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Investment Securities

9 Months Ended

Sep. 30, 2012

7.	Investment Securities

The following is a summary of available-for-sale and held-to-maturity securities (in thousands):

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
At September 30, 2012
Available-for-Sale Securities:

Obligations of U.S. government corporations and agencies	$	21,497	$	152	$	-		$	21,649
U.S. treasury bonds		2,000		4		-			2,004
Mortgage-backed securities – residential		82,023		3,472		-			85,495
REMICs		-		-		-			-
Collateralized mortgage obligations		63,227		1,815		(12	)		65,030
Trust preferred securities and preferred stock		3,604		35		(2,262	)		1,377
Corporate bonds		8,695		167		(13	)		8,849
Obligations of state and political subdivisions		77,945		6,754		(5	)		84,694
Totals	$	258,991	$	12,399	$	(2,292	)	$	269,098

Held-to-Maturity Securities*:
FHLMC certificates	$	72	$	-	$	-		$	72
FNMA certificates		173		6		-			179
GNMA certificates		63		3		-			66
Obligations of state and political subdivisions		277		1		-			278
Totals	$	585	$	10	$	-		$	595

At December 31, 2011
Available-for-Sale Securities:

Obligations of U.S. government corporations and agencies	$	16,989	$	96	$	-		$	17,085
U.S. treasury bonds		2,000		10		-			2,010
Mortgage-backed securities – residential		68,400		2,318		(2	)		70,716
REMICs		2,863		31		-			2,894
Collateralized mortgage obligations		57,083		1,926		-			59,009
Trust preferred securities and preferred stock		3,790		73		(2,413	)		1,450
Corporate bonds		8,629		-		(377	)		8,252
Obligations of state and political subdivisions		65,928		5,580		(5	)		71,503
Totals	$	225,682	$	10,034	$	(2,797	)	$	232,919

Held-to-Maturity Securities*:
FHLMC certificates	$	82	$	1	$	-		$	83
FNMA certificates		199		4		-			203
GNMA certificates		72		3		-			75
Obligations of state and political subdivisions		308		3		-			311
Totals	$	661	$	11	$	-		$	672

* FHLMC, FNMA, and GNMA certificates are residential mortgage-backed securities.

The amortized cost and fair value of the investment securities portfolio at September 30, 2012 are shown below by contractual maturity. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. For purposes of the maturity table, mortgage-backed securities (“MBS”), collateralized mortgage obligations (“CMO”) and REMICs, which are not due at a single maturity date, have not been allocated over the maturity groupings. These securities may mature earlier than their weighted-average contractual maturities because of principal prepayments.

	Available-for-Sale				Held-to-Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
	(In Thousands)
Due in one year or less	$	2,595	$	2,602	$	60	$	61
Due after one year through five years		15,056		15,331		-		-
Due after five years through ten years		39,530		41,614		217		217
Due after ten years		56,560		59,026		-		-
MBS/CMO/REMIC		145,250		150,525		308		317
	$	258,991	$	269,098	$	585	$	595

Investment securities with a carrying amount of $139.6 million at September 30, 2012 were pledged as collateral on public deposits, securities sold under repurchase agreements and FHLB advances.

As of September 30, 2012, the Company’s investment portfolio consisted of 378 securities, 19 of which were in an unrealized loss position.

The following tables summarize First Defiance’s securities that were in an unrealized loss position at September 30, 2012 and December 31, 2011:

	Duration of Unrealized Loss Position
	Less than 12 Months					12 Month or Longer					Total
			Gross					Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Loss			Value		Loss			Value		Losses
	(In Thousands)
At September 30, 2012
Available-for-sale securities:
Mortgage-backed - residential	$	1	$	-		$	-	$	-		$	1	$	-
Collateralized mortgage obligations and REMICs		4,610		(12	)		-		-			4,610		(12	)
Corporate bonds		-		-			1,908		(13	)		1,908		(13	)
Trust preferred stock and preferred stock		-		-			1,308		(2,262	)		1,308		(2,262	)
Obligations of state and political subdivisions		1,514		(5	)		-		-			1,514		(5	)
Total temporarily impaired securities	$	6,125	$	(17	)	$	3,216	$	(2,275	)	$	9,341	$	(2,292	)

	Duration of Unrealized Loss Position
	Less than 12 Months					12 Months or Longer					Total
			Gross					Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Loss			Value		Loss			Value		Loses
	(In Thousands)
At December 31, 2011
Available-for-sale securities:
Mortgage-backed securities - residential	$	2,030	$	(2	)	$	-	$	-		$	2,030	$	(2	)
Obligations of state and political subdivisions		-		-			746		(5	)		746		(5	)
Trust preferred stock and preferred stock		-		-			1,342		(2,413	)		1,342		(2,413	)
Corporate bonds		8,252		(377	)		-		-			8,252		(377	)
Total temporarily impaired securities	$	10,282	$	(379	)	$	2,088	$	(2,418	)	$	12,370	$	(2,797	)

