10-Q 1 v384690_10q.htm FORM 10-Q

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

xQuarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the Quarterly Period Ended June 30, 2014

 

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 of 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 Section 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x   No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

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

 

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Stock, $.01 Par Value – 9,466,102 shares outstanding at July 31, 2014.

 

 
 

 

FIRST DEFIANCE FINANCIAL CORP.

 

INDEX

 

    Page Number
PART I.-FINANCIAL INFORMATION    
       
Item 1. Consolidated Condensed Financial Statements (Unaudited):    
  Consolidated Condensed Statements of Financial Condition – June 30, 2014 and December 31, 2013     2
       
  Consolidated Condensed Statements of Income - Three and six months ended June 30, 2014 and 2013     4
       
  Consolidated Condensed Statements of Comprehensive Income – Three and six months ended June 30, 2014 and 2013     5
       
  Consolidated Condensed Statements of Changes in   Stockholders’ Equity – Six months ended June 30, 2014 and 2013     6
       
  Consolidated Condensed Statements of Cash Flows  - Six months ended June 30, 2014 and 2013     7
       
  Notes to Consolidated Condensed Financial Statements     8
       
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations   47
       
Item 3. Quantitative and Qualitative Disclosures About Market Risk   69
       
Item 4. Controls and Procedures   70
       
PART II-OTHER INFORMATION:    
       
Item 1. Legal Proceedings   71
       
Item 1A. Risk Factors   71
       
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   71
       
Item 3. Defaults Upon Senior Securities   72
       
Item 4. Mine Safety Disclosures   72
       
Item 5. Other Information   72
       
Item 6. Exhibits   72
       
  Signatures   73

 

-1-
 

 

PART I-FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Financial Condition

(UNAUDITED)

(Amounts in Thousands, except per share data)

 

 

 

   June 30,
2014		   December 31,
2013		 
Assets          
Cash and cash equivalents:          
Cash and amounts due from depository institutions  $42,246   $36,318 
Federal funds sold   114,000    143,000 
    156,246    179,318 
Securities:          
Available-for-sale, carried at fair value   232,289    198,170 
Held-to-maturity, carried at amortized cost (fair value $333 and $393 at June 30, 2014 and December 31, 2013, respectively)   330    387 
    232,619    198,557 
Loans held for sale   7,324    9,120 
Loans receivable, net of allowance of $24,627 at June 30, 2014 and $24,950 at December 31, 2013, respectively   1,557,357    1,555,498 
Accrued interest receivable   5,730    5,778 
Federal Home Loan Bank stock   13,802    19,350 
Bank-owned life insurance   47,169    42,715 
Premises and equipment   39,470    38,597 
Real estate and other assets held for sale   5,554    5,859 
Goodwill   61,525    61,525 
Core deposit and other intangibles   2,934    3,497 
Mortgage servicing rights   9,003    9,106 
Deferred taxes   -    565 
Other assets   12,757    7,663 
Total assets  $2,151,490   $2,137,148 

 

(continued)

 

-2-
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Financial Condition

(UNAUDITED)

(Amounts in Thousands, except per share data)

 

 

 

   June 30,
2014		   December 31,
2013		 
Liabilities and stockholders’ equity          
Liabilities:          
Deposits  $1,741,812   $1,735,792 
Advances from the Federal Home Loan Bank   22,034    22,520 
Subordinated debentures   36,083    36,083 
Securities sold under repurchase agreements   52,455    51,919 
Advance payments by borrowers   1,686    1,519 
Deferred taxes   613    - 
Other liabilities   20,358    17,168 
Total liabilities   1,875,041    1,865,001 
           
Stockholders’ equity:          
           
Preferred stock, $.01 par value per share: 4,963,000 shares authorized; no shares issued   —    — 
Common stock, $.01 par value per share: 25,000,000 shares authorized; 12,735,313 and 12,735,313  shares issued and 9,514,591 and 9,719,521 shares outstanding, respectively   127    127 
Common stock warrant   878    878 
Additional paid-in capital   136,139    136,403 
Accumulated other comprehensive income, net of tax of $1,691 and $294, respectively   3,142    545 
Retained earnings   190,246    182,290 
Treasury stock, at cost, 3,220,722 and 3,015,792 shares respectively   (54,083)   (48,096)
Total stockholders’ equity   276,449    272,147 
           
Total liabilities and stockholders’ equity  $2,151,490   $2,137,148 

 

See accompanying notes

 

-3-
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Income

(UNAUDITED)

(Amounts in Thousands, except per share data)

 

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2014   2013   2014   2013 
Interest Income                    
Loans  $16,878   $17,047   $33,529   $33,843 
Investment securities:                    
Taxable   852    674    1,627    1,352 
Non-taxable   756    732    1,508    1,457 
Interest-bearing deposits   118    72    219    130 
FHLB stock dividends   170    207    365    426 
Total interest income   18,774    18,732    37,248    37,208 
Interest Expense                    
Deposits   1,327    1,511    2,685    3,158 
FHLB advances and other   133    92    266    182 
Subordinated debentures   146    150    292    302 
Notes payable   39    61    80    121 
Total interest expense   1,645    1,814    3,323    3,763 
Net interest income   17,129    16,918    33,925    33,445 
Provision for loan losses   446    448    549    873 
Net interest income after provision for loan losses   16,683    16,470    33,376    32,572 
Non-interest Income                    
Service fees and other charges   2,508    2,549    4,832    4,934 
Insurance and investment commission income   2,244    2,277    5,274    5,313 
Mortgage banking income   1,540    2,443    2,787    5,273 
Gain on sale of non-mortgage loans   36    2    39    17 
Gain on sale or call of securities   471    44    471    97 
Trust income   302    238    580    444 
Income from Bank Owned Life Insurance   235    231    454    460 
Other non-interest income   281    114    506    365 
Total non-interest income   7,617    7,898    14,943    16,903 
Non-interest Expense                    
Compensation and benefits   8,709    8,475    17,181    17,273 
Occupancy   1,704    1,670    3,292    3,303 
FDIC insurance premium   353    275    738    931 
State franchise tax   514    627    1,009    1,256 
Data processing   1,479    1,313    2,844    2,494 
Amortization of intangibles   274    313    563    648 
Other non-interest expense   3,324    3,051    7,391    7,061 
Total non-interest expense   16,357    15,724    33,018    32,966 
Income before income taxes   7,943    8,644    15,301    16,509 
Federal income taxes   2,254    2,535    4,433    4,841 
Net Income  $5,689   $6,109   $10,868   $11,668 
                     
Earnings per common share (Note 6)                    
Basic  $0.59   $0.63   $1.13   $1.20 
Diluted  $0.57   $0.60   $1.08   $1.15 
Dividends declared per share (Note 5)  $0.15   $0.10   $0.30   $0.20 
Average common shares outstanding (Note 6)                    
Basic   9,607    9,774    9,644    9,755 
Diluted   10,066    10,156    10,096    10,130 

 

See accompanying notes

 

-4-
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Comprehensive Income

(UNAUDITED)

(Amounts in Thousands)

 

 

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2014   2013   2014   2013 
Net Income  $5,689   $6,109   $10,868   $11,668 
                     
Other comprehensive income (loss):                    
Unrealized gains (losses) on securities available for sale   2,743    (5,500)   4,465    (6,164)
Reclassification adjustment for security gains included in net income(1)   (471)   (43)   (471)   (97)
Income tax benefit (expense)   (795)   1,939    (1,397)   2,191 
Other comprehensive income (loss)   1,477    (3,604)   2,597    (4,070)
                     
Comprehensive income  $7,166   $2,505   $13,465   $7,598 

 

(1) Amounts are included in gains on sale or call of securities on the Consolidated Condensed Statements of Income. Income tax expense associated with the reclassification adjustments, included in federal income taxes, for the three months ended June 30, 2014 and 2013 was $141 and $13, respectively. Income tax expense associated with the reclassification adjustments, included in federal income taxes, for the six months ended June 30, 2014 and 2013 was $141 and $29, respectively.

 

-5-
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Changes in Stockholders’ Equity

(UNAUDITED)

(Amounts in Thousands, except share data)

 

 

 

                   Accumulated             
           Common   Additional   Other           Total 
   Preferred   Common   Stock   Paid-In   Comprehensive   Retained   Treasury   Stockholders’ 
   Stock   Stock   Warrant   Capital   Income (Loss)   Earnings   Stock   Equity 
                                 
Balance at January 1, 2014  $-   $127   $878   $136,403   $545   $182,290   $(48,096)  $272,147 
Net income   -    -    -    -    -    10,868    -    10,868 
Other comprehensive income   -    -    -    -    2,597    -    -    2,597 
Stock option expense   -    -    -    34    -    -    -    34 
26,900 shares issued under stock option plan with $58 income tax benefit, net of repurchases   -    -    -    18    -    (23)   438    433 
Restricted share activity under Stock Incentive Plans including 13,087 shares issued   -    -    -    (342)   -    -    212    (130)
2,352 shares issued direct purchases   -    -    -    26    -    -    38    64 
247,269 shares repurchased   -    -    -    -    -    -    (6,675)   (6,675)
Common stock dividends declared   -    -    -    -    -    (2,889)   -    (2,889)
Balance at June 30, 2014  $-   $127   $878   $136,139   $3,142   $190,246   $(54,083)  $276,449 
                                         
Balance at January 1, 2013  $-   $127   $878   $136,046   $4,274   $164,103   $(47,300)  $258,128 
Net income   -    -    -    -    -    11,668    -    11,668 
Other comprehensive loss   -    -    -    -    (4,070)   -    -    (4,070)
Stock option expense   -    -    -    28    -    -    -    28 
12,027 shares issued under stock option plan with no income tax benefit, net of repurchases   -    -    -    1    -    (97)   254    158 
Restricted share activity under Stock Incentive Plans including 31,796 shares issued   -    -    -    16    -    (45)   500    471 
2,768 shares issued direct purchases   -    -    -    20    -    -    44    64 
Common stock dividends declared   -    -    -    -    -    (1,950)   -    (1,950)
Balance at June 30, 2013  $-   $127   $878   $136,111   $204   $173,679   $(46,502)  $264,497 

 

-6-
 

 

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Cash Flows

(UNAUDITED)

(Amounts in Thousands)

 

 

 

   Six Months Ended 
   June 30, 
   2014   2013 
Operating Activities          
Net income  $10,868   $11,668 
Items not requiring (providing) cash          
Provision for loan losses   549    873 
Depreciation   1,462    1,592 
Amortization of mortgage servicing rights, net of impairment recoveries   623    538 
Amortization of core deposit and other intangible assets   563    648 
Net amortization of premiums and discounts on loans and deposits   295    389 
Amortization of premiums and discounts on securities   156    283 
Loss on sale or disposals of property, plant and equipment   -    1 
Change in deferred taxes   (218)   (23)
Proceeds from the sale of loans held for sale   69,421    211,479 
Originations of loans held for sale   (67,695)   (201,592)
Gain from sale of loans   (1,667)   (4,083)
Gain from sale or call of securities   (471)   (97)
Loss on sale or write-down of real estate and other assets held for sale   3    221 
Stock option expense   34    28 
Restricted stock expense (benefit)   (130)   471 
Income from bank owned life insurance   (454)   (460)
Changes in:          
Accrued interest receivable   48    (297)
Other assets   (5,094)   14 
Other liabilities   3,190    (1,544)
Net cash provided by (used in) operating activities   11,483    20,109 
           
Investing Activities          
Proceeds from maturities of held-to-maturity securities   56    63 
Proceeds from maturities, calls and pay-downs of available-for-sale securities   9,958    24,110 
Proceeds from sale of real estate and other assets held for sale   1,295    1,613 
Proceeds from the sale of available-for-sale securities   3,782    4,027 
Proceeds from sale of non-mortgage loans   10,584    4,893 
Purchases of available-for-sale securities   (43,550)   (28,561)
Proceeds from Federal Home Loan Bank stock redemption   5,548    1,302 
Purchase of bank-owned life insurance   (4,000)   - 
Purchases of portfolio mortgage loans   (5,118)   (4,545)
Purchases of premises and equipment, net   (2,335)   (796)
Net decrease in loans receivable   (7,945)   (44,020)
Net cash provided (used in) by investing activities   (31,725)   (41,914)
           
Financing Activities          
Net increase (decrease) in deposits and advance payments by borrowers   6,187    (31,391)
Repayment of Federal Home Loan Bank advances   (486)   (23)
Increase in Federal Home Loan Bank short-term advances   -    50,000 
Increase (decrease) in securities sold under repurchase agreements   536    (4,142)
Proceeds from exercise of stock options   433    158 
Proceeds from treasury stock purchases   64    64 
Cash dividends paid on common stock   (2,889)   (1,950)
Cash paid for common stock repurchases   (6,675)   - 
Net cash provided by (used in) financing activities   (2,830)   12,716 
Increase (decrease) in cash and cash equivalents   (23,072)   (9,089)
Cash and cash equivalents at beginning of period   179,318    136,832 
Cash and cash equivalents at end of period  $156,246   $127,743 
           
Supplemental cash flow information:          
Interest paid  $3,310   $3,757 
Income taxes paid  $3,650   $5,700 
Transfers from loans to real estate and other assets held for sale  $993   $4,575 

 

See accompanying notes.

 

-7-
 

 

FIRST DEFIANCE FINANCIAL CORP.

Notes to Consolidated Condensed Financial Statements

(Unaudited at June 30, 2014 and 2013)

 

 

 

1.  Basis of Presentation

 

First Defiance Financial Corp. (“First Defiance” or the “Company”) is a unitary thrift holding company that, through its subsidiaries, First Federal Bank of the Midwest (“First Federal”), First Insurance Group of the Midwest, Inc. (“First Insurance”), and First Defiance Risk Management Inc. (collectively, the “Subsidiaries”), focuses on traditional banking and property and casualty, life and group health insurance products. All significant intercompany transactions and balances are eliminated in consolidation.

 

First Federal is primarily engaged in community banking attracting deposits from the general public and using those and other available sources of funds to originate loans primarily in the counties in which its offices are located. First Federal’s traditional banking activities include originating and servicing residential, non-residential real estate, commercial, home improvement and home equity and consumer loans and providing a broad range of depository, trust and wealth management services. First Insurance is an insurance agency that does business in the Defiance, Bryan, Bowling Green, Maumee and Oregon, Ohio areas, offering property and casualty, group health insurance and life insurance products. First Defiance Risk Management is a wholly-owned insurance company subsidiary of the Company to insure the Company and its subsidiaries against certain risks unique to the operations of the Company and for which insurance may not be currently available or economically feasible in today’s insurance marketplace. First Defiance Risk Management pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves.

 

The consolidated condensed statement of financial condition at December 31, 2013 has been derived from the audited financial statements at that date, which were included in First Defiance’s Annual Report on Form 10-K for the year-ended December 31, 2013.

 

The accompanying consolidated condensed financial statements as of June 30, 2014 and for the three and six month periods ended June 30, 2014 and 2013 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 2013 Annual Report on Form 10-K for the year ended December 31, 2013. 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 and six month periods ended June 30, 2014 are not necessarily indicative of the results that may be expected for the entire year.

 

-8-
 

 

2. Significant Accounting Policies

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Significant areas where First Defiance uses estimates are the valuation of certain investment securities, the determination of the allowance for loan losses, the valuation of mortgage servicing rights and goodwill, the determination of unrecognized income tax benefits and the fair value of financial instruments.

 

Earnings Per Common Share

 

Basic earnings per common share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. All outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends are considered participating securities for the calculation. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options, warrants, restricted stock awards and stock grants.

 

Newly Adopted Accounting Standard

 

In January 2014, the FASB issued ASU 2014-01, "Accounting for Investments in Qualified Affordable Housing Projects." ASU 2014-01 applies to all reporting entities that invest in qualified affordable housing projects through limited liability entities. The pronouncement permits reporting entities to make an accounting policy election to account for these investments using the proportional amortization method if certain conditions exist. The pronouncement also requires disclosure that enables users of its financial statements to understand the nature of these investments. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The pronouncement should be applied retrospectively for all periods presented, effective for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company elected to early adopt ASU 2014-01 and such adoption did not have a material impact on the Company’s Consolidated Financial Statements. As of June 30, 2014, the Company had $3.8 million in qualified investments recorded in other assets, $2.3 million in unfunded commitments recorded in other liabilities and $84,000 of tax credits (benefit) recorded in federal income taxes.

 

Newly Issued but Not Yet Effective Accounting Standards

 

In January 2014, the FASB issued ASU 2014-04, “Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.” The objective of the amendments in ASU 2014-04 to Topic 310, “Receivables - Troubled Debt Restructurings by Creditors,” is to reduce diversity by clarifying when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. An entity can elect to adopt the amendments using either a modified retrospective transition method or a prospective transition method. Early adoption is permitted. The adoption of this guidance is not expected to have a material impact on the Company’s Consolidated Financial Statements.

 

-9-
 

 

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” ASU 2014-09 relates to the recognition of revenue from contracts with customers. The new revenue pronouncement creates a single source of revenue guidance for all companies in all industries and is more principles-based than current revenue guidance. The pronouncement provides a five-step model for a company to recognize revenue when it transfers control of goods or services to customers at an amount that reflects the consideration to which it expects to be entitled in exchange for those goods or services. The five steps are (1) identify the contract with the customer, (2) identify the separate performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the separate performance obligations and (5) recognize revenue when each performance obligation is satisfied. The pronouncement is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2016 using either a full retrospective approach for all periods presented in the period of adoption or a modified retrospective approach. Early adoption is not permitted. The Company is currently evaluating the impact of the adoption of this pronouncement on its Consolidated Financial Statements.

