more likely than not the Company will not be required to sell the investments before recovery of their amortized cost bases, which may be at maturity, the Company does not consider these investments to be other-than-temporarily impaired at March 31, 2014.

Corporate Obligations

The Company’s unrealized loss on investments in corporate obligations primarily relates to investments in pooled trust preferred securities. The unrealized losses were primarily caused by (1) a decrease in performance and regulatory capital resulting from exposure to subprime mortgages and (2) a sector downgrade by several industry analysts. The Company currently expects some of the securities to settle at a price less than the amortized cost basis of the investment (that is, the Company expects to recover less than the entire amortized cost basis of the security). The Company has recognized a loss equal to the credit loss for these securities, establishing a new, lower amortized cost basis. The credit loss was calculated by comparing expected discounted cash flows based on performance indicators of the underlying assets in the security to the carrying value of the investment. Because the Company does not intend to sell these investments and it is likely that the Company will not be required to sell the investments before recovery of its new, lower amortized cost basis, which may be at maturity, it does not consider the remainder of the investments to be other-than-temporarily impaired at March 31, 2014.

Other-Than-Temporary Impairment

Upon acquisition of a security, the Company decides whether it is within the scope of the accounting guidance for beneficial interests in securitized financial assets or whether it will be evaluated for impairment under the accounting guidance for investments in debt and equity securities.

The accounting guidance for beneficial interests in securitized financial assets provides incremental impairment guidance for a subset of the debt securities within the scope of the guidance for investments in debt and equity securities. For securities that are a beneficial interest in securitized financial assets, the Company uses the beneficial interests in securitized financial asset impairment model. For securities where the security is not a beneficial interest in securitized financial assets, the Company uses debt and equity securities impairment model.

The Company conducts periodic reviews to identify and evaluate each investment security to determine whether an other-than-temporary impairment has occurred. Economic models are used to determine whether an other-than-temporary impairment has occurred on these securities. While all securities are considered, the securities primarily impacted by other-than-temporary impairment testing are private-label mortgage-backed securities and trust preferred securities.

The Bank’s trust preferred securities valuation was prepared by an independent third party. Their approach to determining fair value involved several steps including:

Detailed credit and structural evaluation of each piece of collateral in the trust preferred securities;

Collateral performance projections for each piece of collateral in the trust preferred security;

Terms of the trust preferred structure, as laid out in the indenture; and

Discounted cash flow modeling.

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

The default and recovery probabilities for each piece of collateral were formed based on the evaluation of the collateral credit and a review of historical industry default data and current/near-term operating conditions. For collateral that has already defaulted, the Company assumed no recovery. For collateral that was in deferral, the Company assumed a recovery of 10% of par for banks, thrifts or other depository institutions and 15% of par for insurance companies. Although the Company conservatively assumed that the majority of the deferring collateral continues to defer and eventually defaults, we also recognize there is a possibility that some deferring collateral may become current at some point in the future.

Credit Losses Recognized on Investments

Certain debt securities have experienced fair value deterioration due to credit losses, as well as due to other market factors, but are not otherwise other-than-temporarily impaired.

The following table provides information about debt securities for which only a credit loss was recognized in income and other losses are recorded in other comprehensive income.



	Accumulated Credit Losses
	Three Months Ended
	March 31,
	2014		2013
Credit losses on debt securities held
Beginning of year	$	1,205	$	1,205
Reductions related to actual losses incurred				-
As of March 31,	$	1,205	$	1,205

Pooled Trust Preferred Securities. The Company has invested in pooled trust preferred securities. At March 31, 2014, the current par balance of our pooled trust preferred securities was $8.2 million. The original par value of these securities was $10.3 million prior to the OTTI write-downs in 2011 and earlier, based on valuations by a third party. OTTI taken on trust preferred securities previously was the result of deterioration in the performance of the underlying collateral. The deterioration was the result of increased defaults and deferrals of dividend payments in the current year, creating credit impairment along with weakening financial performance of performing collateral, increasing the risk of future deferrals of dividends and defaults. No additional OTTI was determined in the first quarter of 2014. All pooled trust preferred securities owned by the Bank are exempt from the Volcker Rule.

The following table provides additional information related to the Bank’s investment in trust preferred securities as of March 31, 2014.



Deal Name	Class	Original Par		Book Value		Fair Value		Unrealized gain/loss		Realized Losses 2014		Lowest Ratings	Number of Banks / Insurance Cos. Currently Performing	Total Number of Banks and Insurance Cos. In Issuance (Unique)	Actual Deferrals/ Defaults (as a % of original collateral)		Total Projected Defaults (as a % of performing collateral) (1)		Excess subordination (after taking into account best estimate of future deferrals/ defaults) (2)
	(Dollars in Thousands)
Alesco Preferred Funding IX	B+	$	1,000	$	908	$	559	$	349	$	-	B2	41	52	14.69	%	15.78	%	54.50	%
Preferred Term Securities XIII	Ca		1,000		777		427		350		-	Ca	44	61	25.75	%	20.21	%	4.36	%
Preferred Term Securities XVIII	Ca		1,000		917		435		482		-	Ca	52	72	22.51	%	10.03	%	6.43	%
Preferred Term Securities XXVII	C		1,000		710		390		320		-	C	33	46	22.62	%	16.29	%	10.02	%
U.S. Capital Funding I	Caa1		3,000		2,890		1,936		954		-	Caa1	28	33	9.44	%	8.60	%	8.90	%
U.S. Capital Funding III	Ca		1,000		500		296		204		-	Ca	29	37	18.01	%	11.61	%	-	%
		$	8,000	$	6,702	$	4,043	$	2,659	$	-

(1) A 10% recovery is applied to all projected defaults by depository institutions. A 15% recovery is applied to all projected defaults by insurance companies. No recovery is applied to current defaults.

(2) Excess subordination represents the additional defaults in excess of both current and projected defaults that the CDO can absorb before the bond experiences any credit impairment. Excess subordinated percentage is calculated by (a) determining what percentage of defaults a deal can experience before the bond has credit impairment, and (b) subtracting from this default breakage percentage both total current and expected future default percentages.