With the exception of Trust Preferred Securities, the above securities all have fixed interest rates, and all securities have defined maturities. Their fair value is sensitive to movements in market interest rates. First Defiance has the ability and intent to hold these investments for a time necessary to recover the amortized cost without impacting its liquidity position and it is not more than likely that the Company will be required to sell the investments before anticipated recovery.

Realized gains from the sales of investment securities totaled $103,000 ($67,000 after tax) in the third quarter of 2012 while there were no realized gains in the third quarter of 2011. Realized gains from the sales of investment securities totaled $528,000 ($343,000 after tax) for the first nine months of 2012 compared to realized gains of $49,000 ($32,000 after tax) for the first nine months of 2011.

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least quarterly, and more frequently when economic or market conditions warrant such an evaluation. The investment portfolio is evaluated for OTTI by segregating the portfolio into two general segments. Investment securities classified as available-for-sale or held-to-maturity are generally evaluated for OTTI under FASB ASC Topic 320. Certain collateralized debt obligations (“CDOs”) are evaluated for OTTI under FASB ASC Topic 325, Investment – Other.

When OTTI occurs under either model, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected compared to the book value of the security and is recognized in earnings. The amount of OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

For the first nine months of 2012, management determined there was no OTTI. For the first nine months of 2011, management determined there was OTTI on one CDO resulting in a write-down of $2,200 ($1,400 after tax).

The Company held eight CDOs at September 30, 2012. Four of those CDOs were written down in full prior to January 1, 2010. The remaining four CDOs have a total amortized cost of $3.6 million at September 30, 2012. Of these, two, with a total amortized cost of $1.6 million, were identified as OTTI in prior periods. The final two CDOs, with a total amortized cost of $2.0 million, continue to pay principal and interest payments in accordance with the contractual terms of the securities and no credit loss impairment has been identified in management’s analysis. Therefore, these two CDO investments have not been deemed by management to be OTTI. In June 2012, the Company was notified that its Preferred Term Security VI was redeemed through an auction process. The security was redeemed at full price with proceeds being received in July 2012. This security had previously identified OTTI of $80,000. The previous OTTI amount was recorded as a yield adjustment in interest income in June 2012 due to the increase in expected cash flows resulting from the auction.

Given the conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, the Company’s CDOs will be classified within Level 3 of the fair value hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

As required under FASB ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.

The Company’s CDO valuations were supported by analysis prepared by an independent third party. Their approach to determining fair value involved several steps: 1) detailed credit and structural evaluation of each piece of collateral in the CDO; 2) collateral performance projections for each piece of collateral in the CDO (default, recovery and prepayment/amortization probabilities) and 3) discounted cash flow modeling.

Trust Preferred CDOs Discount Rate Methodology

First Defiance 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 CDO instruments. 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 trust preferred CDOs, however, First Defiance 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 nevertheless 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 CDOs. Importantly, as part of the analysis described above, First Defiance 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.

Fundamental to this evaluation is an assessment of the likelihood of CDO coverage test failures that would have the effect of diverting cash flow away from the relevant CDO bond for some period of time. Generally speaking, the Company adjusts indicative credit spreads upwards in the case of CDOs that have relatively weaker collateral and/or less cushion with respect to overcollateralization and interest coverage test ratios and downwards if the reverse is true. This aspect of the Company’s discount rate methodology is important because there is frequently a great difference in the risks present in CDO instruments that are otherwise very similar (i.e. CDOs with the same basic type of collateral, the same manager, the same vintage, etc., may exhibit vastly different performance characteristics). With respect to this last point, First Defiance notes that given today’s credit environment, characterized by high default and deferral rates, it is typically the case that deal-specific credit performance (determined on the basis of the credit characteristics of remaining collateral) is the best indicator of what a willing market participant would pay for an instrument.

The Company uses the same methodology for all of its CDOs and believes its valuation methodology is appropriate for all of its CDOs in accordance with FASB ASC Topic 320 as well as other related guidance.

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 deferred, the Company assumed a recovery of 10% of par for banks, thrifts or other depository institutions and 15% for insurance companies. Although there is a possibility that the deferring collateral will become current at some point in the future, First Defiance has conservatively assumed that it will continue to defer and gradually will default.

