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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

LOGO

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

For the transition period from              to             .

COMMISSION FILE NO. 000-49747

 

 

FIRST SECURITY GROUP, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Tennessee   58-2461486
(State of Incorporation)  

(I.R.S. Employer

Identification No.)

531 Broad Street, Chattanooga, TN   37402
(Address of principal executive offices)   (Zip Code)

(423) 266-2000

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)

 

 

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 and 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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  ¨    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 definition 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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Common Stock, $0.01 par value:

16,418,327 shares outstanding and issued as of August 9, 2010

 

 

 


Table of Contents

First Security Group, Inc. and Subsidiary

Form 10-Q

INDEX

 

          Page No.
PART I.    FINANCIAL INFORMATION   
Item 1.    Financial Statements   
  

Consolidated Balance Sheets - June 30, 2010, December 31, 2009 and June 30, 2009

   1
  

Consolidated Income Statements - Three months and six months ended June 30, 2010 and 2009

   3
  

Consolidated Statement of Stockholders’ Equity - Six months ended June 30, 2010

   4
  

Consolidated Statements of Cash Flows - Six months ended June 30, 2010 and 2009

   5
  

Notes to Consolidated Financial Statements

   7
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    23
Item 3.    Quantitative and Qualitative Disclosures about Market Risk    53
Item 4.    Controls and Procedures    54
PART II.    OTHER INFORMATION   
Item 1A.    Risk Factors    55
Item 3.    Defaults Upon Senior Securities    57
Item 6.    Exhibits    57
SIGNATURES    58


Table of Contents

PART I - FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

First Security Group, Inc. and Subsidiary

Consolidated Balance Sheets

 

(in thousands)

   June 30,
2010
(unaudited)
   December 31,
2009
   June 30,
2009
(unaudited)

ASSETS

        

Cash and Due from Banks

   $ 8,960    $ 23,220    $ 20,908

Federal Funds Sold and Securities Purchased under Agreements to Resell

     —        —        —  
                    

Cash and Cash Equivalents

     8,960      23,220      20,908
                    

Interest Bearing Deposits in Banks

     232,720      152,616      12,354
                    

Securities Available-for-Sale

     153,031      143,045      137,494
                    

Loans Held for Sale

     2,713      1,225      3,806

Loans

     848,639      950,793      964,687
                    

Total Loans

     851,352      952,018      968,493

Less: Allowance for Loan and Lease Losses

     26,830      26,492      19,275
                    
     824,522      925,526      949,218
                    

Premises and Equipment, net

     32,274      33,157      33,948
                    

Goodwill

     —        —        27,156
                    

Intangible Assets

     1,685      1,918      2,139
                    

Other Assets

     80,313      74,352      55,176
                    

TOTAL ASSETS

   $ 1,333,505    $ 1,353,834    $ 1,238,393
                    

(See Accompanying Notes to Consolidated Financial Statements)

 

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Table of Contents

First Security Group, Inc. and Subsidiary

Consolidated Balance Sheets

 

(in thousands, except share data)

   June 30,
2010
(unaudited)
    December 31,
2009
    June 30,
2009
(unaudited)
 

LIABILITIES AND STOCKHOLDERS’ EQUITY

      

LIABILITIES

      

Deposits

      

Noninterest Bearing Demand

   $ 152,284      $ 151,174      $ 153,345   

Interest Bearing Demand

     67,122        62,429        63,720   

Savings and Money Market Accounts

     172,588        177,543        157,560   

Certificates of Deposit less than $100 thousand

     232,646        244,312        246,652   

Certificates of Deposit of $100 thousand or more

     189,066        207,465        204,133   

Brokered Deposits

     352,545        339,750        207,636   
                        

Total Deposits

     1,166,251        1,182,673        1,033,046   

Federal Funds Purchased and Securities Sold under Agreements to Repurchase

     19,347        17,911        20,538   

Security Deposits

     961        1,376        1,558   

Other Borrowings

     85        94        102   

Other Liabilities

     9,745        10,181        10,686   
                        

Total Liabilities

     1,196,389        1,212,235        1,065,930   
                        

STOCKHOLDERS’ EQUITY

      

Preferred Stock – no par value – 10,000,000 shares authorized; 33,000 issued as of June 30, 2010, December 31, 2009 and June 30, 2009

     31,525        31,339        31,158   

Common Stock - $.01 par value - 50,000,000 shares authorized as of June 30, 2010, December 31, 2009 and June 30, 2009; 16,418,327 issued as of June 30, 2010, December 31, 2009 and June 30, 2009

     114        114        114   

Paid-In Surplus

     111,623        111,964        111,933   

Common Stock Warrants

     2,006        2,006        2,006   

Unallocated ESOP Shares

     (5,518     (6,193     (6,602

(Accumulated Deficit) Retained Earnings

     (8,144     (3,823     28,262   

Accumulated Other Comprehensive Income

     5,510        6,192        5,592   
                        

Total Stockholders’ Equity

     137,116        141,599        172,463   
                        

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,333,505      $ 1,353,834      $ 1,238,393   
                        

(See Accompanying Notes to Consolidated Financial Statements)

 

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Table of Contents

First Security Group, Inc. and Subsidiary

Consolidated Income Statements

(unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 

(in thousands, except per share data)

   2010     2009     2010     2009  

INTEREST INCOME

        

Loans, including fees

   $ 12,731      $ 14,524      $ 26,181      $ 29,397   

Debt Securities – taxable

     994        1,154        2,084        2,338   

Debt Securities – non-taxable

     349        400        727        804   

Other

     216        21        339        35   
                                

Total Interest Income

     14,290        16,099        29,331        32,574   
                                

INTEREST EXPENSE

        

