10-Q 1 form10q60363_fdfc.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) |X| Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarterly Period Ended March 31, 2004 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 number 0-26850 First Defiance Financial Corp. (Exact name of registrant as specified in its charter) Ohio 34-1803915 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 601 Clinton Street, Defiance, Ohio 43512 (Address or principal executive office) (Zip Code) Registrant's telephone number, including area code: (419) 782-5015 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |X| No |_| Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. Common Stock, $.01 Par Value - 6,391,933 shares outstanding at May 7, 2004 FIRST DEFIANCE FINANCIAL CORP. INDEX Page Number ------ PART I.-FINANCIAL INFORMATION Item 1. Consolidated Condensed Financial Statements (Unaudited): Consolidated Condensed Statements of Financial Condition - March 31, 2004 and December 31, 2003 2 Consolidated Condensed Statements of Income - Three months ended March 31, 2004 and 2003 4 Consolidated Condensed Statement of Changes in Stockholders' Equity - Three months ended March 31, 2004 5 Consolidated Condensed Statements of Cash Flows - Three months ended March 31, 2004 and 2003 7 Notes to Consolidated Condensed Financial Statements 9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 19 Item 3. Quantitative and Qualitative Disclosures about Market Risk 29 Item 4. Controls and Procedures 29 PART II.-OTHER INFORMATION: Item 1. Legal Proceedings 30 Item 2. Changes in Securities 30 Item 3. Defaults upon Senior Securities 30 Item 4. Submission of Matters to a Vote of Security Holders 30 Item 5. Other Information 30 Item 6. Exhibits and Reports on Form 8-K 30 Signatures 32 1 PART 1-FINANCIAL INFORMATION Item 1. Financial Statements FIRST DEFIANCE FINANCIAL CORP. Consolidated Condensed Statements of Financial Condition (UNAUDITED) (Amounts in Thousands) --------------------------------------------------------------------------------
March 31, 2004 December 31, 2003 -------------- ----------------- ASSETS Cash and cash equivalents: Cash and amounts due from depository institutions $ 17,610 $ 28,020 Interest-bearing deposits 4,828 9,763 ---------- ---------- 22,438 37,783 Securities: Available-for-sale, carried at fair value 155,379 168,259 Held-to-maturity, carried at amortized cost (approximate fair value $2,828 and $2,937 at March 31, 2004 and December 31, 2003 respectively) 2,665 2,776 ---------- ---------- 158,044 171,035 Loans held for sale 8,214 5,872 Loans receivable, net 757,920 735,255 Accrued interest receivable 4,821 4,742 Federal Home Loan Bank stock and other interest-earning assets 17,943 17,766 Bank owned life insurance 18,145 17,952 Office properties and equipment 24,131 23,846 Real estate and other assets held for sale 348 404 Goodwill and other intangibles 19,302 20,544 Mortgage servicing rights 3,199 3,431 Other assets 2,595 1,969 ---------- ---------- Total assets $1,037,100 $1,040,599 ========== ==========
See accompanying notes. 2 FIRST DEFIANCE FINANCIAL CORP. Consolidated Condensed Statements of Financial Condition (UNAUDITED) (Amounts in Thousands) --------------------------------------------------------------------------------
March 31, 2004 December 31, 2003 -------------- ----------------- LIABILITIES AND STOCKHOLDERS' EQUITY Non-interest-bearing deposits $ 52,091 $ 52,323 Interest-bearing deposits 669,977 676,673 ----------- ----------- Total deposits 722,068 728,996 Advances from Federal Home Loan Bank 167,974 164,522 Short-term borrowings and other interest-bearing liabilities 8,290 12,267 Advance payments by borrowers for taxes and insurance 162 231 Deferred taxes 2,235 1,859 Other liabilities 9,141 8,455 ----------- ----------- Total liabilities 909,870 916,330 STOCKHOLDERS' EQUITY Preferred stock, no par value per share: 5,000 shares authorized; no shares issued -- -- Common stock, $.01 par value per share: 20,000 shares authorized; 6,401 and 6,328 shares outstanding, respectively 64 63 Additional paid-in capital 52,380 51,144 Stock acquired by ESOP (1,691) (1,904) Deferred compensation (9) (11) Accumulated other comprehensive income, net of income taxes of $2,519 and $2,163, respectively 4,691 4,017 Retained earnings 71,795 70,960 ----------- ----------- Total stockholders' equity 127,230 124,269 ----------- ----------- Total liabilities and stockholders' equity $ 1,037,100 $ 1,040,599 =========== ===========
See accompanying notes 3 FIRST DEFIANCE FINANCIAL CORP. Consolidated Condensed Statements of Income (UNAUDITED) (Amounts in Thousands, except per share data) --------------------------------------------------------------------------------
For the Three Months Ended March 31, 2004 2003 ---- ---- Interest Income Loans $ 10,928 $ 9,338 Investment securities 1,865 2,424 Interest-bearing deposits 32 29 -------- -------- Total interest income 12,825 11,791 Interest Expense Deposits 2,998 3,534 FHLB advances and other 1,785 1,814 Notes payable 23 9 -------- -------- Total interest expense 4,806 5,357 -------- -------- Net interest income 8,019 6,434 Provision for loan losses 379 335 -------- -------- Net interest income after provision for loan losses 7,640 6,099 Non-interest Income Service fees and other charges 1,252 985 Insurance commission income 1,062 926 Dividends on stock and other interest income 177 169 Gain on sale of loans 589 1,800 Gain/(loss) on sale of securities 98 631 Trust income 49 32 Income from Bank Owned Life Insurance 193 201 Other non-interest income 2 47 -------- -------- Total non-interest income 3,422 4,791 Non-interest Expense Compensation and benefits 4,314 3,708 Occupancy 840 728 SAIF deposit insurance premiums (credit) (42) 24 State franchise tax 156 281 Data processing 543 432 Amortization and impairment of mortgage servicing rights 409 763 Amortization of goodwill and other intangibles 27 -- Other non-interest expense 1,217 1,079 -------- -------- Total non-interest expense 7,464 7,015 -------- -------- Income before income taxes 3,598 3,875 Federal income taxes 1,105 1,157 -------- -------- Net Income $ 2,493 $ 2,718 ======== ======== Earnings per share (Note 4) Basic $ 0.41 $ 0.45 ======== ======== Diluted $ 0.39 $ 0.43 ======== ======== Dividends declared per share (Note 3) $ 0.20 $ 0.15 ======== ======== Average shares outstanding (Note 4) Basic 6,113 6,074 ======== ======== Diluted 6,427 6,330 ======== ========
See accompanying notes 4 FIRST DEFIANCE FINANCIAL CORP. Consolidated Condensed Statement of Changes in Stockholders' Equity (UNAUDITED) (Amounts in Thousands) --------------------------------------------------------------------------------
2004 ------------------------------------------------------- Stock Acquired By ----------------- Additional Management Common Paid-in Recognition Stock Capital ESOP Plan ----- ------- ---- ---- Balance at January 1 $ 63 $ 51,144 $ (1,904) $ (11) Comprehensive income: Net income Change in unrealized gains (losses) net of income taxes of ($362) Total comprehensive income ESOP shares released 446 213 Amortization of deferred compensation of Management Recognition Plan 2 Shares issued under stock option plan 1 1,091 Purchase of common stock for treasury (301) Dividends declared (Note 3) ---------------------------------------------------- Balance at March 31 $ 64 $ 52,380 $ (1,691) $ (9) ====================================================