The following table details the six securities with OTTI, their lowest credit rating at September 30, 2012 and the related credit losses recognized in earnings for the three month periods ended March 31, 2012, June 30, 2012, and September 30, 2012 (In Thousands):

	TPREF Funding II Rated		Alesco VIII		Preferred Term Security XXVII		Trapeza CDO I Rated		Alesco Preferred Funding VIII		Alesco Preferred Funding IX
	Caa3		Rated Ca		Rated C		Ca		Not Rated		Not Rated		Total
Cumulative OTTI related to credit loss at January 1, 2012	$	318	$	1,000	$	78	$	857	$	453	$	465	$	3,171
Addition – Qtr 1		-		-		-		-		-		-		-
Cumulative OTTI related to credit loss at March 31, 2012	$	318	$	1,000	$	78	$	857	$	453	$	465	$	3,171
Addition – Qtr 2		-		-		-		-		-		-		-
Cumulative OTTI related to credit loss at June 30, 2012	$	318	$	1,000	$	78	$	857	$	453	$	465	$	3,171
Addition – Qtr 3		-		-		-		-		-		-		-
Cumulative OTTI related to credit loss at September 30, 2012	$	318	$	1,000	$	78	$	857	$	453	$	465	$	3,171

The amount of OTTI recognized in accumulated other comprehensive income (“AOCI”) was $747,000 for the above securities at September 30, 2012. There was $854,000 recognized in AOCI at September 30, 2011.

The following table provides additional information related to the four CDO investments for which a balance remains as of September 30, 2012 (dollars in thousands):

CDO	Class		Amortized Cost		Fair Value		Unrealized Loss			OTTI Losses 2012		Lowest Rating	Current Number of Banks and Insurance Companies		Actual Deferrals and Defaults as a % of Current Collateral			Expected Deferrals and Defaults as a % of Remaining Performing Collateral			Excess Sub- ordination as a % of Current Performing Collateral
TPREF Funding II		B	$	677	$	225	$	(452	)		-	Caa3		17		38.81	%		15.53	%		-
I-Preferred Term Sec I		B-1		1,000		456		(544	)		-	CCC		14		17.24	%		14.70	%		27.44	%
Dekania II CDO		C-1		990		421		(569	)		-	CCC		32		-	%		13.87	%		29.18	%
Preferred Term Sec XXVII		C-1		903		206		(697	)		-	Ca		34		26.68	%		22.84	%		6.09	%
Total			$	3,570	$	1,308	$	(2,262	)	$	-

The Company’s assumed average lifetime default rate declined from 29.7% at the end of the third quarter 2011 to a rate of 28.4% at the end of the third quarter 2012.

The table below presents a roll-forward of the credit losses relating to debt securities recognized in earnings for the three and nine month periods ended September 30, 2012 and 2011 (in thousands):

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012			2011
Beginning balance	$	3,171	$	3,251	$	3,251		$	3,249
Additions for amounts related to credit loss for which an OTTI was not previously recognized		-		-		-			-

Reductions for amounts realized for securities sold/redeemed during the period		-		-		(80	)		-

Reductions for amounts related to securities for which the Company intends to sell or that it will be more than likely than not that the Company will be required to sell prior to recovery of amortized cost basis		-		-		-			-

Reductions for increase in cash flows expected to be collected that are recognized over the remaining life of the security		-		-		-			-

Increases to the amount related to the credit loss for which other-than-temporary was previously recognized		-		-		-			2

Ending balance	$	3,171	$	3,251	$	3,171		$	3,251

The proceeds from the sales and calls of securities and the associated gains are listed below:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(In thousands)				(In thousands)
Proceeds	$	2,122	$	-	$	8,538	$	1,982
Gross realized gains		103		-		528		49
Gross realized losses		-		-		-		-

The following table summarizes the changes within each classification of accumulated other comprehensive income for the quarters ended September 30, 2012 and 2011:

	Unrealized gains (losses) on available for sale securities		Postretirement Benefit			Accumulated other comprehensive income (loss), net
	(In Thousands)
Balance at December 31, 2011	$	4,704	$	(707	)	$	3,997
Other comprehensive income (loss), net		1,866		-			1,866
Balance at September 30, 2012	$	6,570	$	(707	)	$	5,863

	Unrealized gains (losses) on available for sale securities		Postretirement Benefit			Accumulated other comprehensive income (loss), net
	(In Thousands)
Balance at December 31, 2010	$	32	$	(374	)	$	(342	)
Other comprehensive income (loss), net		4,521		-			4,521
Balance at September 30, 2011	$	4,553	$	(374	)	$	4,179