Interest Bearing Demand Deposits

     50        50        95        101   

Savings Deposits and Money Market Accounts

     356        399        764        871   

Certificates of Deposit of less than $100 thousand

     1,248        1,900        2,591        3,949   

Certificates of Deposit of $100 thousand or more

     1,097        1,644        2,291        3,404   

Brokered Deposits

     2,456        1,488        4,710        3,253   

Other

     122        118        244        259   
                                

Total Interest Expense

     5,329        5,599        10,695        11,837   
                                

NET INTEREST INCOME

     8,961        10,500        18,636        20,737   

Provision for Loan and Lease Losses

     3,544        6,196        7,919        11,189   
                                

NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES

     5,417        4,304        10,717        9,548   
                                

NONINTEREST INCOME

        

Service Charges on Deposit Accounts

     1,048        1,170        2,048        2,317   

Gain on Sales of Available-for-Sale Securities

     —          —          57        —     

Other

     1,510        1,474        2,757        2,778   
                                

Total Noninterest Income

     2,558        2,644        4,862        5,095   
                                

NONINTEREST EXPENSES

        

Salaries and Employee Benefits

     4,703        5,043        9,651        10,400   

Expense on Premises and Fixed Assets, net of rental income

     1,373        1,512        2,756        3,032   

Other

     5,907        3,337        9,448        5,920   
                                

Total Noninterest Expenses

     11,983        9,892        21,855        19,352   
                                

LOSS BEFORE INCOME TAX BENEFIT

     (4,008     (2,944     (6,276     (4,709

Income Tax Benefit

     (1,812     (1,536     (2,966     (2,449
                                

NET LOSS

     (2,196     (1,408     (3,310     (2,260

Preferred Stock Dividends

     412        413        825        784   

Accretion on Preferred Stock Discount

     94        87        186        164   
                                

NET LOSS TO COMMON STOCKHOLDERS

   $ (2,702   $ (1,908   $ (4,321   $ (3,208
                                

NET LOSS PER SHARE:

        

Net Loss Per Share - Basic

   $ (0.17   $ (0.12   $ (0.28   $ (0.21

Net Loss Per Share - Diluted

   $ (0.17   $ (0.12   $ (0.28   $ (0.21

Dividends Declared Per Common Share

   $ —        $ 0.01      $ —        $ 0.06   

(See Accompanying Notes to Consolidated Financial Statements)

 

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Table of Contents

First Security Group, Inc. and Subsidiary

Consolidated Statement of Stockholders’ Equity

 

        Common Stock                   Accumulated
Other
Comprehensive
Income
             

(in thousands)

  Preferred
Stock
  Shares    Amount   Paid-In
Surplus
    Common
Stock
Warrants
  Accumulated
Deficit
      Unallocated
ESOP Shares
    Total  

Balance – December 31, 2009

  $ 31,339   16,418    $ 114   $ 111,964      $ 2,006   $ (3,823   $ 6,192      $ (6,193   $ 141,599   

Comprehensive Income:

                  

Net Loss (unaudited)

               (3,310         (3,310

Change Unrealized Gain:

                  

Securities Available-for-Sale, net of tax and reclassification adjustments (unaudited)

                 39          39   

Fair Value of Derivatives, net of tax and reclassification adjustments (unaudited)

                 (721       (721
                        

Total Comprehensive Loss

                     (3,992
                        

Accretion of Discount Associated with Preferred Stock (unaudited)

    186              (186         —     

Preferred Stock Dividend (unaudited)

               (825         (825

Stock-based Compensation, net of forfeitures (unaudited)

           49                49   

ESOP Allocation (unaudited)

           (390           675        285   
                                                              

Balance – June 30, 2010 (unaudited)

  $ 31,525   16,418    $ 114   $ 111,623      $ 2,006   $ (8,144   $ 5,510      $ (5,518   $ 137,116   
                                                              

(See Accompanying Notes to Consolidated Financial Statements)

 

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Table of Contents

First Security Group, Inc. and Subsidiary

Consolidated Statements of Cash Flow

(unaudited)

     Six Months Ended June 30,  

(in thousands)

   2010     2009  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net Loss

   $ (3,310   $ (2,260

Adjustments to Reconcile Net Loss to Net Cash (Used in) Provided by Operating Activities -

    

Provision for Loan and Lease Losses

     7,919        11,189   

Amortization, net

     416        324   

Stock-Based Compensation

     49        200   

ESOP Compensation

     285        321   

Depreciation

     929        1,065   

Gain on Sale of Premises and Equipment

     (8     (3

Loss (Gain) on Sale of Other Real Estate and Repossessions, net

     511        (72

Write-down of Other Real Estate and Repossessions

     1,343        387   

Gain on Sale of Available-for-Sale Securities

     (57     —     

Accretion of Fair Value Adjustment, net

     (25     (99

Accretion of Cash Flow Swaps

     —          (528

Accretion of Terminated Cash Flow Swaps

     (1,042     (722

Changes in Operating Assets and Liabilities -

    

Loans Held for Sale

     (1,488     2,197   

Interest Receivable

     484        287   

Other Assets

     (6,035     (1,072

Interest Payable

     (128     (847

Other Liabilities

     (1,158     256   
                

Net Cash (Used in) Provided by Operating Activities

     (1,315     10,623   
                

CASH FLOWS FROM INVESTING ACTIVITIES

    

Net Change in Interest Bearing Deposits in Banks

     (80,104     (11,436

Activity in Available-for-Sale-Securities -

    

Maturities, Prepayments, and Calls

     30,329        12,891   

Sales

     14,762        —     

Purchases

     (55,143     (10,781

Loan Originations and Principal Collections, net

     85,871        21,984   

Proceeds for Interim Settlements of Cash Flow Swaps, net

     —          938   

Proceeds for Termination of Cash Flow Swaps

     —          5,778   

Proceeds from Sale of Premises and Equipment

     8        13   

Proceeds from Sales of Other Real Estate and Repossessions

     7,001        3,969   

Additions to Premises and Equipment

     (46     (1,246

Capital Improvements to Repossessions and Other Real Estate

     (628     (114
                

Net Cash Provided by Investing Activities

     2,050        21,996   
                

CASH FLOWS FROM FINANCING ACTIVITIES

    