See accompanying notes 5 FIRST DEFIANCE FINANCIAL CORP. Consolidated Condensed Statement of Changes in Stockholders' Equity (Continued) (UNAUDITED) (Amounts in Thousands) --------------------------------------------------------------------------------
2004 2003 --------------------------------------------- ------------- Net Unrealized gains (losses) on Total Total available-for- Retained Stockholders' Stockholder's sale securities Earnings Equity Equity --------------- -------- ------ ------ Balance at January 1 $ 4,017 $ 70,960 $ 124,269 $ 120,110 Comprehensive income: Net income 2,493 2,493 2,718 Change in unrealized gains (losses) net of income taxes of $(362) 674 674 (387) --------- --------- Total comprehensive income 3,167 2,331 ESOP shares released 659 455 Amortization of deferred compensation of Management Recognition Plan 2 5 Shares issued under stock option plan 1,092 516 Purchase of common stock for treasury (420) (721) (2,356) Dividends declared (Note 3) (1,238) (1,238) (914) --------------------------------------- --------- Balance at March 31 $ 4,691 $ 71,795 $ 127,230 $ 120,147 ======================================= =========
See accompanying notes 6 FIRST DEFIANCE FINANCIAL CORP. Consolidated Condensed Statements of Cash Flows (UNAUDITED) (Amounts in Thousands) --------------------------------------------------------------------------------
Three Months Ended March 31, 2004 2003 ---- ---- Operating Activities Net income $ 2,494 $ 2,718 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 379 335 Provision for depreciation 447 396 Net securities amortization 166 289 Amortization of mortgage servicing rights 172 523 Net impairment of mortgage servicing rights 237 240 Amortization of core deposit intangible 27 -- Gain on sale of loans (589) (1,800) Amortization of Management Recognition Plan deferred compensation 2 5 Release of ESOP Shares 659 455 Gains on sales of securities (98) (631) Deferred federal income tax credit 12 67 Proceeds from sale of loans 20,935 75,619 Origination of mortgage servicing rights, net (177) (709) Origination of loans held for sale (22,688) (69,874) Decrease in interest receivable and other assets (898) (1,717) Increase in other liabilities 666 (432) -------- -------- Net cash provided by operating activities 1,746 5,484 Investing Activities Proceeds from maturities of held-to-maturity securities 109 387 Proceeds from maturities of available-for-sale securities 16,836 23,668 Proceeds from sale of available-for-sale securities -- 1,670 Proceeds from sales of real estate and other assets held for sale 459 154 Proceeds from sale of discontinued operations -- 1,228 Purchases of available-for-sale securities (2,984) (12,657) Purchases of Federal Home Loan Bank stock (177) (168) Purchases of office properties and equipment (732) (898) Net increase in loans receivable (22,212) (25,808) -------- -------- Net cash used in investing activities (8,701) (12,424)
7 FIRST DEFIANCE FINANCIAL CORP. Consolidated Condensed Statements of Cash Flows (Continued) (UNAUDITED) (Amounts in Thousands) -------------------------------------------------------------------------------- Three Months Ended March 31, 2004 2003 ---- ---- Financing Activities Net (decrease) increase in deposits (6,997) 8,246 Repayment of Federal Home Loan Bank long-term advances (448) (249) Repayment of term notes payable -- (10) Net increase (decrease) in Federal Home Loan Bank short-term advances 3,900 (1,700) Proceeds from Federal Home Loan Bank long term advances -- 9,000 Decrease in securities sold under repurchase agreements (3,977) (2,301) Purchase of common stock for treasury (722) (2,356) Cash dividends paid (1,238) (914) Proceeds from exercise of stock options 1,092 516 -------- -------- Net cash (used in) provided by financing activities (8,390) 10,232 -------- -------- (Decrease) increase in cash and cash equivalents (15,345) 3,292 Cash and cash equivalents at beginning of period 37,783 28,658 -------- -------- Cash and cash equivalents at end of period $ 22,438 $ 31,950 ======== ======== Supplemental cash flow information: Interest paid $ 4,748 $ 5,192 ======== ======== Income taxes paid $ -- $ 400 ======== ======== Noncash operating activities: Change in deferred tax established on net unrealized gain or loss on available-for-sale securities $ (362) $ 350 ======== ======== Transfers from loans to real estate and other assets held for sale $ 403 $ 7 ======== ======== Noncash investing activities: Increase (decrease) in net unrealized gain or loss on available-for-sale securities $ 1,038 $ (737) ======== ======== Noncash financing activities: Cash dividends declared but not paid $ 1,238 $ 920 ======== ======== See accompanying notes. 8 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 1. Principles of Consolidation The consolidated condensed financial statements include the accounts of First Defiance Financial Corp. ("First Defiance" or "the Company"), its two wholly owned subsidiaries, First Federal Bank of the Midwest ("First Federal") and First Insurance and Investments, Inc. ("First Insurance"). In the opinion of management, all significant intercompany accounts and transactions have been eliminated in consolidation. 2. Basis of Presentation The consolidated condensed statement of financial condition at December 31, 2003 has been derived from the audited financial statements at that date, which were included in First Defiance's Annual Report on Form 10-K. The accompanying consolidated condensed financial statements as of March 31, 2004 and for the three-month period ending March 31, 2004 and 2003 have been prepared by First Defiance without audit and do not include information or footnotes necessary for the complete presentation of financial condition, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States. These consolidated condensed financial statements should be read in conjunction with the financial statements and notes thereto included in First Defiance's 2003 Annual Report on Form 10-K for the year ended December 31, 2003. However, in the opinion of management, all adjustments, consisting of only normal recurring items, necessary for the fair presentation of the financial statements have been made. The results for the three-month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for the entire year. Goodwill Goodwill is the excess of the purchase price over the fair value of the assets and liabilities of companies acquired through business combinations accounted for under the purchase method. Goodwill is evaluated at the business unit level, which for First Defiance are First Federal Bank and First Insurance. At March 31, 2004 goodwill totaled $18.6 million, a reduction from the $19.8 million balance reported at December 31, 2003. The reduction in goodwill is the result of management reassessing the required discount adjustment necessary for the loan portfolio acquired in June 2003 from the RFC Banking Company. Based on early pay-offs of several large classified loans, management reduced the discount recorded in conjunction with the original purchase price allocation. The offsetting adjustment was a $1.2 million reduction in goodwill recorded during the 2004 first quarter. 9 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- Income Taxes The Company's effective tax rate differs from the statutory 35% federal tax rate primarily because of the existence of municipal securities and bank owned life insurance, the earnings of which are exempt from federal income taxes. Stock Compensation At March 31, 2004, the Company had three stock-based compensation plans, which are more fully described in Note 18 in the financial statements included in First Defiance's 2003 Annual Report on Form 10-K. The Company accounts for those plans under recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. Under APB No. 