 

In June 2014, the FASB issued ASU No. 2014-12, "Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period." The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718, Compensation - Stock Compensation, as it relates to awards with performance conditions that affect vesting to account for such awards. The performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. The amendments in this ASU are effective for interim or annual reporting periods beginning after December 15, 2015; early adoption is permitted. Entities may apply the amendments in this ASU either: (1) prospectively to all awards granted or modified after the effective date; or (2) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. The adoption of ASU No. 2014-12 is not expected to have a material impact on the Company's Consolidated Financial Statements.

 

-10-
 

 

3.  Fair Value

 

FASB ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

 

FASB ASC Topic 820 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on the best information available. In that regard, FASB ASC Topic 820 established a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

·Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

 

·Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by a correlation or other means.

 

·Level 3: Unobservable inputs for determining fair value of assets and liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

 

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

 

-11-
 

 

Available for sale securities - Securities classified as available for sale are generally reported at fair value utilizing Level 2 inputs where the Company obtains fair value measurements from an independent pricing service that uses matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows and the bonds’ terms and conditions, among other things. Securities in Level 1 include federal agency preferred stock securities. Securities in Level 2 include U.S. Government agencies, mortgage-backed securities, corporate bonds and municipal securities. The Company classified its pooled trust preferred collateralized debt obligations as Level 1 and Level 3 at December 31, 2013. The portfolio consisted of collateralized debt obligations backed by pools of trust preferred securities issued by financial institutions and insurance companies. The two collateralized debt obligations, which are backed by financial institutions, are allowed under the Volcker Rule and classified as Level 3 based on the lack of observable market data, the Company estimated fair values based on the observable data available and reasonable unobservable market data. The Company estimated fair value based on a discounted cash flow model, which used appropriately adjusted discount rates reflecting credit and liquidity risks.

 

Impaired loans - Fair values for impaired collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure.  Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach.  The cost method bases value in the cost to replace the current property.  The value of market comparison approach evaluates the sales price of similar properties in the same market area.  The income approach considers net operating income generated by the property and an investor’s required return.  Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available.  Comparable sales adjustments are based on known sales prices of similar type and similar use properties and duration of time that the property has been on the market to sell.  Such adjustments made in the appraisal process are typically significant and result in a Level 3 classification of the inputs for determining fair value.

 

Real Estate held for sale - Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are then reviewed monthly by members of the asset review committee for valuation changes and are accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which may utilize a single valuation approach or a combination of approaches including cost, comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments may be significant and typically result in a Level 3 classification of the inputs for determining fair value.

 

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company.  Once received, a member of the Company’s asset quality or collections department reviews the assumptions and approaches utilized in the appraisal.  Appraisal values are discounted from 0% to 20% to account for other factors that may impact the value of collateral. In determining the value of impaired collateral dependent loans and other real estate owned, significant unobservable inputs may be used, which include:  physical condition of comparable properties sold, net operating income generated by the property and investor rates of return.

 

-12-
 

 

 

Mortgage servicing rights - On a quarterly basis, mortgage servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level based on a model that calculates the present value of estimated future net servicing income. The valuation model utilizes assumptions that market participants would use in estimating future net servicing income and are validated against available market data (Level 2).

 

Mortgage banking derivative - The fair value of mortgage banking derivatives are evaluated monthly based on derivative valuation models using quoted prices for similar assets adjusted for specific attributes of the commitments and other observable market data at the valuation date (Level 2).

 

The following table summarizes the financial assets measured at fair value on a recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

 

Assets and Liabilities Measured on a Recurring Basis

 

June 30, 2014  Level 1
Inputs		   Level 2 
Inputs		   Level 3
Inputs		   Total Fair
Value		 
   (In Thousands) 
Available for sale securities:                    
                     
Obligations of U.S. Government corporations and agencies  $-   $5,002   $-   $5,002 
Mortgage-backed - residential   -    49,191    -    49,191 
Collateralized mortgage obligations   -    79,454    -    79,454 
REMIC   -    1,957    -    1,957 
Corporate bonds   -    6,990    -    6,990 
Obligations of state and political subdivisions   -    89,695    -    89,695 
Mortgage banking derivative – asset   -    580    -    580 
Mortgage banking derivative - liability   -    (107)   -    (107)

  

-13-
 

 

December 31, 2013  Level 1
Inputs		   Level 2
 Inputs		   Level 3
 Inputs		   Total Fair
Value		 
   (In Thousands) 
Available for sale securities:                    
                     
Obligations of U.S. Government corporations and agencies  $-   $4,921   $-   $4,921 
Mortgage-backed - residential   -    41,292    -    41,292 
Collateralized mortgage obligations   -    59,841    -    59,841 
Trust preferred stock   1,654    -    582    2,236 
Preferred stock   718    -    -    718 
Corporate bonds   -    8,942    -    8,942 
Obligations of state and political subdivisions   -    80,220         80,220 
Mortgage banking derivative - asset   -    295    -    295 
Mortgage banking derivative - liability   -    -    -    - 

 

The table below presents a reconciliation and income classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and six months ended June 30, 2014 and 2013:

 

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(In Thousands)
Beginning balance, January 1, 2014  $582 

Total gains or (losses) (realized/unrealized)

     
Included in earnings (realized)   (329)
Included in other comprehensive income (presented gross of taxes)   993 
Amortization   - 
Sales   (1,246)
Transfers in and/or out of Level 3   - 
Ending balance, June 30, 2014  $- 

 

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(In Thousands)
Beginning balance, April 1, 2014  $704 

Total gains or (losses) (realized/unrealized)

     
Included in earnings (realized)   (329)
Included in other comprehensive income (presented gross of taxes)   871 
Amortization   - 
Sales   (1,246)
Transfers in and/or out of Level 3   - 
Ending balance, June 30, 2014  $- 

 

-14-
 

  

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(In Thousands)
Beginning balance, January 1, 2013  $1,474 
Total gains or (losses) (realized/unrealized)     
Included in earnings (realized)   - 
Included in other comprehensive income (presented gross of taxes)   262 
Amortization   - 
Sales   - 
Transfers in and/or out of Level 3   - 
Ending balance, June 30, 2013  $1,736 

 

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
(In Thousands)
Beginning balance, April 1, 2013  $1,651 
Total gains or (losses) (realized/unrealized)     
Included in earnings (realized)   - 
Included in other comprehensive income (presented gross of taxes)   85 
Amortization   - 
Sales   - 
Transfers in and/or out of Level 3   - 
Ending balance, June 30, 2013  $1,736 

 

The following table summarizes the financial assets measured at fair value on a non-recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

 

Assets and Liabilities Measured on a Non-Recurring Basis

 

June 30, 2014  Level 1 Inputs   Level 2 Inputs   Level 3 Inputs   Total Fair
Value		 
   (In Thousands) 
Impaired loans                    
Residential Loans  $-   $-   $519   $519 
Commercial Loans   -    -    1,068    1,068 
Multi Family Loans   -    -    303    303 
Home Equity Loans   -    -    102    102 
CRE Loans   -    -    7,512    7,512 
Total impaired loans   -    -    9,504    9,504 
Mortgage servicing rights   -    1,173    -    1,173 
Real estate held for sale                    
Residential Loans   -    -    -    - 
CRE loans   -    -    489    489 
Total Real Estate held for sale   -    -    489    489 

 

-15-
 

 

December 31, 2013  Level 1 Inputs   Level 2 Inputs   Level 3 Inputs   Total Fair
Value		 
   (In Thousands) 
Impaired loans                    
Residential Loans  $-   $-   $259   $259 
Multi Family Residential   -    -    338    338 

Home Equity Loans

   -    -    531    531 

CRE Loans

   -    -    9,590    9,590 
Total impaired loans   -    -    10,718    10,718 
Mortgage servicing rights   -    1,370    -    1,370 
Real estate held for sale                    
Residential   -    -    112    112 
CRE   -    -    1,278    1,278 
Total Real Estate held for sale   -    -    1,390    1,390 

 

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of June 30, 2014, the significant unobservable inputs used in the fair value measurements were as follows:

 

    Fair
Value		     Valuation Technique   Unobservable Inputs   Range of
Inputs		     Weighted
Average		  
          (Dollars in Thousands)
                           
Impaired Loans- Applies to all loan classes   $ 9,504     Appraisals which utilize sales comparison, net income and cost approach   Discounts for collection issues and changes in market conditions     0-10 %     10 %
Real estate held for sale – Applies to all classes   $ 489     Appraisals which utilize sales comparison, net income and cost approach   Discounts for changes in market conditions      0-20 %     20 %

 

For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of December 31, 2013, the significant unobservable inputs used in the fair value measurements were as follows:

 

   Fair
Value		   Valuation Technique  Unobservable Inputs  Range of
Inputs		   Weighted
Average		 
       (Dollars in Thousands)
                   
Trust preferred stock  $582   Discounted cash flow  Constant prepayment rate   40%   40%
           Expected asset default   0-30%   15%
           Expected recoveries   10-15%   10%
                      
Impaired Loans- Applies to all loan classes  $10,718   Appraisals which utilize sales comparison, net income and cost approach  Discounts for collection issues and changes in market conditions   0-10%   10%
                      
Real estate held for sale – Applies to all classes  $1,390   Appraisals which utilize sales comparison, net income and cost approach  Discounts for changes in market conditions   0-20%   20%

 

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a fair value of $9.5 million, with no valuation allowance and a fair value of $10.7 million, with no valuation allowance at June 30, 2014 and December 31, 2013, respectively. A provision expense of $725,000 and $1.5 million for the three and six months ended June 30, 2014 and a provision expense of $551,000 and $1.2 million for the three and six months ended June 30, 2013, respectively, was included in earnings.

 

-16-
 

 

Mortgage servicing rights which are carried at the lower of cost or fair value, had a fair value of $1.2 million with a valuation allowance of $1.0 million at both June 30, 2014 and December 31, 2013. A recovery of $44,000 and $37,000 for the three and six months ended June 30, 2014 and a recovery of $312,000 and $785,000 for the three and six months ended June 30, 2013, respectively, were included in earnings.

 

Real estate held for sale is determined using Level 3 inputs which include appraisals and are adjusted for estimated costs to sell. The change in fair value of real estate held for sale was $73,000 for the three and six months ended June 30, 2014 and $215,000 for the three and six months ended June 30, 2013, which was recorded directly as an adjustment to current earnings through non-interest expense.

 

In accordance with FASB ASC Topic 825, the Fair Value Measurements tables are a comparative condensed consolidated statement of financial condition based on carrying amount and estimated fair values of financial instruments as of June 30, 2014 and December 31, 2013. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of First Defiance.

 

Much of the information used to arrive at “fair value” is highly subjective and judgmental in nature and therefore the results may not be precise. Subjective factors include, among other things, estimated cash flows, risk characteristics and interest rates, all of which are subject to change. With the exception of investment securities, the Company’s financial instruments are not readily marketable and market prices do not exist. Since negotiated prices for the instruments, which are not readily marketable, depend greatly on the motivation of the buyer and seller, the amounts that will actually be realized or paid per settlement or maturity of these instruments could be significantly different.

 

The carrying amount of cash and cash equivalents, term notes payable and advance payments by borrowers for taxes and insurance, as a result of their short-term nature, is considered to be equal to fair value and are classified as Level 1.

 

It was not practicable to determine the fair value of Federal Home Loan Bank (“FHLB”) stock due to restrictions placed on its transferability.

 

The fair value of loans that reprice within 90 days is equal to their carrying amount. For other loans, the estimated fair value is calculated based on discounted cash flow analysis, using interest rates currently being offered for loans with similar terms, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as previously described. The allowance for loan losses is considered to be a reasonable adjustment for credit risk. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price. The fair value of loans held for sale is estimated based on binding contracts and quotes from third party investors resulting in a Level 2 classification.

  

-17-
 

 

The fair value of accrued interest receivable is equal to the carrying amounts resulting in a Level 2 or Level 3 classification, which is consistent with its underlying value.

 

The fair value of non-interest bearing deposits are considered equal to the amount payable on demand at the reporting date (i.e., carrying value) and are classified as Level 1. The fair value of savings, NOW and certain money market accounts are equal to their carrying amounts and are a Level 2 classification. Fair values of fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

 

The fair values of securities sold under repurchase agreements are equal to their carrying amounts resulting in a Level 2 classification. The carrying value of subordinated debentures and deposits with fixed maturities is estimated based on discounted cash flow analyses based on interest rates currently being offered on instruments with similar characteristics and maturities resulting in a Level 3 classification.

 

FHLB advances with maturities greater than 90 days are valued based on discounted cash flow analysis, using interest rates currently being quoted for similar characteristics and maturities resulting in a Level 2 classification. The cost or value of any call or put options is based on the estimated cost to settle the option at June 30, 2014.

 

       Fair Value Measurements at June 30, 2014
(In Thousands)		 
   Carrying
Value		   Total   Level 1   Level 2   Level 3 
Financial Assets:                         
Cash and cash equivalents  $156,246   $156,246   $156,246   $-   $- 
Investment securities   232,619    232,622    -    232,622    - 
Federal Home Loan Bank Stock   13,802    N/A    N/A    N/A    N/A 
Loans, net, including loans held for sale   1,564,681    1,572,926    -    7,665    1,565,261 
Accrued interest receivable   5,730    5,730    -    813    4,917 
                          
Financial Liabilities:                         
Deposits  $1,741,812   $1,743,793   $355,268   $1,388,525   $- 
Advances from Federal Home Loan Bank   22,034    22,290    -    22,290    - 
Securities sold under repurchase agreements   52,455    52,455    -    52,455    - 
Subordinated debentures   36,083    35,256    -    -    35,256 

 

-18-
 

  

       Fair Value Measurements at December 31, 2013
(In Thousands)		 
   Carrying
Value		   Total   Level 1   Level 2   Level 3 
Financial Assets:                         
Cash and cash equivalents  $179,318   $179,318   $179,318   $-   $- 
Investment securities   198,557    198,563    2,372    195,609    582 
Federal Home Loan Bank Stock   19,350    N/A    N/A    N/A    N/A 
Loans, net, including loans held for sale   1,564,618    1,568,929    -    9,140    1,559,789 
Accrued interest receivable   5,778    5,778    4    696    5,078 
                          
Financial Liabilities:                         
Deposits  $1,735,792   $1,738,216   $348,943   $1,389,273   $- 
Advances from Federal Home Loan Bank   22,520    22,713    -    22,713    - 
Securities sold under repurchase agreements   51,919    51,919    -    51,919    - 
Subordinated debentures   36,083    35,237    -    -    35,237 

 

4.        Stock Compensation Plans

 

First Defiance has established equity based compensation plans for its directors and employees. On March 15, 2010, the Board adopted, and the shareholders approved at the 2010 Annual Shareholders Meeting, the First Defiance Financial Corp. 2010 Equity Incentive Plan (the “2010 Equity Plan”). The 2010 Equity Plan replaced all plans that were in existence at the time of adoption. All awards currently outstanding under prior plans will remain in effect in accordance with their respective terms. Any new awards will be made under the 2010 Equity Plan. The 2010 Equity Plan allows for issuance of up to 350,000 common shares through the award of options, stock grants, restricted stock units (“RSU”), stock appreciation rights or other stock-based awards.

 

As of June 30, 2014, 190,520 options had been granted and remained outstanding at option prices based on the market value of the underlying shares on the date the options were granted. Options granted under all plans vest 20% per year except, for the 2009 grant to the Company’s executive officers, which vested 40% in 2011 and then 20% annually. All options expire ten years from the date of grant. Vested options of retirees expire on the earlier of the scheduled expiration date or three months after the retirement date.

 

In March 2013, the Company approved a 2013 Short-Term Incentive Plan (“STIP”) and a 2013 Long-Term Incentive Plan (“LTIP”) for selected members of management.

 

Under the 2013 STIP the participants may earn up to 25% to 45% of their salary for potential payout based on the achievement of certain corporate performance targets during the calendar year. The participants are required to be employed on the day of payout in order to receive such payment. The final amount of benefits under the 2013 STIP was determined as of December 31, 2013 and paid out in cash in the first quarter of 2014.

  

-19-
 

 

Under the 2013 LTIP the participants may earn up to 25% to 45% of their salary for potential payout in the form of equity awards based on the achievement of certain corporate performance targets over a three year period. The Company granted 86,065 RSU’s to the participants in the 2013 LTIP effective January 1, 2013, which represents the maximum target award. The amount of benefit under the 2013 LTIP will be determined individually at the 12 month period ending December 31, 2013, the 24 month period ending December 31, 2014 and the 36 month period ending December 31, 2015. The awards’ vesting will be as follows: 16.7% of the target award after the end of the performance period ending December 31, 2013, 27.8% of the target award at the end of the performance period ending December 31, 2014 and 55.5% of the target award at the end of the performance period ending December 31, 2015. The benefits earned under the 2013 LTIP will be paid out in equity in the first quarter following the close of the applicable performance period. The participants are required to be employed on the day of payout in order to receive such payment. A total of 6,425 RSU’s were issued to the participants in the second quarter of 2014 for the year one performance period ended December 31, 2013.