Net Decrease in Deposits

     (16,422     (43,242

Net Increase (Decrease) in Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

     1,436        (19,498

Net Decrease of Other Borrowings

     (9     (2,675

Proceeds from Issuance of Preferred Stock and Common Stock Warrants

     —          33,000   

Repurchase and Retirement of Common Stock

     —          —     

Repurchase of Common Stock for 401(k) and ESOP Plan

     —          (1,023

Dividends Paid on Preferred Stock

     —          (578

Dividends Paid on Common Stock

     —          (917
                

Net Cash Used in Financing Activities

     (14,995     (34,933
                

NET CHANGE IN CASH AND CASH EQUIVALENTS

     (14,260     (2,314

CASH AND CASH EQUIVALENTS - beginning of period

     23,220        23,222   
                

CASH AND CASH EQUIVALENTS - end of period

   $ 8,960      $ 20,908   
                

(See Accompanying Notes to Consolidated Financial Statements)

 

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Table of Contents
     Six Months Ended June 30,

(in thousands)

   2010    2009

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES

     

Transfers to Foreclosed Properties and Repossessions

   $ 11,604    $ 11,784

SUPPLEMENTAL SCHEDULE OF CASH FLOWS

     

Interest Paid

   $ 10,823    $ 12,684

Income Taxes Paid

   $ 46    $ 539

(See Accompanying Notes to Consolidated Financial Statements)

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of financial condition and the results of operations have been included. All such adjustments were of a normal recurring nature.

The consolidated financial statements include the accounts of First Security Group, Inc. and its subsidiary bank, which is wholly-owned. All significant intercompany balances and transactions have been eliminated.

Operating results for the three and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010 or any other period. These interim financial statements should be read in conjunction with the Company’s latest annual consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

NOTE 2 – COMPREHENSIVE INCOME

Comprehensive income is a measure of all changes in equity, not only reflecting net income but certain other changes as well. The following table presents the comprehensive loss for the three and six month periods ended June 30, 2010 and 2009, respectively.

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  
     (in thousands)  

Net loss

   $ (2,196   $ (1,408   $ (3,310   $ (2,260
                                

Other comprehensive income loss

        

Available-for-sale securities

        

Unrealized net (loss) gain on securities arising during the period

     (70     (683     117        358   

Tax benefit (expense) related to unrealized net (loss) gain

     24        232        (40     (122

Reclassification adjustments for realized gain included in net income

     —          —          (57     —     

Tax expense related to gain realized in net income

     —          —          19        —     
                                

Unrealized (loss) gain on securities, net of tax

     (46     (451     39        236   
                                

Derivative cash flow hedges

        

Unrealized gain (loss) on derivatives arising during the period

     15        33        (51     312   

Tax (expense) benefit related to unrealized (loss) gain

     (5     (10     18        (106

Reclassification adjustments for realized gain included in net income

     (614     (455     (1,042     (1,152

Tax expense related to gain realized in net income

     209        155        354        392   
                                

Unrealized loss on derivatives, net of tax

     (395     (277     (721     (554
                                

Other comprehensive loss, net of tax

     (441     (728     (682     (318
                                

Comprehensive loss, net of tax

   $ (2,637   $ (2,136   $ (3,992   $ (2,578
                                

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

NOTE 3 – EARNINGS PER SHARE

The difference in basic and diluted weighted average shares is due to the assumed conversion of outstanding options using the treasury stock method. The following table presents the computation of basic and diluted earnings per share.

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  
     (in thousands, except per share data)  

Net loss available to common stockholders

   $ (2,702   $ (1,908   $ (4,321   $ (3,208
                                

Denominator:

        

Weighted average common shares outstanding

     15,715        15,503        15,682        15,537   

Equivalent shares issuable upon exercise of stock options, stock warrants and restricted stock grants

     —          —          —          —     
                                

Weighted average diluted shares outstanding

     15,715        15,503        15,682        15,537   
                                

Net loss per share:

        

Basic

   $ (0.17   $ (0.12   $ (0.28   $ (0.21
                                

Diluted

   $ (0.17   $ (0.12   $ (0.28   $ (0.21
                                

For the three and six months ended June 30, 2010, the weighted average stock options, stock warrants and restricted stock awards that were anti-dilutive totaled 1,963 thousand and 2,017 thousand, respectively, compared to 1,321 thousand and 1,287 thousand for the same periods in 2009. Anti-dilutive options expire between 2010 and 2020. Anti-dilutive options and awards are not included in the computation of diluted earnings per share under the treasury stock method.

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

NOTE 4 – SECURITIES

Investment Securities by Type

The following table presents the amortized cost and fair value of securities, with gross unrealized gains and losses.

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair Value
     (in thousands)

Securities available-for-sale

           

June 30, 2010

           

Debt securities—

           

Federal agencies

   $ 29,316    $ 216    $ —      $ 29,532

Mortgage-backed

     83,173      3,075      162      86,086

Municipals

     36,218      1,193      75      37,336

Other

     126      —        49      77
                           

Total

   $ 148,833    $ 4,484    $ 286    $ 153,031
                           

Securities available-for-sale

           

December 31, 2009

           

Debt securities—

           

Federal agencies

   $ 17,226    $ 144    $ 16    $ 17,354

Mortgage-backed

     80,338      3,225      477      83,086

Municipals

     41,216      1,373      66      42,523

Other

     126      —        44      82
                           

Total

   $ 138,906    $ 4,742    $ 603    $ 143,045
                           

Securities available-for-sale

           

June 30, 2009

           

Debt securities—

           

Federal agencies

   $ 12,835    $ 115    $ 34    $ 12,916

Mortgage-backed

     80,190      2,394      813      81,771

Municipals

     42,233      709      232      42,710

Other

     125      —        28      97
                           

Total

   $ 135,383    $ 3,218    $ 1,107    $ 137,494
                           

Proceeds from sales of securities available-for-sale totaled $14,762 thousand for the six months ended June 30, 2010. Gross realized gains from sales of securities were $368 thousand for the six months ended June 30, 2010. Gross losses were $311 thousand for the six months ended June 30, 2010. There were no sales of securities during the six months ended June 30, 2009.