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized. Pro forma information regarding net income and earnings per share is required by SFAS No. 123, Accounting for Stock-Based Compensation and has been determined as if First Defiance had accounted for its employee stock options under the fair value method of that Statement. Under the fair-value based method, compensation cost is measured at the grant date based upon the value of the award and recognized over the service period. For purposes of the pro forma disclosures, the estimated fair value of the option is amortized to expense over the options' vesting period. The following pro forma results of operations use a fair value method of accounting for stock options in accordance with SFAS No. 123. The estimated fair value of the options are amortized to expense over the option and vesting period. The fair value was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions: March 31 2004 2003 ------------------------------ Risk free interest rate 5.65% 5.73% Dividend yield 2.97% 2.96% Volatility factors of expected market price of stock 0.266% 0.269% Weighted average expected life 8.71 years 8.63 years Weighted average grant date fair value of options granted $3.53 $3.45 Based on the above assumptions, pro forma net income and earnings per share are computed as follows (in thousands, except per share amounts): 10 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 2. Basis of Presentation (continued) Three months ended March 31 2004 2003 --------------------------- Net Income $ 2,493 $ 2,718 Stock-based compensation using the fair value method, net of tax (45) (51) --------------------------- Pro forma net income from continuing operations $ 2,448 $ 2,667 =========================== Pro forma earnings per share: Basic $ 0.40 $ 0.44 =========================== Diluted $ 0.38 $ 0.42 =========================== Recent Accounting Pronouncements Medicare Prescription Law In December 2003, the FASB issued guidance that requires disclosure that acknowledges the issuance of this new law and the fact that it may affect a company's accumulated postretirement benefit obligation and net postretirement benefit cost. The required disclosure for First Defiance is presented in Note 14. Consolidation of Variable Interest Entities In January 2003, the FASB issued FASB Interpretation No. 46 (FIN No. 46), Consolidation of Variable Interest Entities. The objective of this interpretation is to provide guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, non-controlling interests and results of operations of a VIE need to be included in a company's consolidated financial statements. A company that holds variable interests in an entity will need to consolidate the entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected loss and/or receive a majority of the entity's expected residual returns, if they occur. FIN No. 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. In December 2003, the FASB issued modifications to FIN No. 46 to provide additional scope exceptions, address certain implementation issues and promote a more consistent application of the provisions. Revised FIN No. 46 superceded FIN No. 46 and was adopted by the Company effective January 1, 2004. First Defiance is not a party to any VIEs as of March 31, 2004. 11 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 2. Basis of Presentation (continued) Accounting for Certain Loans or Debt Securities Acquired in a Transfer In December 2003, the AICPA issued a Statement of Position that addresses the accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (structured as loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. The implementation of this guidance has been deferred to be effective after December 31, 2004. Adoption of this guidance is not expected to have any material effect on the Company's financial condition or results of operations. 3. Dividends on Common Stock As of March 31, 2004, First Defiance had declared a quarterly cash dividend of $.20 per share for the first quarter of 2004, payable April 23, 2004. 12 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 4. Earnings Per Share Basic earnings per share as disclosed under FAS No. 128 has been calculated by dividing net income by the weighted average number of shares of common stock outstanding for the three month period ended March 31, 2004 and 2003. First Defiance accounts for the shares issued to its Employee Stock Ownership Plan ("ESOP") in accordance with Statement of Position 93-6 of the American Institute of Certified Public Accountants ("AICPA"). As a result, shares controlled by the ESOP are not considered in the weighted average number of shares of common stock outstanding until the shares are committed for allocation to an employee's individual account. In the calculation of diluted earnings per share for the three months ended March 31, 2004 and 2003, the effect of shares issuable under stock option plans and unvested shares under the Management Recognition Plan have been accounted for using the Treasury Stock method. The following table sets forth the computation of basic and diluted earning per share (in thousands except per share data):
Three months ended March 31 2004 2003 Numerator for basic and diluted earnings per share - Net income $ 2,493 $ 2,718 Denominator: Denominator for basic earnings per share - weighted average shares 6,113 6,074 Effect of dilutive securities: Employee stock options 311 245 Unvested management recognition plan stock 3 11 ------------------------- Dilutive potential common shares 314 256 ------------------------- Denominator for diluted earnings per share - adjusted weighted average shares and assumed conversions 6,427 6,330 ========================= Basic earnings per share from net income $ 0.41 $ 0.45 ========================= Diluted earnings per share from net income $ 0.39 $ 0.43 =========================
13 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 5. Investment Securities The following is a summary of available-for-sale and held-to-maturity securities (in thousands):
March 31, 2004 --------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value --------------------------------------------------- Available-for-Sale Securities: U.S. Treasury securities and obligations of U.S. Government corporations and agencies $ 61,698 $ 4,417 $ -- $ 66,115 Corporate bonds 6,200 582 -- 6,782 Mortgage-backed securities 18,441 285 5 18,721 REMICs 8,440 18 27 8,431 Collateralized mortgage obligations 14,858 230 -- 15,088 Trust preferred stock 7,238 71 -- 7,309 Equity securities 69 9 -- 78 Obligations of state and political subdivisions 31,213 1,648 6 32,855 --------------------------------------------------- Totals $ 148,157 $ 7,260 $ 38 $ 155,379 =================================================== Held-to-Maturity Securities: FHLMC certificates $ 581 $ 21 $ 1 $ 601 FNMA certificates 1,117 20 1 1,136 GNMA certificates 377 9 -- 386 Obligations of state and political subdivisions 590 115 -- 705 --------------------------------------------------- Totals $ 2,665 $ 165 $ 2 $ 2,828 ===================================================