 

In March 2014, the Company approved a 2014 STIP and a 2014 LTIP for selected members of management.

 

Under the 2014 STIP the participants may earn up to 30% to 45% of their salary for potential payout based on the achievement of certain corporate performance targets during the calendar year. The final amount of benefits under the 2014 STIP will be determined as of December 31, 2014 and will be paid out in cash in the first quarter of 2015. The participants are required to be employed on the day of payout in order to receive such payment.

 

Under the 2014 LTIP the participants may earn up to 20% to 45% of their salary for potential payout in the form of equity awards based on the achievement of certain corporate performance targets over a three year period. The Company granted 30,538 RSU’s to the participants in the 2014 LTIP effective January 1, 2014, which represents the maximum target award. The amount of benefit under the 2014 LTIP will be determined individually at the end of the 36 month performance period ending December 31, 2016. The awards’ will vest 100% of the target award at the end of the performance period ending December 31, 2016. The benefits earned under the 2014 LTIP will be paid out in equity in the first quarter of 2017. The participants are required to be employed on the day of payout in order to receive such payment.

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes model. Expected volatilities are based on historical volatilities of the Company’s common shares. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

 

The fair value of stock options granted during the six months ended June 30, 2014 was determined at the date of grant using the Black-Scholes stock option-pricing model and the following assumptions:

 

   Six Months ended 
   June 30, 2014 
Expected average risk-free rate   1.64%
Expected average life   7.44 years 
Expected volatility   44.62%
Expected dividend yield   2.17%

 

-20-
 

 

The weighted-average fair value of options granted for the six months ended June 30, 2014 was $11.25. There were no options granted in the six months ended June 30, 2013.

 

Following is activity under the plans during the six months ended June 30, 2014:

 

Stock options  Options
Outstanding		   Weighted
Average
Exercise Price		   Weighted
Average
Remaining
Contractual
Term (in years)		   Aggregate
Intrinsic
Value
(in 000’s)		 
Options outstanding, January 1, 2014   251,020   $20.76           
Forfeited or cancelled   (34,100)   26.72           
Exercised   (26,900)   16.09           
Granted   500    27.59           
Options outstanding, June 30, 2014   190,520   $20.37    3.08   $1,587 
Vested or expected to vest at June 30, 2014   190,520   $20.37    3.08   $1,587 
Exercisable at June 30, 2014   190,020   $20.35    3.07   $1,586 

 

As of June 30, 2014, there was $5,000 of total unrecognized compensation costs related to unvested stock options granted under the Company’s equity plans. The cost is expected to be recognized over a weighted-average period of 4.7 years.

 

At June 30, 2014, 91,812 RSU’s were outstanding. Compensation expense is recognized over the performance period based on the achievements of targets as established under the plan documents. Total accrued expense of $130,000 was recorded during the six months ended June 30, 2014 compared to an expense of $570,000 for the same period in 2013. There was approximately $335,000 included within other liabilities at June 30, 2014 related to the STIPs and LTIPs.

 

   Restricted Stock Units   Stock Grants 
       Weighted-Average       Weighted-Average 
       Grant Date       Grant Date 
Unvested Shares  Shares   Fair Value   Shares   Fair Value 
                     
Unvested at January 1, 2014   106,061   $18.66    -   $- 
Granted   30,538    25.77    13,087    21.87 
Vested   (7,320)   18.63    (7,320)   18.63 
Forfeited   (37,467)   18.71    -    - 
Unvested at June 30, 2014   91,812   $21.00    5,767   $25.97 

 

The maximum amount of compensation expense that may be recorded for the 2014 STIP and the 2012, 2013 and 2014 LTIPs at June 30, 2014 is approximately $3.8 million. However, the estimated expense expected to be recorded as of June 30, 2014 based on the performance measures in the plans, is $2.0 million, of which $1.1 million is unrecognized at June 30, 2014 and will be recognized over the remaining performance periods.

 

5.        Dividends on Common Stock

 

First Defiance declared and paid a $0.15 per share common stock dividend in the first and second quarters of 2014 and declared and paid a $0.10 per share common stock dividend in the first and second quarters of 2013.

 

-21-
 

 

6.        Earnings Per Common Share

 

The following table sets forth the computation of basic and diluted earnings per common share (In Thousands except per share data):

 

   Three months ended
June 30,		   Six months ended
June 30,		 
   2014   2013   2014   2013 
Numerator for basic and diluted earnings per common share – Net income  $5,689   $6,109   $10,868   $11,668 
Denominator:                    
Denominator for basic earnings per common share – weighted average common shares, including participating securities   9,607    9,774    9,644    9,755 
Effect of warrants   350    306    345    301 
Effect of restricted stock units   56    27    54    23 
Effect of employee stock options   53    49    53    51 
                     
Denominator for diluted earnings per common share share   10,066    10,156    10,096    10,130 
Basic earnings per common share  $0.59   $0.63   $1.13   $1.20 
Diluted earnings per common share  $0.57   $0.60   $1.08   $1.15 

  

There were 1,000 and 35,000 shares under options granted to employees excluded from the diluted earnings per common share calculation as they were anti-dilutive for the three and six months ended June 30, 2014, respectively. There were 143,350 shares under option granted to employees excluded from the diluted earnings per common share calculation as they were anti-dilutive for both the three and six months ended June 30, 2013.

 

-22-
 

 

7.        Investment Securities

 

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

 

   Amortized
Cost		   Gross
Unrealized
Gains		   Gross
Unrealized
Losses		   Fair Value 
  (In Thousands) 
At June 30, 2014    
Available-for-Sale Securities:                    
Obligations of U.S. government corporations and agencies  $5,000   $24   $(22)  $5,002 
Mortgage-backed securities – residential   48,569    971    (349)   49,191 
Collateralized mortgage obligations   79,161    977    (684)   79,454 
REMICs   1,940    17    -    1,957 
Corporate bonds   6,884    122    (16)   6,990 
Obligations of state and political subdivisions   85,347    4,508    (160)   89,695 
Totals  $226,901   $6,619   $(1,231)  $232,289 

 

   Amortized
Cost		   Gross
Unrecognized
Gains		   Gross
Unrecognized
Losses		   Fair Value 
   (In Thousands) 
Held-to-Maturity Securities*:                    
FHLMC certificates  $29   $-   $-   $29 
FNMA certificates   102    2    -    104 
GNMA certificates   44    1    -    45 
Obligations of state and political subdivisions   155    -    -    155 
Totals  $330   $3   $-   $333 

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
   (In Thousands) 
At December 31, 2013                

Available-for-Sale Securities:

                    
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 

 

   Amortized Cost   Gross
Unrecognized
Gains		   Gross
Unrecognized
Losses		   Fair Value 
   (In Thousands) 
Held-to-Maturity Securities*:                    
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 

 

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

 

-23-
 

 

The amortized cost and fair value of the investment securities portfolio at June 30, 2014 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”) and collateralized mortgage obligations (“CMO”), 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  $1,007   $1,017   $-   $- 
Due after one year through five years   9,398    9,691    155    155 
Due after five years through ten years   38,245    40,045    -    - 
Due after ten years   48,581    50,934    -    - 
MBS/CMO   129,670    130,602    175    178 
   $226,901   $232,289   $330   $333 

 

Investment securities with a carrying amount of $136.7 million at June 30, 2014 were pledged as collateral on public deposits, securities sold under repurchase agreements, Federal Reserve discount window and FHLB advances.

 

As of June 30, 2014, the Company’s investment portfolio consisted of 354 securities, 59 of which were in an unrealized loss position.

 

The following tables summarize First Defiance’s securities that were in an unrealized loss position at June 30, 2014 and December 31, 2013:

 

   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 June 30, 2014                        
Available-for-sale securities:                              
Obligations of U.S. government corporations and agencies  $-   $-   $978   $(22)  $978   $(22)
Mortgage-backed securities - residential   5,723    (25)   18,641    (324)   24,364    (349)
Collateralized mortgage obligations   21,077    (321)   12,646    (363)   33,723    (684)
Obligations of state and political subdivisions   1,379    (29)   8,798    (131)   10,177    (160)
Corporate bonds   -    -    984    (16)   984    (16)
Total temporarily impaired securities  $28,179   $(375)  $42,047   $(856)  $70,226   $(1,231)

 

-24-
 

 

   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)

 

With the exception of trust preferred securities and corporate bonds, 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 $471,000 ($330,000 after tax) in the second quarter of 2014 while there were realized gains of $44,000 ($31,000 after tax) in the second quarter of 2013. Realized gains from the sales of investment securities totaled $471,000 ($306,000 after tax) for the first six months of 2014 compared to realized gains of $97,000 ($68,000 after tax) for the first six months of 2013.

 

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.

 

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 is 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.

 

-25-
 

 

For the first six months of 2014 and 2013, management determined there was no OTTI. The Company held eight Collateralized Debt Obligations (“CDOs”) at December 31, 2013. Two of the eight securities were sold in January 2014 with no gain or loss associated with that transaction and three were sold in June 2014 for a loss of $329,000. The Company holds three CDOs at June 30, 2014 with a zero value.

 

There was no OTTI recognized in accumulated other comprehensive income (“AOCI”) at June 30, 2014. There was $645,000 recognized in AOCI at December 31, 2013.

 

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

 

   Three Months Ended
June 30,		   Six Months Ended
June 30,		 
   2014   2013   2014   2013 
   (In Thousands) 
Proceeds  $2,128   $3,008   $3,782   $4,027 
Gross realized gains   1,113    43    1,113    97 
Gross realized losses   (642)   -    (642)   - 

 

-26-
 

 

8.        Loans

 

Loans receivable consist of the following:

 

   June 30,
2014		   December 31,
2013		 
  (In Thousands) 
Real Estate:    
Secured by 1-4 family residential  $199,886   $195,752 
Secured by multi-family residential   151,008    148,952 
Secured by commercial real estate   650,915    670,666 
Construction   108,478    86,058 
    1,110,287    1,101,428 
Other Loans:          
Commercial   390,055    388,236 
Home equity and improvement   108,460    106,930 
Consumer Finance   15,800    16,902 
    514,315    512,068 
Total loans   1,624,602    1,613,496 
Deduct:          
Undisbursed loan funds   (41,874)   (32,290)
Net deferred loan origination fees and costs   (744)   (758)
Allowance for loan loss   (24,627)   (24,950)
Totals  $1,557,357   $1,555,498 

 

Loan segments have been identified by evaluating the portfolio based on collateral and credit risk characteristics.

 

The following table discloses allowance for loan loss activity for the quarter ended June 30, 2014 and June 30, 2013 by portfolio segment and impairment method (In Thousands):

 

Quarter Ended June 30, 2014  1-4 Family
Residential
Real Estate		   Multi- Family
Residential
Real Estate		   Commercial
Real Estate		   Construction   Commercial   Home Equity
and
Improvement		   Consumer
Finance		   Total 
Beginning Allowance  $2,639   $2,615   $11,987   $138   $5,610   $1,647   $147   $24,783 
Charge-Offs   (42)   (0)   (39)   0    (973)   (80)   (12)   (1,146)
Recoveries   98    2    200    0    173    55    16    544 
Provisions   (350)   (137)   (672)   61    1,389    158    (3)   446 
Ending Allowance  $2,345   $2,480   $11,476   $199   $6,199   $1,780   $148   $24,627 

 

Quarter Ended June 30, 2013  1-4 Family
Residential
Real Estate		   Multi- Family
Residential
Real Estate		   Commercial
Real Estate		   Construction   Commercial   Home Equity
and
Improvement		   Consumer
Finance		   Total 
Beginning Allowance  $3,433   $2,410   $13,367   $67   $5,304   $1,723   $155   $26,459 
Charge-Offs   (184)   (6)   (277)   0    (316)   (170)   (8)   (961)
Recoveries   33    0    167    0    57    38    29    324 
Provisions   (85)   21    (117)   16    429    195    (11)   448 
Ending Allowance  $3,197   $2,425   $13,140   $83   $5,474   $1,786   $165   $26,270 

 

-27-
 

 

The following table discloses allowance for loan loss activity for the year-to-date ended June 30, 2014 and June 30, 2013 by portfolio segment and impairment method (In Thousands):

 

Year-to-date Ended June 30,
2014		  1-4 Family
Residential
Real Estate		   Multi- Family
Residential
Real Estate		   Commercial
Real Estate		   Construction   Commercial   Home Equity
and
Improvement		   Consumer   Total 
Beginning Allowance  $2,847   $2,508   $12,000   $134   $5,678   $1,635   $148   $24,950 
Charge-Offs   (270)   (0)   (267)   0    (1,498)   (264)   (23)   (2,322)
Recoveries   154    5    922    0    249    86    34    1,450 
Provisions   (386)   (33)   (1,179)   65    1,770    323    (11)   549 
Ending Allowance  $2,345   $2,480   $11,476   $199   $6,199   $1,780   $148   $24,627 

 

Year-to-date Ended June 30,
2013		  1-4 Family
Residential
Real Estate		   Multi- Family
Residential
Real Estate		   Commercial
Real Estate		   Construction   Commercial   Home Equity
and
Improvement		   Consumer   Total 
Beginning Allowance  $3,506   $2,197   $12,702   $75   $6,325   $1,759   $147   $26,711 
Charge-Offs   (390)   (6)   (543)   0    (521)   (442)   (54)   (1,956)
Recoveries   132    0    268    0    133    61    48    642 
Provisions   (51)   234    713    8    (463)   408    24    873 
Ending Allowance  $3,197   $2,425   $13,140   $83   $5,474   $1,786   $165   $26,270 

 

-28-
 

 

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of June 30, 2014: (In Thousands)

 

   1-4 Family   Multi- Family                         
   Residential   Residential   Commercial           Home Equity   Consumer     
   Real Estate   Real Estate   Real Estate   Construction   Commercial   & Improvement   Finance   Total 
Allowance for loan losses:                                        
                                         
Ending allowance balance attributable to loans:                                        
                                         
Individually evaluated for impairment  $182   $-   $1,129   $-   $23   $24   $-   $1,358 
                                         
Collectively evaluated for impairment   2,163    2,480    10,347    199    6,176    1,756    148    23,269 
                                         
Acquired with deteriorated credit quality   -    -    -    -    -    -    -    - 
                                         
Total ending allowance balance  $2,345   $2,480   $11,476   $199   $6,199   $1,780   $148   $24,627 
                                         
Loans:                                        
                                         
Loans individually evaluated for impairment  $9,796   $358   $29,630   $262   $7,385   $2,099   $47   $49,577 
                                         
Loans collectively evaluated for impairment   190,502    150,782    623,996    66,312    383,031    106,760    15,739    1,537,122 
                                         
Loans acquired with deteriorated credit quality   1    -    169    -    24    -    -    194 
                                         
Total ending loans balance  $200,299   $151,140   $653,795   $66,574   $390,440   $108,859   $15,786   $1,586,893 

 

-29-
 

 

 

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2013: (In Thousands)

 

   1-4 Family   Multi- Family                         
   Residential   Residential   Commercial           Home Equity   Consumer     
   Real Estate   Real Estate   Real Estate   Construction   Commercial   & Improvement   Finance   Total 
Allowance for loan losses:                                        
                                         
Ending allowance balance attributable to loans:                                        
                                         
Individually evaluated for impairment  $220   $-   $1,121   $-   $6   $45   $-   $1,392 
                                         
Collectively evaluated for impairment   2,627    2,508    10,879    134    5,672    1,590    148    23,558 
Acquired with deteriorated credit quality   -    -    -    -    -    -    -    - 
Total ending allowance balance  $2,847   $2,508   $12,000   $134   $5,678   $1,635   $148   $24,950 
                                         
Loans:                                        
                                         
Loans individually evaluated for impairment  $10,245   $840   $34,874   $263   $8,737   $2,429   $53   $57,441 
                                         
Loans collectively evaluated for impairment   185,923    148,294    637,657    53,467    380,711    104,958    16,838    1,527,848 
                                         
Loans acquired with deteriorated credit quality   29    -    174    -    27    -    -    230 
                                         
Total ending loans balance  $196,197   $149,134   $672,705   $53,730   $389,475   $107,387   $16,891   $1,585,519 

 

-30-
 

 

The following table presents the average balance, interest income recognized and cash basis income recognized on impaired loans by class of loans. (In Thousands)

 

   Three Months Ended June 30, 2014   Six Months Ended June 30, 2014 
   Average
Balance		   Interest
Income
Recognized		   Cash Basis
Income
Recognized		   Average
Balance		   Interest
Income
Recognized		   Cash Basis
Income
Recognized		 
Residential Owner Occupied  $6,133   $81   $75   $6,231   $166   $158 
Residential Non Owner Occupied   3,715    32    33    3,900    70    71 
Total Residential Real Estate   9,848    113    108    10,131    236    229 
Construction   261    3    4    261    6    9 
Multi-Family   369    1    1    378    2    2 
CRE Owner Occupied   8,967    37    33    9,402    73    68 
CRE Non Owner Occupied   18,469    201    204    18,912    405    408 
Agriculture Land   683    5    3    685    8    5 
Other CRE   1,788    5    6    1,825    10    11 
Total Commercial Real Estate   29,907    248    246    30,824    496    492 
Commercial Working Capital   3,286    8    8    3,105    11    11 
Commercial Other   4,552    2    1    4,756    4    3 
Total Commercial   7,838    10    9    7,861    15    14 
Home Equity and Home Improvement   2,095    25    25    2,267    50    50 
Consumer   51    1    1    54    2    2 
Total Impaired Loans  $50,369   $401   $394   $51,776   $807   $798 