At June 30, 2010, December 31, 2009 and June 30, 2009, federal agencies, municipals and mortgage-backed securities with a carrying value of $29,484 thousand, $12,600 thousand and $17,547 thousand, respectively, were pledged to secure public deposits. At June 30, 2010, December 31, 2009 and June 30, 2009, the carrying amount of securities pledged to secure repurchase agreements was $22,491 thousand, $26,472 thousand and $34,915 thousand, respectively. At June 30, 2010, securities of $5,893 thousand were pledged to the Federal Reserve Bank of Atlanta to secure the Company’s daytime correspondent transactions.

 

9


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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

Maturity of Securities

The following table presents the amortized cost and fair value of debt securities by contractual maturity at June 30, 2010.

 

     Amortized
Cost
   Fair
Value
     (in thousands)

Within 1 year

   $ 2,396    $ 2,429

Over 1 year through 5 years

     33,712      34,446

5 years to 10 years

     24,971      25,526

Over 10 years

     4,581      4,544
             
     65,660      66,945

Mortgage-backed securities

     83,173      86,086
             

Total

   $ 148,833    $ 153,031
             

Impairment Analysis

The following table shows the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2010, December 31, 2009 and June 30, 2009.

 

     Less than 12 months    12 months or greater    Totals
     Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
     (in thousands)

June 30, 2010

                 

Federal agencies

   $ —      $ —      $ —      $ —      $ —      $ —  

Mortgage-backed

     2,905      162      —        —        2,905      162

Municipals

     1,675      41      618      34      2,293      75

Other

     —        —        77      49      77      49
                                         

Totals

   $ 4,580    $ 203    $ 695    $ 83    $ 5,275    $ 286
                                         

December 31, 2009

                 

Federal agencies

   $ 1,982    $ 16    $ —      $ —      $ 1,982    $ 16

Mortgage-backed

     2,375      6      3,086      471      5,461      477

Municipals

     1,404      31      617      35      2,021      66

Other

     —        —        82      44      82      44
                                         

Totals

   $ 5,761    $ 53    $ 3,785    $ 550    $ 9,546    $ 603
                                         

June 30, 2009

                 

Federal agencies

   $ 3,301    $ 34    $ —      $ —      $ 3,301    $ 34

Mortgage-backed

     6,896      109      4,777      704      11,673      813

Municipals

     6,704      96      2,055      136      8,759      232

Other

     97      28      —        —        97      28
                                         

Totals

   $ 16,998    $ 267    $ 6,832    $ 840    $ 23,830    $ 1,107
                                         

As of June 30, 2010, the Company performed an impairment assessment of the securities in its portfolio that had an unrealized loss to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) the Company intends to sell the security, (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized costs basis or (3) the Company does not expect to recover the security’s entire amortized cost basis, even if the Company does not intend to sell. Additionally, accounting guidance requires that for impaired securities that the Company does not intend to sell and/or that it is not more-likely-than-not that the Company will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses,

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.

In evaluating the recovery of the entire amortized cost basis, the Company considers factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.

As of June 30, 2010, gross unrealized losses in the Company’s portfolio totaled $286 thousand, compared to $603 thousand as of December 31, 2009. The unrealized losses in mortgage-backed and municipal securities are primarily due to widening credit spreads and changes in interest rates subsequent to purchase. The unrealized losses in other securities are two trust preferred securities. The unrealized losses in the trust preferred securities are primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. Based on results of the Company’s impairment assessment, the unrealized losses at June 30, 2010 are considered temporary.

NOTE 5 – LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES

The following table presents loans by type.

 

     June 30, 2010     December 31, 2009     June 30, 2009  
     (in thousands)  

Loans secured by real estate-

      

Residential 1-4 family

   $ 273,030      $ 281,354      $ 288,836   

Commercial

     247,009        259,819        225,790   

Construction

     113,877        153,144        183,623   

Multi-family and farmland

     40,550        37,960        33,847   
                        
     674,466        732,277        732,096   

Commercial loans

     117,279        146,016        150,472   

Consumer installment loans

     42,262        48,927        54,261   

Leases, net of unearned income

     13,006        19,730        26,784   

Other

     4,339        5,068        4,880   
                        

Total loans

     851,352        952,018        968,493   

Allowance for loan and lease losses

     (26,830     (26,492     (19,275
                        

Net loans

   $ 824,522      $ 925,526      $ 949,218   
                        

 

11


Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

The following table presents an analysis of the allowance for loan and lease losses. The provision expense for loan and lease losses in the table does not include the Company’s provision accrual for unfunded commitments of $11 thousand and $11 thousand for the six months ended June 30, 2010 and 2009, respectively. The reserve for unfunded commitments as of June 30, 2010 and 2009 was $217 thousand and $193 thousand, respectively, and is included in other liabilities in the consolidated balance sheets.

 

     June 30, 2010     June 30, 2009  
     (in thousands)  

Allowance for loan and lease losses-beginning of period

   $ 26,492      $ 17,385   

Provision expense for loan and lease losses

     7,908        11,178   

Loans charged-off

     (7,956     (9,436

Loan loss recoveries

     386        148   
                

Allowance for loan and lease losses-end of period

   $ 26,830      $ 19,275   
                

The Company classifies a loan as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans were, $46,745 thousand, $40,118 thousand and $10,085 thousand at June 30, 2010, December 31, 2009 and June 30, 2009, respectively. Loans past due 90 days or more and still accruing interest were $342 thousand, $4,524 thousand and $3,373 thousand at June 30, 2010, December 31, 2009 and June 30, 2009, respectively. The Company had no significant outstanding commitments to lend additional funds to customers whose loans have been placed on nonaccrual status.

Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may change in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

NOTE 6 – GUARANTEES

The Company, as part of its ongoing business operations, issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company to guarantee the performance of a customer to a third-party. A financial standby letter of credit is a commitment to guarantee a customer’s repayment of an outstanding loan or debt instrument. In a performance standby letter of credit, the Company guarantees a customer’s performance under a contractual nonfinancial obligation for which it receives a fee. The maximum potential amount of future payments the Company could be required to make under its standby letters of credit at June 30, 2010, December 31, 2009, and June 30, 2009 was $14,124 thousand, $16,077 thousand, and $19,236 thousand, respectively. The Company’s outstanding standby letters of credit generally have a term of one year and some may have renewal options. The amount of collateral, if any, the Company obtains on an extension of credit is based on its credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

NOTE 7 – STOCKHOLDERS’ EQUITY

Common Stock and ESOP Activity

On January 27, 2010 and April 28, 2010, the Company’s Board of Directors elected to suspend the dividend on the Company’s common stock and elected to defer payment on the Series A Preferred Stock (Preferred Stock) for the first and second quarters of 2010. If the Company misses six quarterly Preferred Stock dividend payments, whether or not consecutive, the Treasury will have the right to appoint two directors to the Company’s Board of Directors until all accrued but unpaid dividends have been paid. The Company may not pay dividends on common stock unless all dividends have been paid on the Preferred Stock.

 

12


Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

On June 30, 2010 and March 31, 2010, the Company released 70,701 and 65,655 shares, respectively, from the Employee Stock Ownership Plan (ESOP) for the matching contribution of 100% of the employee’s contribution up to 6% of the employee’s compensation for the Plan year. The number of unallocated, committed to be released, and allocated shares for the ESOP are presented in the following table.

 

     Unallocated Shares     Committed to be
released shares
   Allocated
Shares
   Compensation
Expense
(in thousands)

Shares as of December 31, 2009

   768,787      —      431,889   

Shares allocated during 2010

   (136,356   —      136,356    $ 285
                  

Shares as of June 30, 2010

   632,431      —      568,245   
                  

Preferred Stock

On January 27, 2010 and April 28, 2010, the Company’s Board of Directors elected to defer payment on the February 15, 2010 and May 15, 2010 dividends on the Preferred Stock. Dividends for the Series A Preferred Stock are cumulative. The Company recognized $412 thousand and $825 thousand for the three and six months ended June 30, 2010. As of June 30, 2010, the unpaid, accrued dividend is $1,031 thousand. For the three and six months ended June 30, 2010, the Company recognized $94 thousand and $186 thousand, respectively, in Preferred Stock discount accretion.

NOTE 8 – TAXES

The Company accounts for income taxes in accordance with ASC 740, which requires an asset and liability approach for the financial accounting and reporting of income taxes. Under this method, deferred income taxes are recognized for the expected future tax consequences of differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. These balances are measured using the enacted tax rates expected to apply in the year(s) in which these temporary differences are expected to reverse. The effect on deferred income taxes of a change in tax rates is recognized in income in the period when the change is enacted.

For the three and six months ended June 30, 2010, the Company recognized an income tax benefit of $1,812 thousand and $2,966 thousand, respectively, compared to $1,536 thousand and $2,449 thousand for the same periods in 2009, respectively. The following reconciles the income tax benefit to statutory rates:

 

     For the three months ended
June 30,
    For the six months ended
June 30,
 
     2010     2009     2010     2009  
     (in thousands)  

Federal taxes at statutory tax rate

   $ (1,363   $ (1,001   $ (2,134   $ (1,601

Tax exempt earnings on loans and securities

     (121     (138     (250     (277

Tax exempt earnings on bank owned life insurance

     (86     (86     (171     (171

Low-income housing tax credits

     (103     —          (207     —     

Other, net

     46        (119     96        (81

State tax provision, net of federal effect

     (185     (192     (300     (319
                                

Income tax benefit

   $ (1,812   $ (1,536   $ (2,966   $ (2,449
                                

The income tax benefit recognized during 2010 primarily relates to increases in deferred tax assets including the increase associated with the net operating loss for the period. The income tax benefit during 2009 primarily relates to the increase in deferred tax assets including the increase associated with the temporary difference in the allowance for loan and lease losses as well as the net operating loss for the period. Based on the Company’s historical pattern of taxable income, the Company expects to produce sufficient income in the future to realize its deferred tax assets. A valuation allowance is established for any portion of a deferred tax asset that the Company believes is more likely than not that the Company will not be able to realize the benefits. As of June 30, 2010, the Company has no valuation allowances associated with deferred tax assets.

 

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Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

The Company evaluated its material tax positions as of June 30, 2010. Under the “more-likely-than-not” threshold guidelines, the Company believes it has identified all significant uncertain tax benefits. The Company evaluates, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be accrued, in accordance with Internal Revenue Service guidelines, and recorded as a component of income tax expense in the Company’s consolidated financial statements. The roll-forward of unrecognized tax benefits is as follows:

 

      Amount
     (in thousands)

Balance at January 1, 2010

   $ 1,146

Increases related to prior year tax positions

     —  

Increases related to current year tax positions

     100

Lapse of statute

     —  
      

Balance at June 30, 2010

   $ 1,246
      

NOTE 9 – FAIR VALUE MEASUREMENTS

The authoritative accounting guidance for fair value measurements 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. Authoritative guidance establishes 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 following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2010, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the hierarchy. In such cases, the fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The following table presents the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2010.