14 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 5. Investment Securities (continued)
December 31, 2003 --------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value --------------------------------------------------- Available-for-Sale Securities: U.S. Treasury securities and obligations of U.S. Government corporations and agencies $ 72,907 $ 3,980 $ 12 $ 76,875 Corporate bonds 7,210 506 -- 7,716 Mortgage-backed securities 19,621 169 38 19,752 REMICs 8,994 22 54 8,962 Collateralized mortgage obligations 14,687 53 21 14,719 Trust preferred stock 7,238 84 -- 7,322 Equity securities 69 9 -- 78 Obligations of state and political subdivisions 31,352 1,504 21 32,835 --------------------------------------------------- Totals $ 162,078 $ 6,327 $ 146 $ 168,259 =================================================== Held-to-Maturity Securities: FHLMC certificates $ 603 $ 25 $ 1 $ 627 FNMA certificates 1,174 16 6 1,184 GNMA certificates 409 11 -- 420 Obligations of state and political subdivisions 590 117 -- 707 --------------------------------------------------- Totals $ 2,776 $ 169 $ 7 $ 2,938 ===================================================
15 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 6. Loans Loans receivable and held for sale consist of the following (in thousands): March 31, December 31 2004 2003 ------------------------ Real Estate: One-to-four family residential $ 173,367 $ 167,983 Construction 15,272 16,830 Non-residential and multi-family 359,070 341,423 ------------------------ 547,709 526,236 Other Loans: Commercial 119,442 120,677 Consumer finance 40,858 40,257 Home equity and improvement 74,800 70,038 ------------------------ 235,100 230,972 ------------------------ Total real estate and other loans 782,809 757,208 Deduct: Loans in process 6,406 6,079 Net deferred loan origination fees and costs 1,102 1,158 Allowance for loan loss 9,167 8,844 ------------------------ Totals $ 766,134 $ 741,127 ======================= Changes in the allowance for loan losses were as follows (in $000s): Three Months ended March 31 2004 2003 --------------------------- Balance at beginning of period $ 8,844 7,496 Provision for loan losses 379 335 Charge-offs: One-to-four family residential real estate 52 -- Non-residential and multi-family real estate -- -- Commercial 14 25 Consumer finance 38 50 ----------------------- Total charge-offs 104 75 Recoveries 48 168 ----------------------- Net charge-offs 56 (93) ----------------------- Ending allowance $ 9,167 $ 7,924 ======================= 16 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 7. Deposits A summary of deposit balances is as follows (in thousands): March 31, December 31, 2004 2003 Non-interest-bearing checking accounts $ 52,091 $ 52,323 Interest-bearing checking accounts 67,666 67,351 Savings accounts 54,054 51,767 Money market demand accounts 148,527 148,691 Certificates of deposit 399,730 408,864 ----------------------- $ 722,068 $ 728,996 ======================= 8. Commitments, Guarantees and Contingent Liabilities Loan commitments are made to accommodate the financial needs of First Defiance's customers; however, there are no long-term, fixed-rate loan commitments that result in market risk. Standby letters of credit obligate the Company to pay a third party beneficiary when a customer fails to repay an outstanding loan or debt instrument, or fails to perform some contractual non-financial obligation. Standby letters of credit are issued to address customers' financing needs and to facilitate customers' trade transactions. In accordance with FASB interpretation No. 45, "Guarantor's Guarantees of Indebtedness of Others," certain guarantees issued or modified on or after January 1, 2003, require the recognition of a liability on First Defiance's balance sheet for the "stand ready" obligation with such guarantees. If amounts are drawn under standby letters of credit, such amounts are treated as loans. Both loan commitments and standby letters of credit have credit risk, essentially the same as that involved in extending loans to customers, and are subject to the Company's normal credit policies. Collateral (e.g., securities, receivables, inventory and equipment) is obtained based on management's credit assessment of the customer. The Company's maximum obligation to extend credit for loan commitments (unfunded loan and unused lines of credit) and standby letters of credit was as follows: March 31, December 31, 2004 2003 ------------------------- (In Thousands) Commercial $ 119,102 $ 113,247 Real Estate 11,406 6,799 Consumer 59,113 56,823 Standby Letters of Credit 4,481 3,550 ----------------------- Total $ 194,102 $ 180,419 ======================= 17 FIRST DEFIANCE FINANCIAL CORP. Notes to Consolidated Condensed Financial Statements (Unaudited at March 31, 2004 and 2003) -------------------------------------------------------------------------------- 8. Commitments, Guarantees and Contingent Liabilities (continued) The remaining weighted average life for outstanding standby letters of credit was less than one year at March 31, 2004. The Company had $94,000 of standby letters of credit with a life longer than one year. 9. Postretirement Benefits First Defiance sponsors a defined benefit postretirement plan that is intended to supplement Medicare coverage for certain retirees who meet minimum age requirements. A description of employees or former employees eligible for coverage is included in Footnote 14 in the financial statements included in First Defiance's 2003 Annual Report on Form 10-K. Net periodic postretirement benefit costs include the following components for the three-month periods ended March 31, 2004 and 2003: Three Months Ended March 31 2004 2003 ---------------------------- (In Thousands) Service cost-benefits attributable to service during the period $ 12 $ 9 Interest cost on accumulated postretirement benefit obligation 24 21 Net amortization and deferral 6 3 --------------------------- Net periodic postretirement benefit cost $ 42 $ 33 =========================== Prescription drug coverage was added to Medicare under the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act). As a result, net per capita claims cost and the costs borne by retirees have been assumed to decrease in 2006 due to this legislation. The enactment of the Act resulted in a decrease to the accrued postretirement benefit obligation in 2003 which is being amortized beginning in 2004. The Company has assumed that it will opt for coverage under Medicare Part D rather than the Federal subsidy approach. As specific authoritative guidance for matters related to the Act are pending, guidance when issued could require First Defiance to change previously reported information. 