 

-31-
 

 

The following table presents the average balance, interest income recognized and cash basis income recognized on impaired loans by class of loans: (In Thousands)

 

   Three Months Ended June 30, 2013   Six Months Ended June 30, 2013 
   Average
Balance		   Interest
Income
Recognized		   Cash Basis
Income
Recognized		   Average
Balance		   Interest
Income
Recognized		   Cash Basis
Income
Recognized		 
Residential Owner Occupied  $6,693   $92   $92   $6,811   $180   $178 
Residential Non Owner Occupied   4,443    43    44    4,583    79    79 
Total Residential Real Estate   11,136    135    136    11,394    259    257 
Construction   131    3    2    102    3    2 
Multi-Family   1,277    5    6    1,393    11    13 
CRE Owner Occupied   14,452    120    118    14,536    183    176 
CRE Non Owner Occupied   23,692    236    230    24,080    439    423 
Agriculture Land   889    8    3    886    17    10 
Other CRE   4,526    12    8    4,783    14    9 
Total Commercial Real Estate   43,559    376    359    44,285    653    618 
Commercial Working Capital   1,346    17    17    1,593    20    22 
Commercial Other   6,669    28    23    6,759    51    45 
Total Commercial   8,015    45    40    8,352    71    67 
Home Equity and Home Improvement   2,789    33    31    2,749    67    63 
Consumer   82    1    1    96    3    3 
Total Impaired Loans  $66,989   $598   $575   $68,371   $1,067   $1,023 

 

-32-
 

 

The following table presents loans individually evaluated for impairment by class of loans: (In Thousands)

 

   June 30, 2014   December 31, 2013 
   Unpaid
Principal
Balance*		   Recorded
Investment		   Allowance
for Loan
Losses
Allocated		   Unpaid
Principal
Balance*		   Recorded
Investment		   Allowance
for Loan
Losses
Allocated		 
With no allowance recorded:                              
Residential Owner Occupied  $3,698   $4,307   $-   $4,744   $4,729   $- 
Residential Non Owner Occupied   4,416    3,602    -    4,844    4,329    - 
Total 1-4 Family Residential Real Estate   8,114    7,909    -    9,588    9,058    - 
Multi-Family Residential Real Estate   508    358    -    989    840    - 
CRE Owner Occupied   8,453    6,159    -    11,105    8,376    - 
CRE Non Owner Occupied   6,761    5,895    -    9,399    7,740    - 
Agriculture Land   486    467    -    629    488    - 
Other CRE   2,256    1,710    -    3,274    2,452    - 
Total Commercial Real Estate   17,955    14,231    -    24,407    19,056    - 
Construction   261    262    -    300    263    - 
Commercial Working Capital   3,787    2,548    -    3,147    3,146    - 
Commercial Other   4,923    4,280    -    6,063    5,415    - 
Total Commercial   8,710    6,828    -    9,210    8,561    - 
Home Equity and Home Improvement   1,997    1,947    -    1,985    1,992    - 
Consumer Finance   48    47    -    53    53    - 
Total loans with no allowance recorded  $37,594   $31,582   $-   $46,532   $39,823   $- 
                               
With an allowance recorded:                              
Residential Owner Occupied  $1,801   $1,805   $181   $1,100   $1,103   $218 
Residential Non Owner Occupied   82    82    1    84    84    2 
Total 1-4 Family Residential Real Estate   1,883    1,887    182    1,184    1,187    220 
Multi-Family Residential Real Estate   -    -    -    -    -    - 
CRE Owner Occupied   3,101    2,659    157    3,212    2,765    166 
CRE Non Owner Occupied   12,430    12,475    964    12,756    12,803    946 
Agriculture Land   210    215    6    195    197    7 
Other CRE   79    50    2    82    53    2 
Total Commercial Real Estate   15,820    15,399    1,129    16,245    15,818    1,121 
Construction   -    -    -    -    -    - 
Commercial Working Capital   500    501    15    -    -    - 
Commercial Other   55    56    8    176    176    6 
Total Commercial   555    557    23    176    176    6 
Home Equity and Home Improvement   152    152    24    436    437    45 
Consumer Finance   -    -    -    -    -    - 
Total loans with an allowance recorded  $18,410   $17,995   $1,358   $18,041   $17,618   $1,392 

 

*Presented gross of charge-offs

 

-33-
 

 

The following table presents the aggregate amounts of non-performing assets, comprised of non-performing loans and real estate owned on the dates indicated:

 

   June 30,
2014		   December 31,
2013		 
   (In Thousands) 
Non-accrual loans  $24,863   $27,847 
Loans over 90 days past due and still accruing   -    - 
Total non-performing loans   24,863    27,847 
Real estate and other assets held for sale   5,554    5,859 
Total non-performing assets  $30,417   $33,706 

 

The following table presents the aging of the recorded investment in past due and non accrual loans as of June 30, 2014 by class of loans: (In Thousands)

 

   Current   30-59 days   60-89 days   90+ days   Total
Past Due		   Total Non
Accrual		 
Residential Owner Occupied  $134,417   $429   $297   $790   $1,516   $1,085 
Residential Non Owner Occupied   63,228    -    12    1,126    1,138    1,815 
Total 1-4 Family Residential Real Estate   197,645    429    309    1,916    2,654    2,900 
Multi-Family Residential Real Estate   151,140    -    -    -    -    429 
                               
CRE Owner Occupied   297,739    41    -    1,812    1,853    7,041 
CRE Non Owner Occupied   227,708    29    -    2,058    2,087    4,969 
Agriculture Land   84,632    137    -    329    466    751 
Other Commercial Real Estate   39,050    -    -    260    260    1,619 
                               
Total Commercial Real Estate   649,129    207    -    4,459    4,666    14,380 
                               
Construction   66,574    -    -    -    -    - 
                               
Commercial Working Capital   144,112    3    -    1,545    1,548    2,368 
Commercial Other   241,199    94    -    3,487    3,581    4,689 
                               
Total Commercial   385,311    97    -    5,032    5,129    7,057 
                               
Consumer Finance   15,696    84    6    -    90    - 
Home Equity/Home Improvement   107,661    969    127    102    1,198    102 
                               
Total Loans  $1,573,156   $1,786   $442   $11,509   $13,737   $24,868 

 

-34-
 

 

The following table presents the aging of the recorded investment in past due and non accrual loans as of December 31, 2013 by class of loans: (In Thousands)

 

   Current   30-59 days   60-89 days   90+ days   Total
Past Due		   Total Non
Accrual		 
Residential Owner Occupied  $126,855   $1,530   $191   $1,009   $2,730   $1,329 
Residential Non Owner Occupied   65,292    531    403    386    1,320    1,943 
Total 1-4 Family Residential Real Estate   192,147    2,061    594    1,395    4,050    3,272 
Multi-Family Residential Real Estate   149,134    -    -    -    -    583 
                               
CRE Owner Occupied   311,253    334    495    3,671    4,500    7,492 
CRE Non Owner Occupied   225,433    1,067    918    902    2,887    4,717 
Agriculture Land   81,954    21    -    73    94    630 
Other Commercial Real Estate   45,297    -    -    1,287    1,287    2,412 
                               
Total Commercial Real Estate   663,937    1,422    1,413    5,933    8,768    15,251 
                               
Construction   53,730    -    -    -    -    - 
                               
Commercial Working Capital   155,373    -    -    419    419    2,917 
Commercial Other   230,054    37    26    3,566    3,629    5,419 
                               
Total Commercial   385,427    37    26    3,985    4,048    8,336 
                               
Consumer Finance   16,759    131         -    131    - 
Home Equity/Home Improvement   105,657    1,163    155    413    1,731    413 
                               
Total Loans  $1,566,791   $4,814   $2,188   $11,726   $18,728   $27,855 

 

Troubled Debt Restructurings

 

As of June 30, 2014 and December 31, 2013, the Company had a recorded investment in troubled debt restructurings (“TDRs”) of $32.7 million and $33.4 million, respectively. The Company allocated $1.2 million of specific reserves to those loans at each of June 30, 2014 and December 31, 2013, and committed to lend additional amounts totaling up to $28,000 and $300,000 at June 30, 2014 and December 31, 2013, respectively.

 

-35-
 

 

The Company offers various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted. Each TDR is uniquely designed to meet the specific needs of the borrower. Commercial and industrial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral or an additional guarantor is often requested when granting a concession. Commercial mortgage loans modified in a TDR often involve temporary interest-only payments, re-amortization of remaining debt in order to lower payments, and sometimes reducing the interest rate lower than the current market rate. Residential mortgage loans modified in a TDR are comprised of loans where monthly payments are lowered, either through interest rate reductions or principal only payments for a period of time, to accommodate the borrowers’ financial needs, interest is capitalized into principal, or the term and amortization are extended. Home equity modifications are made infrequently and usually involve providing an interest rate that is lower than the borrower would be able to obtain due to credit issues. All retail loans where the borrower is in bankruptcy are classified as TDRs regardless of whether or not a concession is made.

 

Of the loans modified in a TDR, $5.6 million are on non-accrual status and partial charge-offs have in some cases been taken against the outstanding balance. Loans modified as a TDR may have the financial effect of increasing the allowance associated with the loan. If the loan is determined to be collateral dependent, the estimated fair value of the collateral, less any selling costs is used to determine if there is a need for a specific allowance or charge-off. If the loan is determined to be cash flow dependent, the allowance is measured based on the present value of expected future cash flows discounted at the loan’s pre-modification effective interest rate.

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the three and six month periods ending June 30, 2014 and June 30, 2013:

 

   Loans Modified as a TDR for the Three
Months Ended June 30, 2014
($ In Thousands)		   Loans Modified as a TDR for the Six
Months Ended June 30, 2014
($ In Thousands)		 
Troubled Debt Restructurings  Number of Loans   Recorded
Investment (as of
period end)		   Number of Loans   Recorded
Investment (as of
period end)		 
                 
Residential Owner Occupied   7   $674    15   $1,372 
Residential Non Owner Occupied   0    -    0    - 
CRE Owner Occupied   0    -    0    - 
CRE Non Owner Occupied   0    -    1    358 
Agriculture Land   0    -    0    - 
Other CRE   0    -    0    - 
Commercial working capital or other   9    727    11    1,676 
Home Equity / Improvement   4    82    7    167 
Consumer Finance   1    17    2    19 
Total   21   $1,500    36   $3,592 

 

The loans described above increased the allowance for loan loss by $65,000 in the three month period ending June 30, 2014 and decreased the allowance for loan loss by $5,000 in the six month period ending June 30, 2014.

 

-36-
 

 

   Loans Modified as a TDR for the Three
Months Ended June 30, 2013
($ In Thousands)		   Loans Modified as a TDR for the Six
Months Ended June 30, 2013
($ In Thousands)		 
Troubled Debt Restructurings  Number of Loans   Recorded
Investment (as of
period end)		   Number of Loans   Recorded
Investment (as of
period end)		 
                 
Residential Owner Occupied   3   $316    8   $752 
Residential Non Owner Occupied   0    -    1    194 
CRE Owner Occupied   3    758    4    782 
CRE Non Owner Occupied   1    1,374    1    1,374 
Agriculture Land   0    -    1    217 
Other CRE   1    32    1    32 
Commercial working capital or other   1    47    1    47 
Home Equity / Improvement   4    119    12    609 
Consumer Finance   1    11    3    14 
Total   14   $2,657    32   $4,021 

 

The loans described above increased the allowance for loan loss by $327,000 in the three month period ending June 30, 2013 and $355,000 in the six month period ending June 30, 2013.

 

Of the 2014 modifications, 11 were made TDRs due to the fact that the borrower has filed bankruptcy, 3 were made TDRs due to a rate reduction, 1 was made a TDR due to an interest only period, 8 were made TDRs due to extending the amortization, 2 were made TDRs due to a reduction in the payment, 5 were made TDRs due to advancing or renewing funds to a watchlist credit, 2 were made to term out line of credit, and 4 were made TDRs to refinance current debt for payment relief.

 

The following table presents loans by class modified as TDRs for which there was a payment default within twelve months following the modification during the three and six month periods ending June 30, 2014 and June 30, 2013:

 

   Three Months Ended June 30, 2014
($ In Thousands)		   Six Months Ended June 30, 2014
($ In Thousands)		 
Troubled Debt Restructurings
That Subsequently Defaulted		  Number of Loans   Recorded
Investment (as of
period end)		   Number of Loans   Recorded
Investment (as of
period end)		 
                 
Residential Owner Occupied   1   $67    1   $67 
Residential Non Owner Occupied   1    183    1    183 
CRE Owner Occupied   4    153    4    153 
CRE Non Owner Occupied   0    -    0    - 
Agriculture Land   0    -    0    - 
Other CRE   0    -    0    - 
Commercial working capital or other   3    387    3    387 
Home Equity / Improvement   0    -    0    - 
Consumer Finance   0    -    0    - 
Total   8   $790    9   $790 

 

The TDRs that subsequently defaulted described above decreased the allowance for loan losses by $2,000 for the three and six month period ended June 30, 2014.

 

-37-
 

 

A default for purposes of this disclosure is a TDR loan in which the borrower is 90 days contractually past due under the modified terms.

 

   Three Months Ended June 30, 2013
($ In Thousands)		   Six Months Ended June 30, 2013
($ In Thousands)		 
Troubled Debt Restructurings
That Subsequently Defaulted		  Number of Loans   Recorded
Investment (as of
period end)		   Number of Loans   Recorded
Investment (as of
period end)		 
                 
Residential Owner Occupied   4   $303    4   $303 
Residential Non Owner Occupied   1    77    1    77 
CRE Owner Occupied   1    169    2    837 
CRE Non Owner Occupied   1    212    1    212 
Agriculture Land   0    -    0    - 
Other CRE   0    -    0    - 
Commercial / Industrial   0    -    0    - 
Home Equity / Improvement   4    52    4    52 
Consumer Finance   0    -    0    - 
Total   11   $813    12   $1,481 

 

The TDRs that subsequently defaulted described above decreased the allowance for loan losses by $10,000 for the three month period ended June 30, 2013, and by $12,000 for the six month period ended June 30, 2013.

 

The terms of certain other loans were modified during the period ending June 30, 2014 that did not meet the definition of a TDR. The modification of these loans involved a modification of the terms of a loan to borrowers who were not experiencing financial difficulties. A total of 54 loans were modified under this definition during the three month period ended June 30, 2014 and a total of 75 loans were modified under this definition during the six month period ended June 30, 2014.

 

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed on the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification.

 

Credit Quality Indicators

 

Loans are categorized into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Loans are analyzed individually by classifying the loans as to credit risk. This analysis includes all non-homogenous loans, such as commercial and commercial real estate loans and certain homogenous mortgage, home equity and consumer loans. This analysis is performed on a quarterly basis. First Defiance uses the following definitions for risk ratings:

 

Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

 

-38-
 

 

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

 

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

 

Not Graded. Loans classified as not graded are generally smaller balance residential real estate, home equity and consumer installment loans which are originated primarily by using an automated underwriting system. These loans are monitored based on their delinquency status and are evaluated individually only if they are seriously delinquent.