 

     Balance as of
June 30, 2010
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant  Other
Observable
Inputs

(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
     (in thousands)

Financial assets

           

Securities available-for-sale

   $ 153,031    $ —      $ 152,781    $ 250

Loans held for sale

     2,713      —        2,713      —  

Financial liabilities

           

Forward loan sales contracts

     11      —        11      —  

 

14


Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

The following table presents additional information about changes in assets and liabilities measured at fair value on a recurring basis and for which the Company utilized Level 3 inputs to determine fair value as of June 30, 2010.

 

     Beginning
Balance
   Total
Realized
and
Unrealized
Gains or
Losses
   Purchases,
Sales, Other
Settlements
and
Issuances,
net
   Net
Transfers In
and/or Out
of Level 3
   Ending
Balance
     (in thousands)

Financial assets

              

Securities available-for-sale

   $ 250    $ —      $ —      $ —      $ 250

The Company did not recognize any unrealized gains or losses on Level 3 fair value assets or liabilities.

At June 30, 2010, the Company also had assets and liabilities measured at fair value on a non-recurring basis. Items measured at fair value on a non-recurring basis include other real estate owned (OREO), repossessions, and collateral-dependent impaired loans. Such measurements were determined utilizing Level 2 and Level 3 inputs.

Upon initial recognition, OREO and repossessions are measured at fair value, which becomes the cost basis. The cost basis is subsequently re-measured at fair value when events or circumstances occur that indicate the initial fair value has declined. Collateral-dependent impaired loans are measured at fair value based on the appraised value of the collateral. A loan is collateral-dependent when repayment of the loan is expected solely by the underlying collateral and there are no other available and reliable sources of repayment. If the recorded investment in the impaired loan exceeds the measure of fair value, the shortfall is recognized as a charge-off. The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis, for which impairment was recognized for during the six months ended June 30, 2010.

 

     Carrying
Value as of
June 30, 2010
   Level 1
Fair Value
Measurement
   Level 2
Fair Value
Measurement
   Level 3
Fair Value
Measurement
   Valuation
Allowance as of
June 30, 2010
 
     (in thousands)  

Other real estate owned

   $ 11,333    $ —      $ 11,333    $ —      $ (4,112

Repossessions

     118      —        118      —        (189

Collateral-dependent loans

     4,000      —        4,000      —        (113

 

15


Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

The following table presents the estimated fair values of the Company’s financial instruments.

 

      June 30, 2010     December 31, 2009     June 30, 2009  
      Carrying
Amount
    Fair Value     Carrying
Amount
    Fair Value     Carrying
Amount
    Fair Value  
     (in thousands)  

Financial assets

            

Cash and cash equivalents

   $ 8,960      $ 8,960      $ 23,220      $ 23,220      $ 20,908      $ 20,908   

Interest bearing deposits in banks

   $ 232,720      $ 232,720      $ 152,616      $ 152,616      $ 12,354      $ 12,354   

Securities available-for-sale

   $ 153,031      $ 153,031      $ 143,045      $ 143,045      $ 137,494      $ 137,494   

Loans held for sale

   $ 2,713      $ 2,713      $ 1,225      $ 1,225      $ 3,806      $ 3,806   

Loans

   $ 848,639      $ 862,760      $ 950,793      $ 959,689      $ 964,687      $ 971,571   

Allowance for loan and lease losses

   $ (26,830   $ (26,830   $ (26,492   $ (26,492   $ (19,275   $ (19,275

Financial liabilities

            

Deposits

   $ 1,166,251      $ 1,175,546      $ 1,182,673      $ 1,187,263      $ 1,033,046      $ 1,040,345   

Federal funds purchased and securities sold under agreements to repurchase

   $ 19,347      $ 19,347      $ 17,911      $ 17,911      $ 20,538      $ 20,538   

Other borrowings

   $ 85      $ 85      $ 94      $ 94      $ 102      $ 102   

The following methods and assumptions were used by the Company in estimating fair value of each class of financial instruments for which it is practicable to estimate that value:

 

   

Cash and cash equivalents – The carrying value of cash and cash equivalents approximates fair value.

 

   

Interest bearing deposits in banks – The carrying amounts of interest bearing deposits in banks approximate fair value.

 

   

Securities – The Company’s securities are valued utilizing Level 2 inputs with the exception of one $250 thousand bond. Level 2 inputs are based on quoted prices for similar assets in active markets.

 

   

Loans held for sale – Fair value for loans held for sale are based on quoted prices for similar assets in active markets.

 

   

Loans – For variable-rate loans that reprice frequently and have no significant changes in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans and other consumer loans are estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans and leases is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers of similar credit ratings quality. Fair value for impaired loans and leases are estimated using discounted cash flow analysis or underlying collateral values, where applicable.

 

   

Deposit liabilities – The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value for fixed-rate certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregate expected maturities on time deposits.

 

   

Federal funds purchased and securities sold under agreements to repurchase – These borrowings generally mature in 90 days or less and, accordingly, the carrying amount reported in the balance sheet approximates fair value.

 

   

Other borrowings – Other borrowings carrying amount reported in the consolidated balance sheets approximates fair value.

 

16


Table of Contents

FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

NOTE 10 – FAIR VALUE OPTION

Authoritative accounting guidance provides a fair value option election (FVO) that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. The guidance permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.

The Company records all newly-originated loans held for sale under the fair value option. Origination fees and costs are recognized in earnings at the time of origination. The servicing value is included in the fair value of the loan and recognized at origination of the loan. The Company uses derivatives to hedge changes in servicing value as a result of including the servicing value in the fair value of the loan. The estimated impact from recognizing servicing value, net of related hedging costs, as part of the fair value of the loan is captured in the mortgage loan and related fees component of noninterest income.