18 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations General First Defiance Financial Corp. ("First Defiance" of "the Company") is a holding company which conducts business through its two wholly owned subsidiaries, First Federal Bank of the Midwest ("First Federal") and First Insurance and Investments, Inc. ("First Insurance"). First Federal is a federally chartered savings bank that provides financial services to communities based in northwest Ohio where it operates 19 full service branches. First Federal provides a broad range of financial services including checking accounts, savings accounts, certificates of deposit, real estate mortgage loans, commercial loans, consumer loans, home equity loans and trust services. First Insurance sells a variety of property and casualty, group health and life, and individual health and life insurance products and investment and annuity products. Insurance products are sold through First Insurance's office in Defiance, Ohio while investment and annuity products are sold through registered investment representatives located at three First Federal banking center locations. First Defiance invests in U.S. Treasury and federal government agency obligations, obligations of municipal and other political subdivisions, mortgage-backed securities which are issued by federal agencies, corporate bonds, and collateralized mortgage obligations ("CMOs") and real estate mortgage investment conduits ("REMICs"). Management determines the appropriate classification of all such securities at the time of purchase in accordance with FAS Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. Securities are classified as held-to-maturity when First Defiance has the positive intent and ability to hold the security to maturity. Held-to-maturity securities are stated at amortized cost and had a recorded value of $2.7 million at March 31, 2004. Securities not classified as held-to-maturity are classified as available-for-sale, which are stated at fair value and had a recorded value of $155.4 million at March 31, 2004. The available-for-sale portfolio consists of U.S. Treasury securities and obligations of U.S. Government corporations and agencies ($66.1 million), corporate bonds ($6.8 million), certain municipal obligations ($32.9 million), CMOs and REMICs ($23.5 million), mortgage backed securities ($18.7 million) and preferred stock and other equity investments ($7.3 million). In accordance with FAS No. 115, unrealized holding gains and losses deemed temporary on available-for-sale securities are reported in a separate component of stockholders' equity and are not reported in earnings until realized. Net unrealized holding gains on available-for-sale securities were $7.2 million at March 31, 2004, or $4.7 million after considering the related deferred tax liability. The profitability of First Defiance is primarily dependent on its net interest income and non-interest income. Net interest income is the difference between interest income on interest-earning assets, principally loans and securities, and interest expense on interest-bearing deposits, Federal Home Loan Bank advances, and other borrowings. The Company's non-interest income includes deposit and loan servicing fees, gains on sales of mortgage loans, and insurance commissions. First Defiance's earnings also depend on the provision for loan losses and non-interest expenses, such as employee compensation and benefits, occupancy and equipment expense, deposit 19 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued insurance premiums, amortization and impairment of mortgage servicing rights and miscellaneous other expenses, as well as federal income tax expense. Forward-Looking Information Certain statements contained in this quarterly report that are not historical facts, including but not limited to statements that can be identified by the use of forward-looking terminology such as "may", "will", "expect", "anticipate", or "continue" or the negative thereof or other variations thereon or comparable terminology are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21B of the Securities Act of 1934, as amended. Actual results could differ materially from those indicated in such statements due to risks, uncertainties and changes with respect to a variety of market and other factors. Changes in Financial Condition At March 31, 2004, First Defiance's total assets, deposits and stockholders' equity amounted to $1.04 billion, $722.1 million and $127.2 million, respectively, compared to $1.04 billion, $729.0 million and $124.3 million, respectively, at December 31, 2003. Net loans receivable increased to $766.1 million at March 31, 2004 from $741.1 million at December 31, 2003. The increase in loans receivable occurred primarily in non-residential and multi-family real estate loans, which increased by $17.6 million to $359.1 million, one-to-four family residential loans, which increased by $5.4 million to $173.4 million, home equity and improvement loans, which increased by $4.8 million to $74.8 million and consumer loans, which increased by $601,000 to $40.9 million. The increase was partially offset by an $1.2 million decline in commercial loans to $119.4 million. The investment securities portfolio decreased to $158.0 million at March 31, 2004 from $171.0 million at December 31, 2003. The decrease in the balance in the investment portfolio is the result of redeploying funds from securities as they mature or get called to fund loan growth. At March 31, 2004 there were approximately $4.8 million of interest-bearing deposits held at other financial institutions. These funds will be redeployed into higher earning investments as interest rates rise. Deposits decreased from $729.0 million at December 31, 2003 to $722.0 million as of March 31, 2004. This decline resulted from a $9.1 million decrease certificate of deposit balances to $399.7 million. $2.6 million of the decline resulted from a decrease in brokered certificates of deposit balances. There was an increase in savings deposits of $2.3 million to $54.1 million as of March 31, 2004. The Company has focused on increasing its lower cost core deposits, and at the same time has been less aggressive in retaining higher cost CDs during 2004. Additionally, FHLB advances increased to $168.0 million at March 31, 2004 from $164.5 million at December 31, 2003. These borrowings were used to fund loan growth and short-term funding needs. Short-term borrowings decreased to $8.3 million at March 31, 2004 from $12.3 million at December 31, 2003. This is a result of a decrease in the balance of securities sold under repurchase agreements, which are a function of customer demand. 20 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Stockholders' equity increased from $124.3 million at December 31, 2003 to $127.2 million at March 31, 2004. The increase is a result of the $2.5 million of net income, an increase in unrealized gains on available for sale securities (net of tax) of $674,000, the release of ESOP shares which increased equity by $659,000 and $1.1 million from the exercise of stock options by First Defiance employees. Those increases were partially offset by $1.2 million of dividends declared and by $722,000 from the repurchase of shares for treasury. During March 2004, First Defiance repurchased a total of 26,147 shares of stock at an average price of $27.60. The first 1,156 share purchased completed a repurchase program approved by the Board of Directors in 2002. The balance of those shares were purchased under a repurchase program authorized by the Company's board of directors in 2003. The Company is authorized to purchase an additional 614,468 shares under that program. 21 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Average Balances, Net Interest Income and Yields Earned and Rates Paid The following table presents for the periods indicated the total dollar amount of interest from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in thousands of dollars and rates, and the net interest margin. Dividends received on FHLB stock are included as interest income. The table reports interest income from tax-exempt loans and investment on a tax-equivalent basis. All average balances are based upon daily balances.