 

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of June 30, 2014, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows (In Thousands):

 

Class  Pass   Special
Mention		   Substandard   Doubtful   Not
Graded		   Total 
                         
1-4 Family Owner Occupied  $4,229   $3   $1,905   $748   $129,047   $135,932 
1-4 Family Non Owner Occupied   51,624    1,721    5,016    -    6,006    64,367 
                               
Total 1-4 Family Real Estate   55,853    1,724    6,921    748    135,053    200,299 
                               
Multi-Family Residential Real Estate   149,083    228    890    -    939    151,140 
                               
CRE Owner Occupied   279,863    9,364    8,923    -    1,442    299,592 
CRE Non Owner Occupied   204,659    9,081    16,020    -    35    229,795 
Agriculture Land   81,931    2,020    1,147    -    -    85,098 
Other CRE   35,692    63    2,875    -    680    39,310 
                               
Total Commercial Real Estate   602,145    20,528    28,965    -    2,157    653,795 
                               
Construction   55,920    -    262    -    10,392    66,574 
                               
Commercial Working Capital   137,596    5,046    3,017    -    -    145,659 
Commercial Other   231,850    7,288    5,643    -    -    244,781 
                               
Total Commercial   369,446    12,334    8,660    -    -    390,440 
                               
Home Equity and Home Improvement   -    -    1,096    102    107,661    108,859 
Consumer Finance   -    -    90    -    15,696    15,786 
                               
Total Loans  $1,232,447   $34,814   $46,884   $850   $271,898   $1,586,893 

 

-39-
 

 

As of December 31, 2013, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows (In Thousands):

 

Class  Pass   Special
Mention		   Substandard   Doubtful   Not
Graded		   Total 
                         
1-4 Family Owner Occupied  $4,287   $18   $3,515   $-   $121,765   $129,585 
1-4 Family Non Owner Occupied
   51,660    2,894    5,699    -    6,359    66,612 
                               
Total 1-4 Family Real Estate   55,947    2,912    9,214    -    128,124    196,197 
                               
Multi-Family Residential Real Estate   145,407    875    1,888    -    964    149,134 
                               
CRE Owner Occupied   291,770    10,584    11,665    -    1,734    315,753 
CRE Non Owner Occupied   200,790    10,254    17,185    -    91    228,320 
Agriculture Land   80,418    578    1,051    -    -    82,047 
Other CRE   40,676    2,074    3,104    -    731    46,585 
                               
Total Commercial Real Estate   613,654    23,490    33,005    -    2,556    672,705 
                               
Construction   43,465    -    263    -    10,002    53,730 
                               
Commercial Working Capital   148,703    3,429    3,660    -    -    155,792 
Commercial Other   219,790    6,994    6,899    -    -    233,683 
                               
Total Commercial   368,493    10,423    10,559    -    -    389,475 
                               
Home Equity and Home Improvement   -    -    755    45    106,587    107,387 
Consumer Finance   -    -    31    -    16,860    16,891 
                               
Total Loans  $1,226,966   $37,700   $55,715   $45   $265,093   $1,585,519 

 

-40-
 

 

9. Mortgage Banking

 

Net revenues from the sales and servicing of mortgage loans consisted of the following:

 

   Three Months Ended
 June 30,		   Six Months Ended
 June 30,		 
   2014   2013   2014   2013 
   (In Thousands)   (In Thousands) 
Gain from sale of mortgage loans  $986   $1,890   $1,628   $4,066 
Mortgage loans servicing revenue (expense):                    
Mortgage loans servicing revenue   878    875    1,782    1,745 
Amortization of mortgage servicing rights   (368)   (634)   (660)   (1,323)
Mortgage servicing rights valuation adjustments   44    312    37    785 
    554    553    1,159    1,207 
                     
Net revenue from sale and servicing of mortgage loans  $1,540   $2,443   $2,787   $5,273 

 

The unpaid principal balance of residential mortgage loans serviced for third parties was $1.4 billion at June 30, 2014 and December 31, 2013.

 

Activity for capitalized mortgage servicing rights and the related valuation allowance follows for the three and six months ended June 30, 2014 and 2013:

 

   Three Months Ended
June 30,		   Six Months Ended
June 30,		 
   2014   2013   2014   2013 
   (In Thousands)   (In Thousands) 
Mortgage servicing assets:                    
Balance at beginning of period  $10,048   $10,194   $10,133   $10,121 
Loans sold, servicing retained   313    674    520    1,436 
Amortization   (368)   (634)   (660)   (1,323)
Carrying value before valuation allowance at end of period   9,993    10,234    9,993    10,234 
                     
Valuation allowance:                    
Balance at beginning of period   (1,034)   (1,815)   (1,027)   (2,288)
Impairment recovery (charges)   44    312    37    785 
Balance at end of period   (990)   (1,503)   (990)   (1,503)
Net carrying value of MSRs at end of period  $9,003   $8,731   $9,003   $8,731 
Fair value of MSRs at end of period  $9,584   $9,080   $9,584   $9,080 

 

Amortization of mortgage servicing rights is computed based on payments and payoffs of the related mortgage loans serviced. Estimates of future amortization expense are not easily estimable.

 

The Company established an accrual for estimated secondary market buy-back losses beginning in 2014. An accrual for secondary market buy-backs was established in the first and second quarters of 2014 totaling $184,000 for the first six months of 2014 which was partially offset by reversing $67,000 of accrued expenses in the first quarter of 2014 related to the Freddie Mac post-foreclosure review that began in the third quarter of 2013 and was reversed in 2014 with no losses resulting. This resulted in secondary market buy-back losses of $117,000 for the first six months of 2014 compared to $642,000 of expense for the same period in 2013.

 

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Included in the first six months of 2013 was an accrual for estimated secondary market buy-back losses of $581,000. These losses were accrued and expensed as of March 31, 2013 based on an estimated exposure to repurchase requests resulting from notifications received from Fannie Mae’s post-foreclosure review process during the first quarter of 2013.

 

10. Deposits

 

A summary of deposit balances is as follows:

 

   June 30,
2014		   December 31,
2013		 
   (In Thousands) 
Non-interest-bearing checking accounts  $355,268   $348,943 
Interest-bearing checking and money market accounts   717,506    715,939 
Savings accounts   200,626    185,121 
Retail certificates of deposit less than $100,000   299,288    313,335 
Retail certificates of deposit greater than $100,000   169,124    172,454 
Brokered or national certificates of deposit   -    - 
Total  $1,741,812   $1,735,792 

 

11. Borrowings

 

First Defiance’s debt, FHLB advances and junior subordinated debentures owed to unconsolidated subsidiary trusts are comprised of the following:

 

   June 30,
2014		   December 31,
2013		 
   (In Thousands) 
FHLB Advances:          
Putable advances   12,000   $12,000 
Amortizable mortgage advances   10,034    10,520 
Total  $22,034   $22,520 
           
Junior subordinated debentures owed to unconsolidated subsidiary trusts  $36,083   $36,083 

 

The putable advances can be put back to the Company at the option of the FHLB on a quarterly basis. At June 30, 2014, $12.0 million of the putable advances with a weighted average rate of 2.72% were not yet callable by the FHLB. The call dates for these advances range from July 14, 2014 to September 12, 2014 and the maturity dates range from January 14, 2015 to March 12, 2018. Putable advances are callable at the option of the FHLB on a quarterly basis.

 

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In March 2007, the Company sponsored an affiliated trust, First Defiance Statutory Trust II (“Trust Affiliate II”) that issued $15 million of Guaranteed Capital Trust Securities (“Trust Preferred Securities”). In connection with this transaction, the Company issued $15.5 million of Junior Subordinated Deferrable Interest Debentures (“Subordinated Debentures”) to Trust Affiliate II. The Company formed Trust Affiliate II for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Subordinated Debentures held by Trust Affiliate II are the sole assets of Trust Affiliate II. The Company is not considered the primary beneficiary of Trust Affiliate II (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the Trust Preferred Securities issued by Trust Affiliate II are payable quarterly at a fixed rate equal to 6.441% for the first five years and a floating interest rate based on three-month LIBOR plus 1.5%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate II was 1.73% as of June 30, 2014 and 1.75% as of December 31, 2013.

 

The Company also sponsored an affiliated trust, First Defiance Statutory Trust I (“Trust Affiliate I”), that issued $20 million of Trust Preferred Securities in 2005. In connection with this transaction, the Company issued $20.6 million of Subordinated Debentures to Trust Affiliate I. Trust Affiliate I was formed for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Junior Debentures held by Trust Affiliate I are the sole assets of Trust Affiliate I. The Company is not considered the primary beneficiary of Trust Affiliate I (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the Trust Preferred Securities issued by Trust Affiliate I are payable quarterly at a variable rate equal to the three-month LIBOR rate plus 1.38%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate I was 1.61% and 1.63% on June 30, 2014 and December 31, 2013, respectively.

 

The Trust Preferred Securities issued by Trust Affiliate I and Trust Affiliate II are subject to mandatory redemption, in whole or part, upon repayment of the Subordinated Debentures. The Company has entered into agreements that fully and unconditionally guarantee the Trust Preferred Securities subject to the terms of the guarantees. The Trust Preferred Securities and Subordinated Debentures issued by Trust Affiliate I mature on December 15, 2035 but may be redeemed by the issuer at par after October 28, 2010. The Trust Preferred Securities issued by Trust Affiliate II mature on June 15, 2037, but may be redeemed at the Company’s option at any time on or after June 15, 2012, or at any time upon certain events.

 

Interest on both issues of trust preferred securities may be deferred for a period of up to five years at the option of the issuer.

 

12. Commitments, Guarantees and Contingent Liabilities

 

Loan commitments are made to accommodate the financial needs of First Federal’s customers; however, there are no long-term, fixed-rate loan commitments that result in market risk. Standby letters of credit commit the Company to make payments on behalf of customers when certain specified future events occur. They primarily are issued to facilitate customers’ trade transactions.

 

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Both arrangements 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 loans and unused lines of credit) and standby letters of credit outstanding as of the periods stated below were as follows (In Thousands):

 

   June 30, 2014   December 31, 2013 
   Fixed Rate   Variable Rate   Fixed Rate   Variable Rate 
Commitments to make loans  $47,963   $94,050   $57,914   $59,632 
Unused lines of credit   13,987    275,892    18,048    257,939 
Standby letters of credit   -    17,800    -    17,680 
Total  $61,950   $387,742   $75,962   $335,251 

 

Commitments to make loans are generally made for periods of 60 days or less.

 

In addition to the above commitments, First Defiance had commitments to sell $17.8 million and $12.1 million of loans to Freddie Mac, Fannie Mae, Federal Home Loan Bank of Cincinnati or BB&T Mortgage at June 30, 2014 and December 31, 2013, respectively.

 

13. Income Taxes

 

The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax in the state of Indiana. The Company is no longer subject to examination by taxing authorities for years before 2009. The Company currently operates primarily in the states of Ohio and Michigan, which tax financial institutions based on their equity rather than their income.

 

14. Derivative Financial Instruments

 

Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated in hedge relationships. First Federal had approximately $6.6 million and $7.5 million of interest rate lock commitments at June 30, 2014 and December 31, 2013, respectively. There were $17.9 million and $12.1 million of forward commitments for the future delivery of residential mortgage loans at June 30, 2014 and December 31, 2013, respectively.

 

The fair value of these mortgage banking derivatives are reflected by a derivative asset. The table below provides data about the carrying values of these derivative instruments:

 

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   June 30, 2014   December 31, 2013 
   Assets   (Liabilities)       Assets   (Liabilities)     
           Derivative           Derivative 
   Carrying   Carrying   Net Carrying   Carrying   Carrying   Net Carrying 
   Value   Value   Value   Value   Value   Value 
   (In Thousands) 
Derivatives not designated as hedging instruments                              
Mortgage Banking                              
Derivatives  $580   $(107)  $473   $295   $-   $295 

 

The table below provides data about the amount of gains and losses recognized in income on derivative instruments not designated as hedging instruments:

 

   Three Months Ended 
June 30,		   Six Months Ended
June 30,		 
   2014   2013   2014   2013 
   (In Thousands)   (In Thousands) 
Derivatives not designated as hedging instruments                    
                     
Mortgage Banking Derivatives – Gain (Loss)  $128  $(79)  $178  $(240)

 

The above amounts are included in mortgage banking income with gain on sale of mortgage loans. During the first quarter of 2014, management determined that a group of loans, previously classified as held for sale, were no longer sellable and transferred such loans back into the portfolio. As a result, a $5,000 loss related to a fair value adjustment on those loans was recorded in the second quarter of 2014.

 

15. Other Comprehensive Income (Loss)

 

The before and after tax amounts allocated to each component of other comprehensive income (loss) are presented in the table below. Reclassification adjustments related to securities available for sale are included in gains on sale or call of securities in the accompanying consolidated condensed statements of income.

 

   Before Tax
Amount		   Tax Expense
(Benefit)		   Net of Tax
Amount		 
Three months ended June 30, 2014:               
Securities available for sale and transferred securities:               
Change in net unrealized gain (loss) during the period  $2,743   $936   $1,807 
Reclassification adjustment for net gains included in net income   (471)   (141)   (330)
Total other comprehensive loss  $2,272   $795   $1,477 

 

   Before Tax
Amount		   Tax Expense
(Benefit)		   Net of Tax
Amount		 
Six months ended June 30, 2014:               
Securities available for sale and transferred securities:               
Change in net unrealized gain (loss) during the period  $4,465   $1,538   $2,927 
Reclassification adjustment for net gains included in net income   (471)   (141)   (330)
Total other comprehensive loss  $3,994   $1,397   $2,597 

 

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   Before Tax
Amount		   Tax Expense
(Benefit)		   Net of Tax
Amount		 
Three months ended June 30, 2013:               
Securities available for sale and transferred securities:               
Change in net unrealized gain/loss during the period  $(5,500)  $(1,927)  $(3,573)
Reclassification adjustment for net gains included in net income   (44)   (13)   (31)
Total other comprehensive loss  $(5,544)  $(1,940)  $(3,604)

 

   Before Tax
Amount		   Tax Expense
(Benefit)		   Net of Tax
Amount		 
Six months ended June 30, 2013:               
Securities available for sale and transferred securities:               
Change in net unrealized gain/loss during the period  $(6,164)  $(2,162)  $(4,002)
Reclassification adjustment for net gains included in net income   (97)   (29)   (68)
Total other comprehensive loss  $(6,261)  $(2,191)  $(4,070)

 

Activity in accumulated other comprehensive income (loss), net of tax, was as follows:

 

           Accumulated 
   Securities   Post-   Other 
   Available   retirement   Comprehensive 
   For Sale   Benefit   Income 
Balance January 1, 2014  $906   $(361)  $545 
Other comprehensive loss before reclassifications   2,927    -    2,927 
Amounts reclassified from accumulated other comprehensive loss   (330)   -    (330)
                
Net other comprehensive loss during period   2,597    -    2,597 
                
Balance June 30, 2014  $3,503   $(361)  $3,142 
                
Balance January 1, 2013  $4,851   $(577)  $4,274 
Other comprehensive loss before reclassifications   (4,002)   -    (4,002)
Amounts reclassified from accumulated other comprehensive loss   (68)   -    (68)
                
Net other comprehensive loss during period   (4,070)   -    (4,070)
                
Balance June 30, 2013  $781   $(577)  $204 

 

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Information

 

Certain statements contained in this quarterly report 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 21E of the Securities Exchange 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. The Company assumes no obligation to update any forward-looking statements.

 

General

 

First Defiance is a unitary thrift holding company that conducts business through its subsidiaries, First Federal, First Insurance and First Defiance Risk Management. First Federal is a federally chartered stock savings bank that provides financial services to communities through 32 full service banking centers in communities based in northwest Ohio, northeast Indiana, and southeastern Michigan. 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 and wealth management services through its extensive branch network. First Insurance sells a variety of property and casualty, group health and life, and individual health and life insurance products. Insurance products are sold through First Insurance’s offices in Defiance, Bryan, Bowling Green, Maumee and Oregon, Ohio areas. First Defiance Risk Management is a wholly-owned insurance company subsidiary of the Company that insures the Company and its subsidiaries against certain risks unique to the operations of the Company and for which insurance may not be currently available or economically feasible in today’s insurance marketplace. First Defiance Risk Management pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. First Defiance Risk Management was incorporated on December 20, 2012.

 

Impact of Legislation - Over the last several years, Congress and the U.S. Department of the Treasury have enacted legislation and taken actions to address the disruptions in the financial system, declines in the housing market, and the overall regulation of financial institutions and the financial system. In this regard, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), includes provisions affecting large and small financial institutions alike, including several provisions that profoundly affect the regulation of community banks, thrifts, and bank and thrift holding companies, such as First Defiance. Also, the Dodd-Frank Act abolished the Office of Thrift Supervision effective July 21, 2011 and transferred its functions to the Office of the Comptroller of the Currency (“OCC”), FDIC, and Federal Reserve. The Dodd-Frank Act relaxed rules regarding interstate branching, allows financial institutions to pay interest on business checking accounts, changed the scope of federal deposit insurance coverage, imposed new capital requirements on bank and thrift holding companies, and imposed limits on debit card interchange fees charged by issuer banks (commonly known as the Durbin Amendment).

 

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The Dodd-Frank Act also established the Consumer Financial Protection Bureau (“CFPB”) as an independent bureau within the Federal Reserve, which has broad authority to regulate consumer financial products and services and entities offering such products and services, including banks. Many of the consumer financial protection functions formerly assigned to the federal banking and other designated agencies are now performed by the CFPB. The CFPB has broad rulemaking authority over providers of credit, savings, and payment services and products. In this regard, the CFPB has the authority to implement regulations under federal consumer protection laws and enforce those laws against, and examine, financial institutions. State officials also will be authorized to enforce consumer protection rules issued by the CFPB. The CFPB also is authorized to collect fines and provide consumer restitution in the event of violations, engage in consumer financial education, track consumer complaints, request data, and promote the availability of financial services to underserved consumers and communities. The CFPB also is directed to prevent “unfair, deceptive or abusive practices” and ensure that all consumers have access to markets for consumer financial products and services and that such markets are fair, transparent, and competitive. Although the CFPB has begun to implement its regulatory, supervisory, examination, and enforcement authority, there continues to be significant uncertainty as to how the agency’s strategies and priorities will impact First Defiance.

 

The CFPB has indicated that mortgage lending is an area of supervisory focus and that it will concentrate its examination and rulemaking efforts on the variety of mortgage-related topics required under the Dodd-Frank Act, including steering consumers to less-favorable products, discrimination, abusive or unfair lending practices, predatory lending, origination disclosures, minimum mortgage underwriting standards, mortgage loan originator compensation and servicing practices. The CFPB recently published several final regulations impacting the mortgage industry, including rules related to ability-to-pay, mortgage servicing, and mortgage loan originator compensation. The ability-to-repay rule makes lenders liable if they fail to assess ability to repay under a prescribed test, but also creates a safe harbor for so called “qualified mortgages.” The “qualified mortgages” standards include a tiered cap structure that places limits on the total amount of certain fees that can be charged on a loan, a 43% cap on debt-to-income (i.e., total monthly payments on debt to monthly gross income), exclusion of interest-only products, and other requirements. The 43% debt-to-income cap does not apply for the first seven years the rule is in effect for loans that are eligible for sale to Fannie Mae or Freddie Mac or eligible for government guarantee through the FHA or the Veterans Administration. Failure to comply with the ability-to-repay rule may result in possible CFPB enforcement action and special statutory damages plus actual, class action, and attorney fees damages, all of which a borrower may claim in defense of a foreclosure action at any time. First Defiance’s management team is currently assessing the impact of these requirements on our mortgage lending business.

