5. Investment Securities

The following tables summarize the amortized cost and fair value of available-for-sale securities and held-to-maturity investment securities portfolio at December 31, 2013 and 2012 and the corresponding amounts of gross unrealized gains and losses were as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value

	(In Thousands)
2013
Available-for-sale
Obligations of U.S. government corporations and agencies	$	5,000	$	-	$	(79)	$	4,921
Mortgage-backed securities - residential		41,368		765		(841)		41,292
Collateralized mortgage obligations		59,865		739		(763)		59,841
Trust preferred stock and preferred stock		3,264		683		(993)		2,954
Corporate bonds		8,854		129		(41)		8,942
Obligations of state and political subdivisions		78,426		2,704		(910)		80,220
Total Available-for-Sale	$	196,777	$	5,020	$	(3,627)	$	198,170

			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
	Cost		Gains		Losses		Value

	(In Thousands)
Held-to-Maturity
FHLMC certificates	$	31	$	-	$	-	$	31
FNMA certificates		120		4		-		124
GNMA certificates		50		2		-		52
Obligations of states and political subdivisions		186		-		-		186
Total Held-to-Maturity	$	387	$	6	$	-	$	393

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(In Thousands)
2012
Available-for-sale
Obligations of U.S. government corporations and agencies	$	11,000	$	69	$	-	$	11,069
U.S. treasury bonds		1,000		2		-		1,002
Mortgage-backed securities - residential		30,020		1,441		-		31,461
Collateralized mortgage obligations		55,962		1,504		-		57,466
Trust preferred stock and preferred stock		3,600		99		(2,091)		1,608
Corporate bonds		8,717		167		-		8,884
Obligations of state and political subdivisions		76,339		6,277		(5)		82,611
Total Available-for-Sale	$	186,638	$	9,559	$	(2,096)	$	194,101

			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
	Cost		Gains		Losses		Value
	(In Thousands)
Held-to-Maturity
FHLMC certificates	$	69	$	-	$	(1)	$	68
FNMA certificates		162		6		-		168
GNMA certificates		60		3		-		63
Obligations of states and political subdivisions		217		-		-		217
Total Held-to-Maturity	$	508	$	9	$	(1)	$	516

The amortized cost and fair value of the investment securities portfolio at December 31, 2013 and 2012 are shown below by contractual maturity. Expected maturities will differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. For purposes of the maturity tables below, mortgage-backed securities and collateralized mortgage obligations, which are not due at a single maturity date, have not been allocated over maturity groupings.

	Available-for-Sale
	Amortized		Fair
	Cost		Value

	(In Thousands)
2013
Available-for-sale
Due in one year or less	$	2,135	$	2,137
Due after one year through five years		8,198		8,526
Due after five years through ten years		38,707		40,016
Due after ten years		46,504		46,358
MBS/CMO		101,233		101,133
Total	$	196,777	$	198,170

Held-to-maturity
Due after five years through ten years	$	186	$	186
MBS/CMO		201		207
Total	$	387	$	393

	Available-for-Sale
	Amortized		Fair
	Cost		Value


	(In Thousands)
2012
Available-for-sale
Due in one year or less	$	1,252	$	1,258
Due after one year through five years		15,719		15,996
Due after five years through ten years		33,743		36,024
Due after ten years		49,942		51,896
MBS/CMO		85,982		88,927
	$	186,638	$	194,101

Held-to-maturity
Due after five years through ten years	$	217	$	217
MBS/CMO		291		299
Total	$	508	$	516

Securities pledged at year-end 2013 and 2012 had a carrying amount of $132.7 million and $135.0 million and were pledged to secure public deposits, securities sold under repurchase agreements and FHLB advances.

As of December 31, 2013, the Company’s investment portfolio consisted of 337 securities, 88 of which were in an unrealized loss position. The Company does not hold any single security that is greater than 10% of the Company’s equity at December 31, 2013.