Three Months Ended March 31, ---------------------------------------------------------------------- 2004 2003 --------------------------------- --------------------------------- Average Yield/ Average Yield/ Balance Interest(1) Rate(2) Balance Interest(1) Rate(2) ------- ----------- ------- ------- ----------- ------- Interest-earning assets: Loans receivable $ 749,848 $ 10,932 5.86% $ 589,837 $ 9,398 6.46% Securities 165,239 2,024 4.93 206,645 2,591 5.09 Interest-earning deposits 8,490 32 1.52 6,865 29 1.71 FHLB stock and other 17,768 177 4.01 17,960 169 3.82 ---------- -------- ---------- -------- Total interest-earning assets 941,345 13,165 5.62 821,307 12,187 6.02 Non-interest-earning assets 95,226 63,231 ---------- ---------- Total assets $1,036,571 $ 884,538 ========== ========== Interest-bearing liabilities: Deposits $ 673,193 $ 2,998 1.79% $ 555,524 $ 3,534 2.58% FHLB advances and other 163,242 1,785 4.40 156,561 1,814 4.70 Notes payable 10,741 23 .86 3,010 9 1.21 ---------- -------- ---------- -------- Total interest-bearing liabilities 847,176 4,806 2.28 715,095 5,357 3.04 Non-interest bearing deposits 53,109 -- 38,339 -- ---------- -------- ---------- -------- Total including non-interest bearing demand deposits 900,285 4,806 2.15 753,434 5,357 2.88 Other non-interest-bearing liabilities 10,414 10,851 ---------- ---------- Total liabilities 910,699 764,285 Stockholders' equity 125,872 120,253 ---------- ---------- Total liabilities and stock- holders' equity $1,036,571 $ 884,538 ========== ========== Net interest income; interest rate spread $ 8,359 3.34% $ 6,830 2.98% ======== ====== ======== ====== Net interest margin (3) 3.57% 3.37% ====== ====== Average interest-earning assets to average interest-bearing liabilities 111% 115% ====== ======
---------- (1) Interest on certain tax exempt loans and securities is not taxable for Federal income tax purposes. In order to compare the tax-exempt yields on these assets to taxable yields, the interest earned on these assets is adjusted to a pre-tax equivalent amount based on the marginal corporate federal income tax rate of 35%. (2) Annualized (3) Net interest margin is net interest income divided by average interest-earning assets. 22 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Results of Operations Three Months Ended March 31, 2004 compared to Three Months Ended March 31, 2003 On a consolidated basis, First Defiance had net income of $2.5 million or $.39 per share for the three months ended March 31, 2004 compared to $2.7 million or $0.43 per share in 2003. Net Interest Income. Net interest income for the quarter ended March 31, 2004 was $8.0 million compared to $6.4 million for the same period in 2003. Net interest margin for the 2004 first quarter was 3.57% compared to 3.37% for the same period in 2003. On a tax-equivalent basis, net interest income for the quarter ended March 31, 2004 was $8.4 million compared to $6.8 million for the same period in 2003. Total interest income increased by $1.0 million to $12.8 million for the three months ended March 31, 2004 from $11.8 million for the three months ended March 31, 2003. On a tax equivalent basis, total interest income increased by $978,000 to $13.2 million for the three months ended March 31, 2004 from $12.2 million for the three months ended March 31, 2003. Interest on loans increased $1.6 million to $10.9 million in the first quarter of 2004 from $9.3 million in the first quarter of 2003. The increase in interest from loans was due to a $160.0 million increase in average loan balances between the first quarter of 2003 and the first quarter of 2004. A portion of the increase was attributable to the $79.0 million of loans acquired in June 2003 as part of the acquisition of banking center offices in Findlay, Ottawa and McComb Ohio from RFC Banking Company. The balance of the increase is due to growth of the Company's commercial and commercial real estate portfolios over the past twelve months Some of the benefit of increased loan volumes has been offset by declining portfolio yields. The yield on First Defiance's loan portfolio declined from 6.46% for the three months ended March 31, 2003 to 5.86% for the same period in 2004 because of falling interest rates over that time period. The Company also has experienced a change in the mix of its loan portfolio as commercial loans and non-residential real estate loans were $478.5 million at March 31, 2004, up from $462.1 million at December 31, 2003 and $359.6 million at March 31, 2003. During that same time one-to-four family residential loans, excluding loans held for sale, increased only $1.5 million to $180.4 million from $178.9 million (one-to-four family residential loans were $149.7 million at March 31, 2003). The Company sells most of its new mortgage loan originations into the secondary market. Interest earnings from the investment portfolio and interest-earning deposits, on a tax equivalent basis, decreased $556,000 to $2.2 million for the three months ended March 31, 2004 compared to $2.8 million for the same period in 2003. The decrease is due to the decline in the average balance by $40.0 million from $231.5 million at March 31, 2003 to $191.5 million at March 31, 2004. To compare the tax-exempt asset yields to taxable yields, amounts are adjusted to pretax equivalents based using a marginal corporate Federal tax rate of 35%. The tax-equivalent adjustments to net interest income for 2004 and 2003 were $163,000 and $227,000 respectively. The tax-equivalent yield on the investment portfolio was 4.93% for the three months ended March 31, 2004, down from 5.09% for the first three months of 2003. 23 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Total interest expense decreased by $551,000 to $4.8 million for the first quarter of 2004 compared to $5.4 million for the same period in 2003. Interest expense on interest bearing deposits decreased by $536,000 to $3.0 million for the quarter ended March 31, 2004 from $3.5 million for the quarter ended March 31, 2003. This happened despite growth in deposits because of the change in the mix of deposits from higher costing certificates of deposit to checking and money market deposit accounts. The average cost of funds decreased from 2.88% for the first quarter of 2003 to 2.15% for the first quarter of 2004. The average balances of interest-bearing liabilities increased $132.1 million from $715.1 million in the first quarter of 2003 to $847.2 million in the first quarter of 2004. Provision for Loan Losses. The provision for loan losses was $379,000 in the first quarter of 2004 compared to $335,000 for the first quarter of 2003 despite significant growth in loan balances. The lower provision was due in part to the Company's very low loss experience in the 2004 first quarter, which showed net charge-offs of $56,000. Provisions for loan losses are charged to earnings to bring the total allowance for loan losses to the level deemed appropriate by management based on the following factors: historical experience; the volume and type of lending conducted by First Defiance; the amount of non-performing assets, including loans which meet the FASB Statement No. 114 definition of impaired; the amount of assets graded by management as substandard, doubtful, or loss; industry standards; general economic conditions, particularly as they relate to First Defiance's market area; and other factors related to the collectibility of First Defiance's loan portfolio. Management believes the balance of the allowance for loan losses is appropriate. Non-performing assets and asset quality ratios for First Defiance were as follows (in $000's): March 31, December 31, 2004 2003 Non-accrual loans $ 2,375 $ 2,545 Loans over 90 days past due and still accruing -- -- ----------------------- Total non-performing loans $ 2,375 $ 2,545 Real estate owned (REO) 348 404 ----------------------- Total non-performing assets $ 2,723 $ 2,949 ======================= Allowance for loans losses as a percentage of total loans 1.18% 1.18% Allowance for loan losses as a percentage