 

In addition, the Federal Reserve and other federal bank regulatory agencies have issued a proposed rule under the Dodd-Frank Act that would exempt “qualified residential mortgages” from the securitization risk retention requirements of the Dodd-Frank Act. The final definition of what constitutes a “qualified residential mortgage” may impact the pricing and depth of the secondary market into which the Company may sell mortgages it originates. At this time, First Defiance cannot predict the content of the final CFPB and other federal agency regulations or the impact they might have on First Defiance’s financial results. The CFPB’s authority over mortgage lending, and its authority to change regulations adopted in the past by other regulators, or to rescind or ignore past regulatory guidance, could increase First Defiance’s compliance costs and litigation exposure.

 

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First Defiance’s management team continues to actively monitor the implementation of the Dodd-Frank Act and the regulations promulgated thereunder and assess its probable impact on the business, financial condition, and results of operations of First Defiance. However, the ultimate effect of the Dodd-Frank Act on the financial services industry in general, and First Defiance in particular, continues to be uncertain.

 

New Capital Rules - On July 2, 2013, the Federal Reserve approved final rules that substantially amend the regulatory risk-based capital rules applicable to First Defiance and First Federal. The FDIC and the OCC have subsequently approved these rules. The final rules were adopted following the issuance of proposed rules by the Federal Reserve in June 2012, and implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act.

 

 The rules include new risk-based capital and leverage ratios, which will be phased in from 2015 to 2019, and will refine the definition of what constitutes “capital” for purposes of calculating those ratios. The new minimum capital level requirements applicable to First Defiance and First Federal under the final rules are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The final rules also establish a “capital conservation buffer” above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. The capital conservation buffer will be phased-in over four years beginning on January 1, 2016, as follows: the maximum buffer will be 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. This will result in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, an institution is subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

 

The final rules implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses, as well as certain instruments that will no longer qualify as Tier 1 capital, some of which will be phased out over time. However, the final rules provide that small depository institution holding companies with less than $15 billion in total assets as of December 31, 2009 (which includes First Defiance) will be able to permanently include non-qualifying instruments that were issued and included in Tier 1 or Tier 2 capital prior to May 19, 2010 in additional Tier 1 or Tier 2 capital until they redeem such instruments or until the instruments mature.

 

The final rules also contain revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including First Federal, if their capital levels begin to show signs of weakness. These revisions take effect January 1, 2015. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions will be required to meet the following increased capital level requirements in order to qualify as “well capitalized”: (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%).

 

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The final rules set forth certain changes for the calculation of risk-weighted assets, which First Federal will be required to utilize beginning January 1, 2015. The standardized approach final rule utilizes an increased number of credit risk exposure categories and risk weights, and also addresses: (i) an alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (ii) revisions to recognition of credit risk mitigation; (iii) rules for risk weighting of equity exposures and past due loans; (iv) revised capital treatment for derivatives and repo-style transactions; and (v) disclosure requirements for top-tier banking organizations with $50 billion or more in total assets that are not subject to the “advanced approaches rules” that apply to banks with greater than $250 billion in consolidated assets.

 

Based on our current capital composition and levels, management believes it will be in compliance with the requirements as set forth in the final rules.

 

Business Strategy - First Defiance’s primary objective is to be a high performing community banking organization, well regarded in its market areas. First Defiance accomplishes this through emphasis on local decision making and empowering its employees with tools and knowledge to serve its customers’ needs. First Defiance believes in a “Customer First” philosophy that is strengthened by its Trusted Advisor initiative. First Defiance also has a tagline of “Better Together” as an indication of its commitment to local, responsive, personalized service. First Defiance believes this strategy results in greater customer loyalty and profitability through core relationships. First Defiance is focused on diversification of revenue sources and increased market penetration in areas where the growth potential exists for a balance between acquisition and organic growth. The primary elements of First Defiance’s business strategy are commercial banking, consumer banking, including the origination and sale of single family residential loans, enhancement of fee income, wealth management and insurance sales, each united by a strong customer service culture throughout the organization.

 

Commercial and Commercial Real Estate Lending - Commercial and commercial real estate lending have been an ongoing focus and a major component of First Federal’s success. First Federal provides primarily commercial real estate and commercial business loans with an emphasis on owner occupied commercial real estate and commercial business lending with a focus on the deposit balances that accompany these relationships. First Federal’s client base tends to be small to middle market customers with annual gross revenues generally between $1 million and $50 million. First Federal’s focus is also on securing multiple guarantors in addition to collateral where possible. These customers require First Federal to have a high degree of knowledge and understanding of their business in order to provide them with solutions to their financial needs. First Federal’s Customer First philosophy and culture complements this need of its clients. First Federal believes this personal service model differentiates First Federal from its competitors, particularly the larger regional institutions. First Federal offers a wide variety of products to support commercial clients including remote deposit capture and other cash management services. First Federal also believes that the small business customer is a strong market for First Federal. First Federal participates in many of the Small Business Administration lending programs and implemented a new program in 2014 targeting the small business customer. Maintaining a diversified portfolio with an emphasis on monitoring industry concentrations and reacting to changes in the credit characteristics of industries is an ongoing focus.

 

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Consumer Banking - First Federal offers customers a full range of deposit and investment products including demand, checking, money market, certificates of deposits, Certificate of Deposit Account Registry Service (“CDARS”) and savings accounts. First Federal offers a full range of investment products through the wealth management department and a wide variety of consumer loan products, including residential mortgage loans, home equity loans and installment loans. First Federal also offers online banking services, which include mobile banking, online bill pay along with debit cards.

 

Fee Income Development - Generation of fee income and the diversification of revenue sources are accomplished through the mortgage banking operation, insurance subsidiary and the wealth management department as First Defiance seeks to reduce reliance on retail transaction fee income.

 

Deposit Growth - First Federal’s focus has been to grow core deposits with an emphasis on total relationship banking with both our retail and commercial customers. First Federal has initiated a pricing strategy that considers the whole relationship of the customer. First Federal will continue to focus on increasing its market share in the communities it serves by providing quality products with extraordinary customer service, business development strategies and branch expansion. First Federal will look to grow its footprint in areas believed to further complement its overall market share and complement its strategy of being a high performing community bank.

 

Asset Quality - Maintaining a strong credit culture is of the utmost importance to First Federal. First Federal has maintained a strong credit approval and review process that has allowed the Company to maintain a credit quality standard that balances the return with the risks of industry concentrations and loan types. First Federal is primarily a collateral lender with an emphasis on cash flow performance, while obtaining additional support from personal guarantees and secondary sources of repayment. First Federal has directed its attention on loan types and markets that it knows well and in which it has historically been successful. First Federal strives to have loan relationships that are well diversified in both size and industry, and monitor the overall trends in the portfolio to maintain its industry and loan type concentration targets. First Federal maintains a problem loan remediation process that focuses on detection and resolution. First Federal maintains a strong process of internal control that subjects the loan portfolio to periodic internal reviews as well as independent third party loan review.

 

Expansion Opportunities - First Defiance believes it is well positioned to take advantage of acquisitions or other business opportunities in its market areas. First Defiance believes it has a track record of successfully accomplishing both acquisitions and de novo branching in its market area. This track record puts the Company in a solid position to expand its business. First Defiance will consider expansion opportunities, including bank and insurance acquisitions, de novo branching, with a particular focus on its primary geographic market area, as well as loan production offices.

 

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Investments - 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 FASB ASC Topic 320.

 

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 $330,000 at June 30, 2014. 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 $232.3 million at June 30, 2014. The available-for-sale portfolio consists of obligations of U.S. Government corporations and agencies ($5.0 million), certain municipal obligations ($89.7 million), CMOs ($79.5 million), REMICs ($2.0 million), corporate bonds ($7.0 million), and mortgage backed securities ($49.2 million).

 

In accordance with 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 amount of the impairment related to other factors is recognized in other comprehensive income.

 

Lending - In order to properly assess the collateral dependent loans included in its loan portfolio, the Company has established policies regarding the monitoring of the collateral underlying such loans. The Company requires an appraisal that is less than one year old for all new collateral dependent real estate loans, and all renewed collateral dependent real estate loans where significant new money is extended. The appraisal process is handled by the Credit Department, which selects the appraiser and orders the appraisal. First Defiance’s loan policy prohibits the account officer from talking or communicating with the appraiser to insure that the appraiser is not influenced by the account officer in any way in making their determination of value.

 

First Federal generally does not require updated appraisals for performing loans unless significant new money is requested by the borrower.

 

When a collateral dependent loan is downgraded to classified status, First Federal reviews the most current appraisal on file and if necessary, based on First Federal’s assessment of the appraisal, such as age, market, etc., First Federal will discount this amount to a more appropriate current value based on inputs from lenders and realtors. This amount may then be discounted further by First Federal’s estimation of the carrying and selling costs. In most instances, if the appraisal is more than twelve to fifteen months old, we may require a new appraisal. Finally, First Federal assesses whether there is any collateral short fall, taking into consideration guarantor support and liquidity, and determines if a charge off is necessary.

 

When a collateral dependent loan moves to non-performing status, First Federal generally gets a new third party appraisal and charges the loan down appropriately based upon the new appraisal and an estimate of costs to liquidate the collateral. All properties that are moved into the Other Real Estate Owned (“OREO”) category are supported by current appraisals, and the OREO is carried at the lower of cost or fair value, which is determined based on appraised value less First Federal’s estimate of the liquidation costs.

 

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First Federal does not adjust any appraisals upward without written documentation of this valuation change from the appraiser. When setting reserves and charge offs on classified loans, appraisal values may be discounted downward based upon First Federal’s experience with liquidating similar properties.

 

All loans over 90 days past due and/or on non-accrual are classified as non-performing loans. Non-performing status automatically occurs in the month in which the 90 day delinquency occurs.

 

As stated above, once a collateral dependent loan is identified as non-performing, First Federal generally gets an appraisal.

 

Appraisals are received within approximately 60 days after they are requested. The First Federal Loan Loss Reserve Committee reviews the amount of each new appraisal and makes any necessary charge off decisions at its meeting prior to the end of each quarter.

 

Any partially charged-off collateral dependent loans are considered non-performing, and as such, would need to show an extended period of time with satisfactory payment performance as well as cash flow coverage capability supported by current financial statements before First Federal will consider an upgrade to performing status. First Federal may consider moving the loan to accruing status after approximately six months of satisfactory payment performance.

 

For loans where First Federal determines that an updated appraisal is not necessary, other means are used to verify the value of the real estate, such as recent sales of similar properties on which First Federal had loans as well as calls to appraisers, brokers, realtors and investors. First Federal monitors and tracks its loan to value quarterly to determine accuracy and any necessary charge offs. Based on these results, changes may occur in the processes used.

 

Loan modifications constitute a Troubled Debt Restructuring (“TDR”) if First Federal for economic or legal reasons related to the borrower’s financial difficulties grants a concession to the borrower that it would not otherwise consider. For loans that are considered TDRs, First Federal either computes the present value of expected future cash flows discounted at the original loan’s effective interest rate or it may measure impairment based on the fair value of the collateral. For those loans measured for impairment utilizing the present value of future cash flows method, any discount is carried as a reserve in the allowance for loan and lease losses. For those loans measured for impairment utilizing the fair value of the collateral, any shortfall is charged off.

 

Earnings - 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, FHLB advances, and other borrowings. The Company’s non-interest income is mainly derived from service fees and other charges, mortgage banking income, 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 insurance premiums, and miscellaneous other expenses, as well as federal income tax expense.

 

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Changes in Financial Condition

 

At June 30, 2014, First Defiance's total assets, deposits and stockholders' equity amounted to $2.15 billion, $1.74 billion and $276.4 million, respectively, compared to $2.14 billion, $1.74 billion and $272.1 million, respectively, at December 31, 2013.

 

Net loans receivable (excluding loans held for sale) increased $1.9 million to $1.56 billion. The variance in loans receivable between June 30, 2014 and December 31, 2013 includes increases in home equity and improvement loans (up $1.5 million), one to four family residential real estate loans (up $4.2 million), construction loans (up $22.4 million) and commercial loans (up $1.8 million) while the remaining categories decreased, including commercial real estate loans (down $17.7 million) and consumer loans (down $1.1 million).

 

The investment securities portfolio increased $34.1 million to $232.6 million at June 30, 2014 from $198.6 million at December 31, 2013. The increase is the result of $43.6 million of securities being purchased during the first six months of 2014, somewhat offset by $2.4 million of securities maturing or being called in the period, principal pay downs of $7.6 million in CMOs and mortgage-backed securities, and $3.8 million from five securities being sold. There was an unrealized gain in the investment portfolio of $5.4 million at June 30, 2014 compared to an unrealized gain of $1.4 million at December 31, 2013.

 

Deposits increased from $1.736 billion at December 31, 2013 to $1.742 billion at June 30, 2014. Non-interest bearing demand deposits increased $6.3 million to $355.3 million, savings accounts increased $15.5 million to $200.6 million and interest-bearing demand deposits and money market accounts increased $1.6 million to $717.5 million. These increases were partially offset by a decrease in retail time deposits accounts of $17.4 million to $468.4 million.

 

Stockholders’ equity increased from $272.1 million at December 31, 2013 to $276.4 million at June 30, 2014. The increase in stockholders’ equity was the result of recording net income of $10.9 million and an increase in other comprehensive income of $2.6 million. These increases were partially offset by $2.9 million of common stock dividends being paid in the first six months of 2014 and $6.7 million of common stock repurchases.

 

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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. The table reports interest income from tax-exempt loans and investment on a tax-equivalent basis. All average balances are based upon daily balances (dollars in thousands).

 

   Three Months Ended June 30, 
   2014   2013 
   Average       Yield/   Average       Yield/ 
   Balance   Interest (1)   Rate (2)   Balance   Interest (1)   Rate (2) 
Interest-earning assets:                              
Loans receivable  $1,551,799   $16,918    4.37%  $1,520,708   $17,064    4.50%
Securities   217,848    2,015    3.79    195,942    1,800    3.82 
Interest bearing deposits   168,991    118    0.28    89,116    72    0.32 
FHLB stock   13,802    170    4.94    19,964    207    4.16 
Total interest-earning assets   1,952,440    19,221    3.96    1,828,730    19,143    4.22 
Non-interest-earning assets   213,046              204,977           
Total assets  $2,165,486             $2,030,707           
                               
Interest-bearing liabilities:                              
Deposits  $1,407,795   $1,327    0.38%  $1,343,378   $1,511    0.45%
FHLB advances   22,116    133    2.41    14,443    92    2.55 
Subordinated debentures   36,132    146    1.62    36,136    150    1.66 
Notes payable   51,478    39    0.30    49,728    61    0.49 
Total interest-bearing liabilities   1,517,521    1,645    0.43    1,443,985    1,814    0.50 
Non-interest bearing deposits   348,303    -         301,099    -      
Total including non-interest bearing demand deposits   1,865,824    1,645    0.35    1,745,084    1,814    0.42 
Other non-interest-bearing liabilities   23,172              21,330           
Total liabilities   1,888,996              1,766,414           
Stockholders' equity   276,490              264,293           
Total liabilities and stockholders' equity  $2,165,486             $2,030,707           
Net interest income; interest rate spread       $17,576    3.53%       $17,329    3.72%
Net interest margin (3)             3.62%             3.82%
Average interest-earning assets to average interest-bearing liabilities             129%             126%

 

 

(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.

 

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   Six Months Ended June 30, 
   2014   2013 
   Average       Yield/   Average       Yield/ 
   Balance   Interest (1)   Rate (2)   Balance   Interest (1)   Rate (2) 
Interest-earning assets:                              
Loans receivable  $1,548,351   $33,590    4.37%  $1,510,465   $33,878    4.50%
Securities   210,061    3,947    3.88    196,257    3,594    3.81 
Interest bearing deposits   170,829    219    0.26    97,724    130    0.27 
FHLB stock   15,552    365    4.73    19,659    426    4.35 
Total interest-earning assets   1,944,793    38,121    3.95    1,824,105    38,028    4.18 
Non-interest-earning assets   211,134              205,202           
Total assets  $2,155,927             $2,029,307           
                               
Interest-bearing liabilities:                              
Deposits  $1,403,873   $2,685    0.39%  $1,350,112   $3,158    0.47%
FHLB advances   22,240    266    2.41    13,616    182    2.68 
Subordinated debentures   36,133    292    1.63    36,136    302    1.68 
Notes payable   52,033    80    0.31    48,062    121    0.50 
Total interest-bearing liabilities   1,514,279    3,323    0.44    1,447,926    3,763    0.52 
Non-interest bearing deposits   344,795    -         297,662    -      
Total including non-interest bearing demand deposits   1,859,074    3,323    0.36    1,745,588    3,763    0.43 
Other non-interest-bearing liabilities   21,735              21,760           
Total liabilities   1,880,809              1,767,348           
Stockholders' equity   275,118              261,959           
Total liabilities and stock- holders' equity  $2,155,927             $2,029,307           
Net interest income; interest rate spread       $34,798    3.51%       $34,265    3.66%
Net interest margin (3)             3.62%             3.78%
Average interest-earning assets to average interest-bearing liabilities             128%             126%

 

 

(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.