The following table summarizes First Defiance’s securities that were in an unrealized loss position at December 31, 2013 and December 31, 2012:

	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, 2013
Available-for-sale securities:
Obligations of U.S. government corporations and agencies	$	4,921	$	(79)	$	-	$	-	$	4,921	$	(79)
Mortgage-backed securities - residential		24,846		(841)		-		-		24,846		(841)
Collateralized mortgage obligations		26,530		(763)		-		-		26,530		(763)
Corporate bonds		2,959		(41)		-		-		2,959		(41)
Obligations of state and political subdivisions		19,209		(871)		375		(39)		19,584		(910)
Trust preferred stock and preferred stock		-		-		582		(993)		582		(993)
Total temporarily impaired securities	$	78,465	$	(2,595)	$	957	$	(1,032)	$	79,422	$	(3,627)


At December 31, 2012
Available-for-sale securities:
Mortgage-backed securities - residential	$	1	$	-	$	-	$	-	$	1	$	-
Obligations of state and political subdivisions		949		(5)		-		-		949		(5)
Trust preferred stock and preferred stock		-		-		1,474		(2,091)		1,474		(2,091)
Total temporarily impaired securities	$	950	$	(5)	$	1,474	$	(2,091)	$	2,424	$	(2,096)

With the exception of trust preferred stock, 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 and calls of investment securities totaled $97,000 ($68,000 after tax) in 2013 while there were realized gains of $2.1 million ($1.4 million after tax) and $218,000 ($142,000 after tax) in 2012 and 2011, respectively.

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequent 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.

In 2013, management determined that two CDOs had OTTI resulting in a write-down of $337,000 ($219,000 after tax). The 2013 OTTI is related to two CDOs that were disallowed under the Final Interim Volcker Rule of the Dodd-Frank Act released on January 14, 2014 requiring the Company to liquidate these securities before a certain date. The Company received Level 1 pricing and wrote these two CDOs to that value as of December 31, 2013 and subsequently sold these two securities on January 15, 2014. In 2012, management determined that one CDO had OTTI resulting in a write-down of $4,500 ($2,900 after tax). In 2011, management determined that one CDO had OTTI resulting in a write-down of $2,200 ($1,400 after tax).

The Company held eight CDOs at December 31, 2013. Four of those CDOs were written down in full prior to January 1, 2010. The remaining four CDOs have a total amortized cost of $3.2 million at December 31, 2013. Of these, two, with a total amortized cost of $1.7 million, have been sold in January 2014 as stated above. The final two CDOs, with a total amortized cost of $1.5 million, had OTTI in prior periods.

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, excluding the two CDOs sold in January 2014, 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. The two CDOs sold in January 2014, will be classified within Level 1 of the fair value hierarchy.

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 Level 3 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 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.

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).

The Company 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. The Company’s assumed average lifetime default rate declined to 26.2% at the end of 2013 from 27.9% at the end of 2012.

The amount of OTTI recognized in accumulated other comprehensive income (“AOCI”) was $645,000 for the above eight securities at December 31, 2013. There was $749,000 recognized in accumulated other comprehensive income at December 31, 2012.

The following table provides additional information related to the four CDO investments for which a balance remains as of December 31, 2013 (dollars in thousands):

CDO	Class	Amortized Cost		Fair Value		Unrealized Loss		OTTI Losses 2013		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	$	673	$	266	$	407	$	0	Caa3	16	41.10	%	13.48	%	-	%
I-Preferred Term Sec I	B-1		839		839		-		161	CCC-	14	17.24	%	11.72	%*	23.61	%
Dekania II CDO	C-1		815		815		-		176	CCC	30	-	%	13.16	%*	26.03	%
Preferred Term Sec XXVII	C-1		902		316		586		0	C	32	26.18	%	18.29	%	6.39	%
Total		$	3,229	$	2,236	$	993	$	337

*Assumption not applicable as Level 1 pricing was utilized at December 31, 2013.

The table below presents a roll-forward of the credit losses relating to debt securities recognized in earnings for the years ended December 31, 2013, 2012 and 2011 (in thousands):

	2013		2012		2011
Beginning balance, January 1	$	3,176	$	3,251	$	3,249
Additions for amounts related to credit loss for which an OTTI was not previously recognized		337		-		-

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 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		-		5		2

Ending balance, December 31	$	3,513	$	3,176	$	3,251

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

	2013		2012		2011
	(In Thousands)
Proceeds	$	4,027	$	72,262	$	8,719
Gross realized gains		97		2,163		218
Gross realized losses		-		(24)		-