of non-performing assets 336.65% 299.90% Allowance for loan losses as a percentage of non-performing loans 385.98% 347.50% Total non-performing assets as a percentage of total assets 0.26% 0.28% Total non-performing loans as a percentage of total loans 0.31% 0.34% Of the $2.4 million in non-accrual loans, $1.8 million were commercial loans or non-residential real estate loans and $545,000 were residential mortgage loans. The allowance for loan losses at March 31, 2004 was $9.2 million compared to $7.9 million at both March 31, 2003 and $8.8 million at December 31, 2003. For the quarter ended March 31, 2004, First Defiance charged off 24 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued $104,000 of loans against its allowance and realized recoveries of $48,000 from loans previously charged off. During the same quarter in 2003, First Defiance charged off $75,000 in loans and realized recoveries of $168,000. In conjunction with the acquisition of the banking centers in June 2003, management recorded a discount of $2.9 million to offset expected credit losses in the acquired portfolio. Subsequent to December 31, 2003, several large classified loans in the acquired portfolio were paid off by the borrower, resulting in a reduction in the required discount. During the 2004 first quarter management adjusted the discount downward by $1.2 million to $1.6 million. The offsetting adjustment was a $1.2 million reduction in the goodwill recorded in conjunction with the acquisition. Non-Interest Income. Non-interest income decreased $1.4 million in the first quarter of 2004, to $3.4 million for the quarter ended March 31, 2004 from $4.8 million for the same period in 2003. Individual components of non-interest income are as follows: Gain on Sale of Loans. Gains realized from the sale of mortgage loans decreased $1.2 million to $589,000 for the three months ended March 31, 2004 from $1.8 million during the 2003 first quarter. The decrease is due to a decline in mortgage loan origination activity starting in the fourth quarter of 2003 and continuing through the first two months of 2004 as interest rates increased from their record low levels of mid-2003. The origination and servicing of mortgage loans continues to be a core activity of First Federal in its local market areas. Gain on Sale of Securities. Gains realized from the sale of investment securities was $98,000 in the first quarter of 2004. This was a decrease of $533,000 from a gain of $631,000 in the first quarter of 2003. First Defiance did not sell any securities during the 2004 first quarter. However, several securities with call provisions that were purchased at discounts were called during the first three months of 2004. The resulting write-off of unamortized discounts is reflected as securities gains. Service Fees. Loan and deposit fees increased $267,000 to $1.3 million for the quarter ended March 31, 2004 from $985,000 for the quarter ended March 31, 2003. Increases occurred primarily in loan servicing fees on sold loans, debit card interchange fees, and checking NSF fees. Insurance and Investment Sales Commission. Insurance and investment sales commission income increased $136,000 to $1.1 million in the first quarter of 2004 from $926,000 in the same period of 2003. Increases occurred in the property and casualty lines as well as income from the sale of securities and annuities. Other Non-Interest Income. Other non-interest income, including dividends on Federal Home Loan Bank stock, income from Bank Owned Life Insurance and other miscellaneous charges, decreased to $421,000 for the quarter ended March 31, 2004 from $449,000 for the same period in 2003. 25 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Non-Interest Expense. Total non-interest expense increased $449,000 to $7.5 million for the quarter ended March 31, 2004 from $7.0 million for the same period in 2003. Significant individual components of the increase are as follows: Compensation and Benefits. Compensation and benefits increased $606,000 to $4.3 million for the quarter ended March 31, 2004 from $3.7 million for the same period in 2003. The increase was the result of an increase in staffing due to the significant expansion in the Company's branch network. In addition to the June 2003 acquisition of three banking centers, the Company opened a de novo branch in Findlay, Ohio in December 2003 and in the Toledo suburb of Maumee, Ohio in February 2004. Amortization and Impairment of Mortgage Servicing Rights. Amortization of mortgage servicing rights ("MSR's") totaled $172,000 in the 2004 first quarter compared to $523,000 in the 2003 first quarter, the result of a decline in the significant refinancing activity in the First Federal loan servicing portfolio that was taking place a year ago. Also, the Company recognized a $237,000 adjustment for impairment in the value of its MSR portfolio during the 2004 first quarter, the result of the decline in the market value of MSRs in the face of falling interest rates late in March 2004. There was a $240,000 impairment adjustment recognized in the first quarter of 2003. First Defiance has a total impairment reserve of $843,000 recorded against an asset with a book value before reserves of $4.0 million at March 31, 2004. That portfolio represents approximately 5,430 loans with unpaid balances of approximately $436 million. Other Non-Interest Expenses. Other non-interest expenses (including occupancy, state franchise tax, data processing, and deposit insurance premiums) increased to $2.7 million for the quarter ended March 31, 2004 from $2.5 million for the same period in 2003. First Defiance computes federal income tax expense in accordance with FASB Statement No. 109 which resulted in an effective tax rate of 30.71% for the quarter ended March 31, 2004 compared to 29.86% for the same period in 2003. The effective tax rate is lower than the Company's statutory 35% rate because it has approximately $31.8 million invested in municipal securities, and $18.1 million of bank owned life insurance which are both exempt from federal tax. As a result of the above factors, income for the quarter ended March 31, 2004 was $2.5 million compared to income of $2.7 million for the comparable period in 2003. On a per share basis, basic and diluted earnings per share for the three months ended March 31, 2004 were each $0.41 and $.39, respectively, compared to basic and diluted earnings per share from continuing operations of $0.45 and $0.43, respectively, for the quarter ended March 31, 2003. Liquidity and Capital Resources As a regulated financial institution, First Federal is required to maintain appropriate levels of "liquid" assets to meet short-term funding requirements. First Defiance generated $1.7 million of cash from operating activities during the first three months of 2004. The Company's cash from operating activities resulted from net income for the period, adjusted for various non-cash items, including the provision for loan losses, depreciation and 26 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued amortization of mortgage servicing rights, ESOP expense related to release of shares, and changes in loans available for sale, interest receivable and other assets, and other liabilities. The primary investing activity of First Defiance is the origination of loans (both for sale in the secondary market and to be held in portfolio), which is funded with cash provided by operations, proceeds from the amortization and prepayments of existing loans, the sale of loans, proceeds from the sale or maturity of securities, borrowings from the FHLB, and customer deposits. At March 31, 2004, First Defiance had $59.3 million in outstanding loan commitments and loans in process to be funded generally within the next six months and an additional $134.8 million committed under existing consumer and commercial lines of credit and standby letters of credit. Also at that date, First Defiance had commitments to sell $21.5 million of loans held-for-sale. Also as of March 31, 2004, the total amount