 

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Results of Operations

 

Three Months Ended June 30, 2014 and 2013

 

On a consolidated basis, First Defiance’s net income for the quarter ended June 30, 2014 was $5.7 million compared to net income of $6.1 million for the comparable period in 2013. On a per share basis, basic and diluted earnings per common share for the three months ended June 30, 2014 were $0.59 and $0.57, respectively, compared to basic and diluted earnings per common share of $0.63 and $0.60, respectively, for the quarter ended June 30, 2013.

 

Net Interest Income

 

First Defiance’s net interest income is determined by its interest rate spread (i.e. the difference between the yields on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.

 

Net interest income was $17.1 million for the quarter ended June 30, 2014, up from $16.9 million for the same period in 2013. The tax-equivalent net interest margin was 3.62% for the quarter ended June 30, 2014, down from 3.82% for the same period in 2012. The reduction in margin between the 2013 and 2014 second quarters was due to a reduction in interest-earning asset yields, which decreased to 3.96% for the quarter ended June 30, 2014, down 26 basis points from 4.22% for the same period in 2013. This was partially offset by the cost of interest-bearing liabilities between the two periods decreasing 7 basis points to 0.35% in the second quarter of 2014 from 0.42% in the same period in 2013. Operating at a high level of liquidity along with lower loan yields has impacted the net interest margin negatively in the second quarter of 2014. Management continues to analyze and pursue opportunities to maintain its margin, as well as alternatives to minimize the impact of the sustained low rate environment.

 

Total interest income remained flat at $18.7 million for the quarters ended June 30, 2014 and June 30, 2013. An increase in the investment portfolio was partially offset by a decrease in loan interest income caused by a drop in yields, which declined 13 basis points to 4.37% at June 30, 2014. Interest income from investments increased to $1.6 million for the quarter ended June 30, 2014 compared to $1.4 million for the same period in 2013, while income from loans decreased to $16.9 million for the quarter ended June 30, 2014 compared to $17.0 million for the same period in 2013.

 

Interest expense decreased by $169,000 in the second quarter of 2014 compared to the same period in 2013, to $1.6 million from $1.8 million. This decrease was due to a 7 basis point decline in the average cost of interest-bearing liabilities in the second quarter of 2014 from the continued low rate environment resulting in slight decreases in rates on all the interest-bearing liability categories. Interest expense related to interest-bearing deposits was $1.3 million in the second quarter of 2014 compared to $1.5 million for the same period in 2013. Interest expense recognized by the Company related to subordinated debentures was $146,000 in the second quarter of 2014 compared to $150,000 for the same period in 2013. Expenses on FHLB advances and securities sold under repurchase agreements were $133,000 and $39,000 respectively in the second quarter of 2014 compared to $92,000 and $61,000 respectively for the same period in 2013.

 

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Allowance for Loan Losses

 

The allowance for loan losses represents management’s assessment of the estimated probable credit losses in the loan portfolio at each balance sheet date. Management analyzes the adequacy of the allowance for loan losses regularly through reviews of the loan portfolio. Consideration is given to economic conditions, changes in interest rates and the effect of such changes on collateral values and borrower’s ability to pay, changes in the composition of the loan portfolio and trends in past due and non-performing loan balances. The allowance for loan losses is a material estimate that is susceptible to significant fluctuation and is established through a provision for loan losses based on management’s evaluation of the inherent risk in the loan portfolio. In addition to extensive in-house loan monitoring procedures, the Company utilizes an outside party to conduct an independent loan review of all commercial loan and commercial real estate loan relationships that exceed $5.0 million of aggregate exposure and all watchlist relationships that exceed $500,000 of aggregate exposure over a twelve month period. Management utilizes the results of this outside loan review to assess the effectiveness of its internal loan grading system as well as to assist in the assessment of the overall adequacy of the allowance for loan losses associated with these types of loans.

 

The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable credit losses within the existing loan portfolio in the normal course of business. The allowance for loan loss is made up of two basic components. The first component is the specific allowance in which the Company sets aside reserves based on the analysis of individual credits that are cash flow dependent, yet there is a discount between the present value of the future cash flows and the carrying value. This was $1.4 million at June 30, 2014. The second component is the general reserve. The general reserve is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolios based on quantitative and qualitative factors. Due to the uncertainty of risks in the loan portfolio, the Company’s judgment on the amount of the allowance necessary to absorb loans losses is approximate.

 

Due to regulatory guidance, the Company no longer carries specific reserves on collateral dependent loans, and instead charges off any shortfall. First Federal analyzes all loans on its classified and special mention lists at least quarterly and makes judgments about the risk of loss based on the cash flow of the borrower, the value of any collateral and the financial strength of any guarantor in determining the amount of impairment of individual loans and the charge off to be taken.

 

For purposes of the general reserve analysis, the loan portfolio is stratified into nine different loan pools based on loan type and by market to allocate historic loss experience. The loss experience factor applied to the non-impaired loan portfolio was based upon historical losses of the most recent rolling twelve quarters ending June 30, 2014.

 

The stratification of the loan portfolio resulted in a quantitative general allowance of $9.4 million at June 30, 2014 compared to $11.2 million at December 31, 2013. The decrease in the quantitative allowance was due to a decrease in the historical loss factors relating to commercial, commercial real estate, and residential loans.

 

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In addition to the quantitative analysis, a qualitative analysis is performed each quarter to provide additional general reserves on the non-impaired loan portfolio for various factors. The overall qualitative factors are based on nine sub-factors. The nine sub-factors have been aggregated into three qualitative factors: economic, environment and risk.

 

ECONOMIC

1)Changes in international, national and local economic business conditions and developments, including the condition of various market segments.
2)Changes in the value of underlying collateral for collateral dependent loans.

 

ENVIRONMENT

3)Changes in the nature and volume in the loan portfolio.
4)The existence and effect of any concentrations of credit and changes in the level of such concentrations.
5)Changes in lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices.
6)Changes in the quality and breadth of the loan review process.
7)Changes in the experience, ability and depth of lending management and staff.

 

RISK

8)Changes in the trends of the volume and severity of delinquent and classified loans, and changes in the volume of non-accrual loans, trouble debt restructuring, and other loan modifications.
9)Changes in the political and regulatory environment.

 

The qualitative analysis at June 30, 2014 indicated a general reserve of $13.9 million compared with $12.3 million at December 31, 2013. Management reviewed the overall economic, environmental and risk factors and determined that it was appropriate to increase and/or decrease these sub-factors. The economic factors for commercial, commercial real estate and residential loans were decreased primarily due to the results of three items: a regional and national economy rebounding from a decline in the first quarter, distinct improvement in unemployment rates in the Northwest Ohio and adjoining market counties in Indiana and Michigan both versus the first quarter of 2014 and for the same period in 2013 and no significant indication of continued declines in appraisal values for commercial real estate and other commercial asset collateral in the second quarter of 2014. The environmental factors for commercial and commercial real estate were increased mainly due to the continuous competitive conditions on pricing and terms, implementation of a new business banking initiative and a greater recognition of exposure to asset-based lending. The risk factors for commercial and commercial real estate were increased, even though the overall levels of non-performing assets reflect a continued modest improvement from the first quarter of 2014, these levels remain elevated compared to the Company’s peers. First Defiance’s general reserve percentages for main loan segments not otherwise classified ranged from 0.30% for construction loans to 1.64% for nonresidential real estate loans.

 

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As a result of the quantitative and qualitative analyses, along with the change in specific reserves, the Company’s provision for loan losses for the second quarter of 2014 was $446,000, compared to $448,000 for the same period in 2013. The allowance for loan losses was $24.6 million and $25.0 million and represented 1.56% and 1.58% of loans, net of undisbursed loan funds and deferred fees and costs, as of June 30, 2014 and December 31, 2013, respectively. The provision of $446,000 along with charge offs of $1.1 million and recoveries of $544,000, resulted in a decrease to the overall allowance for loan loss of $156,000 in the second quarter of 2014. In management’s opinion, the overall allowance for loan losses of $24.6 million as of June 30, 2014 is adequate.

 

Management also assesses the value of real estate owned as of the end of each accounting period and recognizes write-downs to the value of that real estate in the income statement if conditions dictate. In the three month period ended June 30, 2014, First Defiance had write-downs that totaled $73,000 compared to write-downs of $215,000 for the same period in 2013. Management believes that the values recorded at June 30, 2014 for real estate owned and repossessed assets represent the realizable value of such assets.

 

Total classified loans decreased to $46.7 million at June 30, 2014, compared to $55.6 million at December 31, 2013.

 

First Federal’s ratio of allowance for loan losses to non-performing loans was 99.1% at June 30, 2014 compared with 89.6% at December 31, 2013. Management monitors collateral values of all loans included on the watch list that are collateral dependent and believes that allowances for those loans at June 30, 2014 were appropriate. Of the total non-accrual loans, $15.5 million or 62.5%, are less than 90 days past due.

 

At June 30, 2014, First Defiance had total non-performing assets of $30.4 million, compared to $33.7 million at December 31, 2013. Non-performing assets include loans that are on non-accrual, real estate owned and other assets held for sale. Non-performing assets at June 30, 2014 and December 31, 2013 by category were as follows:

 

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Table 1 – Non-Performing Assets

 

   June 30,   December 31, 
   2014   2013 
   (In Thousands) 
Non-performing loans:          
One to four family residential real estate  $2,901   $3,273 
Non-residential and multi-family residential real estate   14,807    15,834 
Commercial   7,052    8,327 
Construction   -    - 
Home equity and improvement   103    413 
Consumer Finance   -    - 
Total non-performing loans   24,863    27,847 
           
Real estate owned   5,554    5,859 
Other repossessed assets   -    - 
Total repossessed assets  $5,554    5,859 
           
Total Nonperforming assets  $30,417   $33,706 
           
Restructured loans, accruing  $26,975   $27,630 
           
Total nonperforming assets as a percentage of total assets   1.41%   1.58%
Total nonperforming loans as a percentage of total loans*   1.57%   1.76%
Total nonperforming assets as a percentage of total loans plus REO*   1.92%   2.12%
Allowance for loan losses as a percent of total nonperforming assets   80.96%   74.02%

 

* Total loans are net of undisbursed loan funds and deferred fees and costs.

 

The decrease in non-performing loans between December 31, 2013 and June 30, 2014 is primarily in non-residential real estate and commercial loans. These balances were $1.0 million and $1.3 million lower at June 30, 2014 compared to December 31, 2013, respectively.

 

Non-performing loans in the commercial real estate category represented 1.85% of the total loans in that category at June 30, 2014 compared to 1.93% for the same category at December 31, 2013. Non-performing loans in the commercial category represented 1.81% of the total loans in that category at June 30, 2014 compared to 2.14% for the same category at December 31, 2013. Management believes that the current allowance for loan losses is appropriate and that the provision for loan losses recorded in the second quarter of 2014 is consistent with both charge-off experience and the risk inherent in the overall credits in the portfolio.

 

First Federal’s Asset Review Committee meets monthly to review the status of work-out strategies for all criticized relationships, which include all non-accrual loans. Based on such factors as anticipated collateral values in liquidation scenarios, cash flow projections, assessment of net worth of guarantors and all other factors which may mitigate risk of loss, the Asset Review Committee makes recommendations regarding proposed charge-offs which are approved by the Senior Loan Committee or the Loan Loss Reserve Committee.

 

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The following table details net charge-offs and nonaccrual loans by loan type. For the six months ended and as of June 30, 2014, commercial real estate, which represented 49.36% of total loans, offset net charge-offs with a recovery of (75.69%) of total charge-offs and 59.56% of nonaccrual loans, and commercial loans, which represented 24.01% of total loans, accounted for 143.12% of net charge-offs and 28.36% of nonaccrual loans. For the six months ended and as of June 30, 2013, commercial real estate, which represented 51.98% of total loans, accounted for 21.38% of net charge-offs and 69.79% of nonaccrual loans, and commercial loans, which represented 25.1% of total loans, accounted for 29.53% of net charge-offs and 18.81% of nonaccrual loans

 

Table 2 – Net Charge-offs (Recoveries) and Non-accruals by Loan Type

 

   For the Six Months Ended June 30, 2014   As of June 30, 2014 
   Net
Charge-offs		   % of Total Net   Nonaccrual   % of Total Non- 
  

(Recoveries)

   Charge-offs   Loans   Accrual Loans 
   (In Thousands)   (In Thousands) 
Residential  $116    13.30%  $2,901    11.67%
Construction   -    0.00%   -    0.00%
Commercial real estate   (660)   (75.69)%   14,807    59.56%
Commercial   1,248    143.12%   7,052    28.36%
Consumer   (11)   (1.26)%   -    0.00%
Home equity and improvement   179    20.53%   103    0.41%
Total  $872    100.00%  $24,863    100.00%

 

   For the Six Months Ended June 30, 2013   As of June 30, 2013 
   Net          
  

Charge-offs

(Recoveries)

  

% of Total Net

Charge-offs

  

Nonaccrual

Loans

  

% of Total Non-

Accrual Loans

 
   (In Thousands)   (In Thousands) 
Residential  $258    19.63%  $3,065    10.70%
Construction   -    0.00%   -    0.00%
Commercial real estate   281    21.38%   19,994    69.79%
Commercial   388    29.53%   5,390    18.81%
Consumer   6    0.46%   -    0.00%
Home equity and improvement   381    29.00%   201    0.70%
Total  $1,314    100.00%  $28,650    100.00%

 

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Table 3 – Allowance for Loan Loss Activity

 

   For the Quarter Ended 
   2nd 2014   1st 2014   4th 2013   3rd 2013   2nd 2013 
   (In Thousands) 
                     
Allowance at beginning of period  $24,783   $24,950   $25,964   $26,270   $26,459 
Provision for credit losses   446    103    475    476    448 
Charge-offs:                         
Residential   42    228    175    78    184 
Commercial real estate   39    228    1,097    829    283 
Commercial   973    525    670    39    316 
Consumer finance   12    11    7    33    8 
Home equity and improvement   80    184    144    170    170 
Total charge-offs   1,146    1,176    2,093    1,149    961 
Recoveries   544    906    604    367    324 
Net charge-offs   602    270    1,489    782    637 
Ending allowance  $24,627   $24,783   $24,950   $25,964   $26,270 

 

The following table sets forth information concerning the allocation of First Federal’s allowance for loan losses by loan categories at the dates indicated.

 

Table 4 – Allowance for Loan Loss Allocation by Loan Category

 

   June 30, 2014   March 31, 2014   December 31, 2013   September 30, 2013   June 30, 2013 
       Percent of       Percent of       Percent of       Percent of       Percent of 
       total loans       total loans       total loans       total loans       total loans 
   Amount   by category   Amount   by category   Amount   by category   Amount   by category   Amount   by category 
   (Dollars In Thousands) 
Residential  $2,345    12.30%  $2,639    12.38%  $2,847    12.13%  $2,798    12.14%  $3,197    12.47%
Construction   199    6.68%   138    5.15%   134    5.33%   119    3.77%   83    2.63%
Commercial real estate   13,956    49.36%   14,602    50.85%   14,508    50.80%   15,616    51.93%   15,565    51.98%
Commercial   6,199    24.01%   5,610    23.89%   5,678    24.06%   5,546    24.42%   5,474    25.10%
Consumer   148    0.97%   147    1.03%   148    1.05%   162    1.05%   165    1.07%
Home equity and improvement   1,780    6.68%   1,647    6.70%   1,635    6.63%   1,723    6.69%   1,786    6.75%
   $24,627    100.00%  $24,783    100.00%  $24,950    100.00%  $25,964    100.00%  $26,270    100.00%

 

Key Asset Quality Ratio Trends

 

Table 5 – Key Asset Quality Ratio Trends

 

   2nd Qtr 2014   1st Qtr 2014   4th Qtr 2013   3rd Qtr 2013   2nd Qtr 2013 
Allowance for loan losses / loans*   1.56%   1.58%   1.58%   1.66%   1.68%
Allowance for loan losses to net charge-offs   4090.86%   9178.89%   1675.62%   3320.20%   4124.02%
Allowance for loan losses / non-performing assets   80.96%   75.55%   74.02%   72.06%   74.64%
Allowance for loan losses / non-performing loans   99.05%   92.56%   89.60%   85.09%   91.69%
Non-performing assets / loans plus REO*   1.92%   2.09%   2.12%   2.30%   2.24%
Non-performing assets / total assets   1.41%   1.52%   1.58%   1.75%   1.70%
Net charge-offs / average loans (annualized)   0.16%   0.07%   0.39%   0.20%   0.17%

* Total loans are net of undisbursed funds and deferred fees and costs.

 

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Non-Interest Income

 

Total non-interest income decreased $281,000 in the second quarter of 2014 to $7.6 million from $7.9 million for the same period in 2013.

 

Service Fees. Service fees and other charges remained relatively flat at $2.5 million in the second quarter of 2014 compared to the same period in 2013.