As of June 30, 2010 and 2009, there was $2,713 thousand and $3,806 thousand in loans held for sale recorded at fair value, respectively. For the three and six months ended June 30, 2010, approximately $236 thousand and $385 thousand in loan origination and related fee income was recognized in noninterest income, respectively, and an insignificant amount of origination and related fee expense, respectively, was recognized in noninterest expense utilizing the fair value option.

For the six months ended June 30, 2010, the Company recognized a loss of $58 thousand due to changes in fair value for loans held for sale in which the fair value option was elected. This amount does not reflect the change in fair value attributable to the related hedges the Company used to mitigate the interest rate risk associated with loans held for sale. The changes in the fair value of the hedges were also recorded in the mortgage loan and related fee component of noninterest income, and provided $69 thousand of income.

The following table provides the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale for which the fair value option has been elected.

 

     Aggregate fair
value
   Aggregate unpaid
principal balance
under FVO
   Fair value carrying
amount over (under)
unpaid principal
     (in thousands)

Loans held for sale

   $ 2,713    $ 2,702    $ 11

NOTE 11 – DERIVATIVE FINANCIAL INSTRUMENTS

The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity, as necessary, to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of June 30, 2010, the Company has not entered into a transaction in a dealer capacity.

When a derivative is intended to be a qualifying hedged instrument, the Company prepares written hedge documentation that designates the derivative as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or (2) a hedge of a forecasted transaction, such as, the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).

The written documentation includes identification of, among other items, the risk management objective, hedging instrument, hedged item, and methodologies for assessing and measuring hedge effectiveness and ineffectiveness, along with support for management’s assertion that the hedge will be highly effective. Methodologies related to hedge effectiveness and ineffectiveness include (1) statistical regression analysis of changes in the cash flows of the actual derivative and a perfectly effective

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

hypothetical derivative, (2) statistical regression analysis of changes in fair values of the actual derivative and the hedged item and (3) comparison of the critical terms of the hedged item and the hedging derivative. Changes in fair value of a derivative that is highly effective and that has been designated and qualifies as a fair value hedge are recorded in current period earnings, along with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. Changes in the fair value of a derivative that is highly effective and that has been designed and qualifies as a cash flow hedge are initially recorded in other comprehensive income and reclassified to earnings in conjunction with the recognition of the earnings impacts of the hedged item; any ineffective portion is recorded in current period earnings. Designated hedge transactions are reviewed at least quarterly for ongoing effectiveness. Transactions that are no longer deemed to be effective are removed from hedge accounting classification and the recorded impacts of the hedge are recognized in current period income or expense in conjunction with the recognition of the income or expense on the originally hedged item.

The Company’s derivatives are based on underlying risks, primarily interest rates. The Company has utilized swaps to reduce the risks associated with interest rates. Swaps are contracts in which a series of net cash flows, based on a specific notional amount that is related to an underlying risk, are exchanged over a prescribed period. The Company also utilizes forward contracts on the held for sale loan portfolio. The forward contracts hedge against changes in fair value of the held for sale loans.

Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk is equal to the fair value gain of the derivative. The credit exposure for swaps is the replacement cost of contracts that have become favorable. Credit risk is minimized by entering into transactions with high quality counterparties that are initially approved by the Board of Directors and reviewed periodically by the Asset/Liability Committee. It is the Company’s policy of requiring that all derivatives be governed by an International Swap and Derivatives Associations Master Agreement (ISDA). Bilateral collateral agreements may also be required.

On August 28, 2007 and March 26, 2009, the Company elected to terminate a series of interest rate swaps with a total notional value of $150 million and $50 million, respectively. At termination, the swaps had a market value of $2,010 thousand and $5,778 thousand, respectively. These gains are being accreted into interest income over the remaining life of the originally hedged items. The Company recognized a total of $1,042 thousand for the six months ended June 30, 2010.

The following table presents the accretion of the remaining gain for the terminated swaps.

 

     20101    2011    2012    Total
     (in thousands)

Accretion of gain from 2007 terminated swaps

   $ 159    $ 219    $ 62    $ 440

Accretion of gain from 2009 terminated swaps

   $ 821    $ 1,628    $ 1,272    $ 3,721

 

1

Represents the gain accretion for July 1, 2010 to December 31, 2010. Excludes the amounts recognized in the first six months of 2010.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

The following table presents the cash flow hedges as of June 30, 2010.

 

      Notional
Amount
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Accumulated
Other
Comprehensive
Income (Loss)
    Maturity
Date
     (in thousands)

Asset hedges

             

Cash flow hedges:

             

Forward contracts

   $ 2,713    $ 5    $ 16    $ (7   Various
                               
   $ 2,713    $ 5    $ 16    $ (7  
                               

Terminated asset hedges

             

Cash flow hedges: 1

             

Interest rate swap

   $ 25,000    $ —      $ —      $ 71      June 28, 2011

Interest rate swap

     20,000      —        —        54      June 28, 2011

Interest rate swap

     35,000      —        —        166      June 28, 2012

Interest rate swap

     25,000      —        —        1,228      October 15, 2012

Interest rate swap

     25,000      —        —        1,228      October 15, 2012
                               
   $ 130,000    $ —      $ —      $ 2,747     
                               

 

1

The $2.7 million of gains, net of taxes, recorded in accumulated other comprehensive income as of June 30, 2010, will be reclassified into earnings as interest income over the remaining life of the respective hedged items.

The following table presents additional information on the active derivative positions as of June 30, 2010.

 

          

Consolidated Balance

Sheet Presentation

  

Consolidated Income
Statement Presentation

         

Assets

   Liabilities   

Gains

     Notional   

Classification

   Amount    Classification    Amount   

Classification

   Amount
Recognized
     (in thousands)

Hedging Instrument:

                    

Forward contracts

   $ 2,713    Other assets    $ N/A    Other liabilities    $ 11    Noninterest
income – other
   $ 69

Hedged Items:

                    

Loans held for sale

     N/A    Loans held for sale    $ 2,713    N/A      N/A    Noninterest
income – other
     N/A

For the three and six months ended June 30, 2010, no significant amounts were recognized for hedge ineffectiveness.