of certificates of deposit that are scheduled to mature by March 31, 2005 is $249.8 million. First Defiance believes that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If First Defiance requires funds beyond its internal funding capabilities, advances from the FHLB of Cincinnati and other financial institutions are available. First Defiance utilizes forward purchase and forward sale agreements to meet the needs of its customers and manage its exposure to fluctuations in the fair value of mortgage loans held for sale and its pipeline. These forward purchase and forward sale agreements are considered to be derivatives as defined by FAS 133, Accounting for Derivatives and Hedging Instruments. The change in value in the forward purchase and forward sale agreements is approximately equal to the change in value in the loans held for sale and the effect of this accounting treatment is not material to the financial statements. First Defiance also invests in on-balance sheet derivative securities as part of the overall asset and liability management process. Such derivative securities include REMIC and CMO investments. As of March 31, 2004, $834,000 of these securities do not pass the FFIEC high risk security test. The weighted average life of these securities exceeds the test limits in an instantaneous rate increase scenario of 200 and 300 basis points. The company feels that at this time the return being realized is worth this risk. The remaining $22.7 million of these securities are not classified as high risk at March 31, 2004 and do not present risk significantly different than other mortgage-backed or agency securities. First Federal is required to maintain specified amounts of capital pursuant to regulations promulgated by the OTS. The capital standards generally require the maintenance of regulatory capital sufficient to meet a tangible capital requirement, a core capital requirement, and a risk-based capital requirement. The following table sets forth First Federal's compliance with each of the capital requirements at March 31, 2004. 27 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued
Core Capital Risk-Based Capital Adequately Well Adequately Well Capitalized Capitalized Capitalized Capitalized ----------- ----------- ----------- ----------- Regulatory capital $ 98,468 $ 98,468 $ 107,415 $ 107,415 Minimum required regulatory capital 40,334 50,418 62,206 77,757 --------- --------- --------- --------- Excess regulatory capital $ 58,134 $ 48,050 $ 45,209 $ 29,658 ========= ========= ========= ========= Regulatory capital as a percentage of assets (1) 9.8% 9.8% 13.8% 13.8% Minimum capital required as a percentage of assets 4.0% 5.0% 8.0% 10.0% --------- --------- --------- --------- Excess regulatory capital as a percentage of assets 5.8% 4.8% 5.8% 3.8% ========= ========= ========= =========
(1) Core capital is computed as a percentage of adjusted total assets of $1.0 billion. Risk-based capital is computed as a percentage of total risk-weighted assets of $777.6 million. Critical Accounting Policies First Defiance has established various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of its financial statements. The significant accounting policies of First Defiance are described in the footnotes to the consolidated financial statements included in the Company's Annual Report on Form 10-K. Certain accounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. Those policies which are identified and discussed in detail in the Company's Annual Report on Form 10-K include the Allowance for Loan Losses, the Valuation of Mortgage Servicing Rights and the Deferral of Fees under SFAS 91. There have been no material changes in assumptions or judgments relative to those critical policies during the first quarter of 2004. FDIC Insurance The deposits of First Federal are currently insured by the Savings Association Insurance Fund ("SAIF") which is administered by the FDIC. The FDIC also administers the Bank Insurance Fund ("BIF") which generally provides insurance to commercial bank depositors. Both the SAIF and BIF are required by law to maintain a reserve ratio of 1.25% of insured deposits. First Federal's annual deposit insurance premiums for 2004 are approximately $0.015 per $100 of deposits. 28 Item 3. Qualitative and Quantitative Disclosure About Market Risk As discussed in detail in the 2003 Annual Report on Form 10-K, First Defiance's ability to maximize net income is dependent on management's ability to plan and control net interest income through management of the pricing and mix of assets and liabilities. Because a large portion of assets and liabilities of First Defiance are monetary in nature, changes in interest rates and monetary or fiscal policy affect its financial condition and can have significant impact on the net income of the Company. First Defiance does not use off balance sheet derivatives to enhance its risk management, nor does it engage in trading activities beyond the sale of mortgage loans. First Defiance monitors its exposure to interest rate risk on a monthly basis through simulation analysis which measures the impact changes in interest rates can have on net income. The simulation technique analyzes the effect of a presumed 100 basis point shift in interest rates (which is consistent with management's estimate of the range of potential interest rate fluctuations) and takes into account prepayment speeds on amortizing financial instruments, loan and deposit volumes and rates, nonmaturity deposit assumptions and capital requirements. The results of the simulation indicate that in an environment where interest rates rise or fall 100 basis points over a 12 month period, using March 2004 amounts as a base case, First Defiance's net interest income would be impacted by less than the board mandated guidelines of 10%. Item 4. Controls and Procedures Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and regulations and are operating in an effective manner. No change in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15(d)-15(f) under the Securities Exchange Act of 1934) occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 29 FIRST DEFIANCE FINANCIAL CORP. PART II-OTHER INFORMATION Item 1. Legal Proceedings First Defiance is not engaged in any legal proceedings of a material nature. Item 2. Changes in Securities The information presented in changes in Financial Condition of Management's Discussion and Analysis related to share report base activity is incorporated herein by reference. Item 3. Defaults upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders At the annual meeting of shareholders held on April 20, 2004, in Defiance, Ohio the shareholders elected three directors to three-year terms. The following is a tabulation of all votes timely cast in person or by proxy by shareholders of First Defiance for the annual meeting: I. Nominees for Director with Three-year Terms Expiring in 2006: NOMINEE FOR WITHHELD Stephen L. Boomer 5,289,463 367,276 Peter A. Diehl 5,149,772 506,967 William J. Small 5,556,202 100,537 Item 5. Other Information Not applicable. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act Exhibit 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act Exhibit 32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act Exhibit 32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act 30 (b) Reports on Form 8-K First Defiance Financial Corp. filed a report on Form 8-K with the Securities and Exchange Commission on April 21, 2004 which included a copy of the Company's earnings release for the quarter ended March 31, 2004 31 FIRST DEFIANCE FINANCIAL CORP. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed by the undersigned thereunto duly authorized. First Defiance Financial Corp. (Registrant) Date: May 10, 2004 By: /s/ William J. Small --------------------------------- William J. Small Chairman, President and Chief Executive Officer Date: May 10, 2004 By: /s/ John C. Wahl --------------------------------- John C. Wahl Senior Vice President, Chief Financial Officer and Treasurer 32