 

First Federal’s overdraft privilege program generally provides for the automatic payment of modest overdraft limits on all accounts deemed to be in good standing when the account is accessed using paper-based check processing, a teller withdrawal, a point-of-sale terminal, an ACH transaction, an online banking or voice-response transfer, or an ATM. To be in good standing, an account must be brought to a positive balance within a 30-day period and have not excessively used the overdraft privilege program. Overdraft limits are established for all customers without discrimination using a risk assessment approach for each account classification. The approach includes a systematic review and evaluation of the normal deposit flows made to each account classification to establish reasonable and prudent negative balance limits that would be routinely repaid by normal, expected and reoccurring deposits. The risk assessment by portfolio approach assumes a minimal degree of undetermined credit risk associated with unidentified individual accounts that are overdrawn for 30 or more days. Consumer accounts overdrawn for more than 60 days are automatically charged off. Fees are charged as a one-time fee per occurrence, up to five charges per day, and the fee charged for an item that is paid is equal to the fee charged for a non-sufficient fund item that is returned.

 

Overdrawn balances, net of allowance for losses, are reflected as loans on First Defiance’s balance sheet. The fees charged for this service are established based both on the return of processing costs plus a profit, and on the level of fees charged by competitors in the Company’s market area for similar services. These fees are considered to be compensation for providing a service to the customer and therefore deemed to be noninterest income rather than interest income. Fee income recorded for the quarters ending June 30, 2014 and 2013 related to the overdraft privilege product, net of adjustments to the allowance for uncollectible overdrafts, were $737,000 and $854,000, respectively. Accounts charged off are included in noninterest expense. The allowance for uncollectible overdrafts was $12,000 at June 30, 2014, $22,000 at December 31, 2013 and $5,000 at June 30, 2013.

 

Mortgage Banking Activity. Total revenue from the sale and servicing of mortgage loans decreased $903,000 to $1.5 million for the second quarter of 2014 compared to $2.4 million for the same period of 2013. The rise in long term rates in 2014 led to a significant decline in mortgage volumes primarily in the refinance activity. Gains realized from the sale of mortgage loans decreased in the second quarter of 2014 to $986,000 from $1.9 million in the second quarter of 2013. The amortization of mortgage servicing rights expense decreased $266,000 to $368,000 in the second quarter of 2014 compared to $634,000 in the same period in 2013 resulting from a slow-down of payoffs driving down amortization expense. The Company recorded a small positive valuation adjustment of $44,000 on mortgage servicing rights in the second quarter of 2014 compared to a positive valuation adjustment of $312,000 in the second quarter of 2013. The positive valuation adjustment in the second quarter of 2014 was driven by a slight increase in the fair values of certain sectors of the Company’s portfolio of mortgage servicing rights. The increase in fair values was driven by a slight increase in market rates in the second quarter of 2014 which was also a contributing factor in the lower amortization of mortgage servicing rights in the second quarter of 2014.

 

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Gain on Sale of Securities. First Defiance sold three Trust Preferred Collateralized Debt Obligation (“CDO”) and two Preferred Stock investments for a net gain of $471,000 in the second quarter of 2014 compared to two investments being sold in the second quarter of 2013 for a net gain of $44,000. As of June 30, 2014, the Company held three CDOs in its investment portfolio with a zero value.

 

Non-Interest Expense

 

Non-interest expense increased to $16.4 million for the second quarter of 2014 compared to $15.7 million for the same period in 2013.

 

Compensation and Benefits. Compensation and benefits increased to $8.7 million for the quarter ended June 30, 2014 from $8.5 million for the same period in 2013. The increase is mainly attributable to merit increases and higher health insurance costs.

 

Other Non-Interest Expenses. Other non-interest expenses increased by $273,000 to $3.3 million for the quarter ended June 30, 2014 from $3.1 million for the same period in 2013. There is no one significant increase or decrease within the individual categories of other non-interest expense when comparing the second quarter of 2014 to the same period in 2013.

 

The efficiency ratio, considering tax equivalent interest income and excluding securities gains and losses, for the second quarter of 2014 was 66.16% compared to 62.36% for the same period in 2013.

 

Income Taxes

 

First Defiance computes federal income tax expense in accordance with ASC Topic 740, Subtopic 942, which resulted in an effective tax rate of 28.4% for the quarter ended June 30, 2014 compared to 29.3% for the same period in 2013. The tax rate is lower than the statutory 35% tax rate for the Company mainly because of investments in tax-exempt securities. The earnings on tax-exempt securities are not subject to federal income tax.

 

Six Months Ended June 30, 2014 and 2013

 

On a consolidated basis, First Defiance’s net income for the six months ended June 30, 2014 of $10.9 million compared to income of $11.7 million for the comparable period in 2013. On a per share basis, basic and diluted earnings per common share for the six months ended June 30, 2014 were $1.13 and $1.08, respectively, compared to basic and diluted earnings per common share of $1.20 and $1.15, respectively, for the comparable period in 2013.

 

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Net Interest Income

 

Net interest income was $33.9 million for the six months ended June 30, 2014 compared to $33.4 million for the same period in 2013. For the six month period ended June 30, 2014, total interest income was $37.2 million, flat compared to the same period in 2013.

 

Interest expense decreased by $440,000 to $3.3 million for the six months ended June 30, 2014 compared to $3.8 million for the same period in 2013. The decline in the average cost of interest-bearing liabilities for the six months ending June 30, 2014, to 0.44%, an 8 basis point decrease from the 0.52% average cost in the first half of 2013 is the result of the continued low rate environment which has resulted in liabilities re-pricing at lower rates.

 

Provision for Loan Losses

 

The provision for loan losses was $549,000 for the six months ended June 30, 2014, compared to $873,000 during the six months ended June 30, 2013. Charge-offs for the first half of 2014 were $2.3 million and recoveries of previously charged off loans totaled $1.5 million for net charge-offs of $872,000. By comparison, $2.0 million of charge-offs were recorded in the same period of 2013 and $642,000 of recoveries were realized for net charge-offs of $1.3 million.

 

Non-Interest Income

 

Total non-interest income decreased to $14.9 million for the six months ended June 30, 2014 from $16.9 million recognized in the same period of 2013.

 

Mortgage Banking Activity. Total revenue from the sale and servicing of mortgage loans decreased $2.5 million to $2.8 million for the six months ended June 30, 2014 from $5.3 million for the same period of 2013. Gains realized from the sale of mortgage loans decreased $2.4 million to $1.6 million for the first half of 2014 from $4.1 million during the same period of 2013. Mortgage loan servicing revenue remained relatively flat at $1.8 million in the first half of 2014 compared to the same period of 2013. The gains realized from the sale of mortgage loans were partially offset by the amortization of mortgage servicing rights in the amount of $660,000 in first half of 2014 down from $1.3 million in the same period of 2013. The Company recorded a small positive valuation adjustment of $37,000 in the first half of 2014 compared to a positive adjustment of $785,000 in the first half of 2013.

 

Gain on Sale of Securities. First Defiance recorded nets gains of $471,000 from the sale of investments in the first half of 2014 compared to net gains of $97,000 for the same period in 2013.

 

Non-Interest Expense

 

Non-interest expenses were $33.0 million for the first six months of 2014, basically level with the same period in 2013.

 

FDIC Insurance Premiums. FDIC expense decreased to $738,000 in the first six months of 2014, from $931,000 in the same period of 2013. This decrease was due to the improvement in the Company’s risk category.

 

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Data Processing. Data processing expenses increased to $2.8 million in the first six months of 2014, from $2.5 million in the same period of 2013. This increase is primarily due to Company strategic initiatives in implementing new products and alternative delivery channels for new and existing products.

 

Other Non-Interest Expenses. Other non-interest expenses increased by $330,000 to $7.4 million for the first six months of 2014 from $7.1 million for the same period in 2013. Year-over-year increases between 2014 and 2013 include $786,000 of cost associated with the termination of First Federal’s merger agreement with First Community Bank in the first quarter of 2014. This was partially offset by a decrease in REO costs of $417,000 in the first six months of 2014 compared to the same period in 2013.

 

The efficiency ratio for the first half of 2014 was 67.01% compared to 64.48% for the same period of 2013.

 

Liquidity

 

As a regulated financial institution, First Federal is required to maintain appropriate levels of "liquid" assets to meet short-term funding requirements.

 

First Defiance had $11.5 million of cash provided by operating activities during the first six months of 2014. The Company's cash used in operating activities resulted from the origination of loans held for sale mostly offset by the proceeds on the sale of loans.

 

At June 30, 2014, First Federal had $142.0 million in outstanding loan commitments and loans in process to be funded generally within the next six months and an additional $307.7 million committed under existing consumer and commercial lines of credit and standby letters of credit. Also at that date, First Federal had commitments to sell $17.8 million of loans held-for-sale. 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.

 

Liquidity risk arises from the possibility that the Company may not be able to meet its financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, the Company’s Board of Directors has established a Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates First Federal’s Asset/Liability Committee (“ALCO”) as the body responsible for meeting these objectives. The ALCO reviews liquidity on a monthly basis and approves significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company’s Chief Financial Officer and Controller.

 

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Capital Resources

 

Capital is managed at First Federal and on a consolidated basis. Capital levels are maintained based on regulatory capital requirements and the economic capital required to support credit, market, liquidity and operational risks inherent in our business, as well as flexibility needed for future growth and new business opportunities.

 

First Federal is required to maintain specified amounts of capital pursuant to regulations promulgated by the Office of the Comptroller of the Currency. 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 June 30, 2014 (in thousands).

 

   Actual   Minimum Required for
Adequately Capitalized		   Minimum Required for Well
Capitalized		 
   Amount   Ratio   Amount   Ratio   Amount   Ratio 
Tier 1 Capital (1)                              
Consolidated  $248,694    11.93%  $83,416    4.0%   N/A    N/A 
First Federal Bank  $237,691    11.41%  $83,302    4.0%  $104,128    5.0%
                               
Tier 1 Capital (to Risk Weighted Assets) (1)                              
Consolidated  $248,694    14.27%  $69,698    4.0%   N/A    N/A 
First Federal Bank  $237,691    13.65%  $69,650    4.0%  $104,474    6.0%
                               
Total Capital (to Risk Weighted Assets) (1)                              
Consolidated  $270,510    15.52%  $139,396    8.0%   N/A    N/A 
First Federal Bank  $259,492    14.90%  $139,299    8.0%  $174,124    10.0%

 

(1)Core capital is computed as a percentage of adjusted total assets of $2.09 billion and $2.08 billion for consolidated and the bank, respectively. Risk-based capital is computed as a percentage of total risk-weighted assets of $1.74 billion and $1.74 billion for consolidated and the bank, respectively.

 

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, Valuation of Securities, Goodwill, and the Valuation of Mortgage Servicing Rights. There have been no material changes in assumptions or judgments relative to those critical policies during the first six months of 2014.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

As discussed in detail in the Annual Report on Form 10-K for the year ended December 31, 2013, 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 that measures the impact changes in interest rates can have on net interest 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, non-maturity deposit assumptions and capital requirements. The results of the simulation indicate that in an environment where interest rates rise 100 basis points over a 24 month period, using June 30, 2014 amounts as a base case, First Defiance’s net interest income would be impacted by less than the board mandated guidelines of 10%.

 

In addition to the simulation analysis, First Defiance also uses an economic value of equity (“EVE”) analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis generally calculates the net present value of First Federal’s assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. However, the likelihood of a decrease in rates beyond 100 basis points as of June 30, 2014 was considered to be remote given the current interest rate environment and therefore, was not included in this analysis. The results of this analysis are reflected in the following tables for the six months ended June 30, 2014 and the year-ended December 31, 2013.

 

June 30, 2014 
Economic Value of Equity 
Change in Rates  $ Amount   $ Change   % Change 
   (Dollars in Thousands)     
+400 bp   464,941    41,764    9.87%
+ 300 bp   458,856    35,680    8.43%
+ 200 bp   450,494    27,318    6.46%
+ 100 bp   439,527    16,351    3.86%
0 bp   423,176    –    – 
- 100 bp   402,228    (20,948)   (4.95)%

 

December 31, 2013 
Economic Value of Equity 
Change in Rates  $ Amount   $ Change   % Change 
   (Dollars in Thousands)     
+400 bp   474,469    41,679    9.63%
+ 300 bp   467,691    34,901    8.06%
+ 200 bp   458,844    26,054    6.02%
+ 100 bp   447,701    14,911    3.45%
0 bp   432,790    -    - 
- 100 bp   413,917    (18,873)   (4.36)%

 

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Item 4. Controls and Procedures

 

Disclosure controls are procedures designed to ensure that information required to be disclosed in the Company's reports filed under the Exchange Act, such as this report, is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms. Disclosure controls are also designed to ensure that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

An evaluation was carried out under the supervision and with the participation of the Company's management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of June 30, 2014. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

 

No changes occurred in the Company’s internal controls over financial reporting during the quarter ended June 30, 2014 that materially affected, or are reasonably likely to materially affect, the internal controls over financial reporting.

 

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FIRST DEFIANCE FINANCIAL CORP.

 

PART II-OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Neither First Defiance nor any of its Subsidiaries is engaged in any legal proceedings of a material nature.

 

Item 1A. Risk Factors

 

There are no material changes from the risk factors set forth under Part I, Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

In the second quarter of 2014, First Defiance discovered that it inadvertently issued approximately 129,466 more shares of the Company’s common stock in connection with its Employee Investment Plan (“EIP”) than were registered on September 1, 2000 on the previously filed Registration Statement on Form S-8 (File No. 333-45142) relating to the EIP. Because the Company sponsors the EIP, it is required to register shares issued through the EIP. On July 2, 2014, the Company filed a new registration statement on Form S-8 (File No. 333-197203) to register future shares issued through the EIP.

 

The Company has always treated the shares issued through the EIP as outstanding for financial reporting purposes. The Company believes that it has always provided the employee-participants in the EIP with the same information they would have received had the additional shares been registered. Original purchasers of the unregistered EIP shares may have rescission rights with respect to such shares under applicable federal securities laws for up to one year following the date of acquisition of the shares. These rescission rights represent a contingent liability of the Company. In addition, the Company may be subject to civil and other penalties by regulatory authorities as a result of the failure to register these transactions.

 

The following table provides information regarding First Defiance’s purchases of its common stock during the three-month period ended June 30, 2014:

 

Period  Total Number of
Shares
Purchased		   Average Price
Paid Per
Share		   Total Number of
Shares Purchased
as Part of
Publicly
Announced Plans
or Programs (1)		   Maximum Number of
Shares (or Approximate
Dollar Value) that May
Yet Be Purchased Under
the Plans or Programs (2)		 
Beginning Balance, April 1, 2014                  339,062 
April 1 – April 30, 2014   3,000    26.50    3,000    336,062 
May 1 – May 31, 2014   101,247    27.32    101,247    234,815 
June 1 – June 30, 2014   64,050    27.95    64,050    170,765 
Total   247,269   $27.00    247,269    170,765 

 

(1)The reported shares were repurchased pursuant to First Defiance’s publicly announced stock repurchase program, which became effective September 30, 2013. Up to 489,000 shares were authorized to be purchased under the program. There is no expiration date for the program.

 

(2)The number of shares shown represents, as of the end of each period, the maximum number of shares of common stock that may yet be purchased under publicly announced stock repurchase programs. The shares may be purchased, from time to time, depending on market conditions.

 

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Item 3. Defaults upon Senior Securities

 

Not applicable.

 

Item 4. Mine Safety Disclosures

 

Not applicable.

 

Item 5. Other Information

 

Not applicable.

 

Item 6. Exhibits

 

Exhibit 3.1Articles of Incorporation (1)

 

Exhibit 3.2Code of Regulations (1)

 

Exhibit 3.3Amendment to Articles of Incorporation (2)

 

Exhibit 31.1Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 31.2Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 32.2Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Exhibit 101The following financial information from the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2014 is formatted in eXtensible Business Reporting Language (“XBRL”): (i) Unaudited Consolidated Condensed Balance Sheet at June 30, 2014 and December 31, 2013, (ii) Unaudited Consolidated Condensed Statements of Income for the Three and Six Months ended June 30, 2014 and 2013 (iii) Unaudited Consolidated Condensed Statements of Comprehensive Income for the Three and Six Months ended June 30, 2014 and 2013, (iv) Unaudited Consolidated Condensed Statements of Changes in Stockholder’ Equity for the Six Months ended June 30, 2014 and 2013, (v) Unaudited Consolidated Condensed Statements of Cash Flows for the Six Months ended June 30, 2014 and 2013 and (vi) Notes to Unaudited Consolidated Condensed Financial Statements.

 

(1)Incorporated herein by reference to the like numbered exhibit in the Registrant’s Form S-1 (File No. 33-93354)
(2)Incorporated herein by reference to exhibit 3 in Form 8-K filed December 8, 2008 (Film No. 081236105)

 

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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 on its behalf by the undersigned thereunto duly authorized.

 

  First Defiance Financial Corp.
  (Registrant)
     
Date:  August 8, 2014 By: /s/ Donald P. Hileman
    Donald P. Hileman
    President and
    Chief Executive Officer
     
Date:  August 8, 2014 By: /s/ Kevin T. Thompson
    Kevin T. Thompson
    Executive Vice President and
    Chief Financial Officer

 

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