NOTE 12 – RECENT ACCOUNTING PRONOUNCEMENTS

Effective January 1, 2010, the Company adopted the provisions of the FASB Accounting Standards Update 2010-06, “Improving Disclosures about Fair Value Measurements” (ASU 2010-06), which updates ASC 820 to require disclosure of significant transfers into and out of Level 1 and Level 2 of the fair value hierarchy, as well as disclosure of an entity’s policy for determining when transfers between all levels of the hierarchy are recognized. ASC 820, as amended, also provides enhanced disclosure requirements regarding purchases, sales, issuances, and settlements related to recurring Level 3 measurements, and requires separate disclosure in the Level 3 reconciliation of total gains and losses recognized in other comprehensive income. The updated provisions of ASC 820 require that fair value measurement disclosures be provided by each “class” of assets and liabilities, and that disclosures providing a description of the valuation techniques and inputs used to measure fair value be included for both recurring and nonrecurring fair value measurements classified as either Level 2 or Level 3. The provisions of ASU 2010-06 are effective for periods beginning after December 15, 2009, except for the requirement to provide the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis which will be effective for periods beginning after December 15, 2010. Comparative disclosures are required only for periods ending subsequent to initial adoption. The Company revised its disclosures accordingly.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

Effective January 1, 2010, the Company adopted the provisions of the FASB Accounting Standards Update 2009-16, “Accounting for Transfers of Financial Assets” (ASU 2009-16). ASU 2009-16 updates ASC 860 to provide for the removal of the qualifying special purpose entity (“QSPE”) concept from GAAP, resulting in the evaluation of all former QSPEs for consolidation on and after January 1, 2010 in accordance with ASC 810. The amendments to ASC 860 modify the criteria for achieving sale accounting for transfers of financial assets and define the term participating interest to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale. The updated provisions of ASC 860 also provide that a transferor should recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. ASC 860, as amended, requires enhanced disclosures which are generally consistent with, and supersede, the disclosures previously required by the Codification update to ASC 810 and ASC 860 which was effective for periods ending after December 15, 2008. The provisions of ASU 2009-16 are effective prospectively for new transfers of financial assets occurring in fiscal years beginning after November 15, 2009, and in interim periods within those fiscal years. ASC 860’s amended disclosure requirements should be applied to transfers that occurred both before and after the effective date of the Codification update, with comparative disclosures required only for periods subsequent to initial adoption for those disclosures not previously required under the Codification update to ASC 810 and ASC 860 which was effective for periods ending after December 15, 2008. The adoptions did not impact the Company’s consolidated financial statements.

Effective December 31, 2009, the Company adopted the provisions of FASB Accounting Standards Update 2009-05, “Measuring Liabilities at Fair Value” (ASU 2009-05) to the FASB Accounting Standards Codification (ASC or Codification). ASU 2009-05 updates ASC 820 to clarify that a quoted price for the identical liability, when traded as an asset in an active market, is a Level 1 measurement for that liability when no adjustment to the quoted price is required. ASU 2009-05 further amends ASC 820 to provide that if a quoted price for an identical liability does not exist in an active market, the fair value of the liability should be measured using an approach that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. Under the updated provisions of ASC 820, for such liabilities fair value will be measured using either a valuation technique that uses the quoted price of the identical liability when traded as an asset, a valuation technique that uses the quoted price for similar liabilities or similar liabilities when traded as an asset, or another valuation technique that is consistent with the principles of ASC 820. The adoption had no significant impact on the Company’s consolidated financial statements.

Effective September 30, 2009, the Company adopted the provisions of the FASB Accounting Standard Codification 105-10, “Generally Accepted Accounting Principles.” This standard establishes the FASB Accounting Standards Codification as the single source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP, other than guidance issued by the SEC. Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority, with this Statement superseding all then-existing non-SEC accounting and reporting standards as of its effective date. Following this Statement, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standard Updates that will serve only to update the Codification. In conjunction with the adoption of this Statement, all references to pre-Codification Statements have either been removed or updated to reflect the new Codification reference. The adoption of this Statement did not have a significant impact on the Company’s consolidated financial statements.

Effective June 30, 2009, the Company adopted the FASB ASC 855, “Subsequent Events.” ASC 855 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. Effective upon its issuance in February 2010, the Company adopted the provisions of ASU 2010-09, “Subsequent Events – Amendments to Certain Recognition and Disclosure Requirements” (ASU 2010-09). ASU 2010-09 amends ASC 855 to clarify that an entity must disclose the date through which subsequent events have been evaluated in both originally issued and restated financial statements unless the entity has a regular requirement to review subsequent events up through the filing or furnishing of financial statements with the Securities and Exchange Commission. Upon adoption of the provisions of ASU 2010-09, the Company revised its disclosures accordingly.

Effective June 30, 2009, the Company adopted ASC 825-10, “Financial Instruments.” This update requires disclosures about the fair value of financial instruments in interim financial statements. The guidance requires that disclosures be included in both interim and annual financial statements of the

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

methods and significant assumptions used to estimate the fair value of financial instruments. Comparative disclosures are required only for periods ending subsequent to initial adoption. The additional required disclosures are presented in Note 9 of the Company’s consolidated financial statements.

Effective March 31, 2009, the Company adopted the FASB Codification update ASC 320-10-35 which replaces the “intent and ability to hold to recovery” indicator of other-than-temporary impairment in ASC 320-10-35 for debt securities. The guidance, issued in April 2009, establishes a new method of recognizing and reporting other-than-temporary impairments of debt securities as well as requiring additional disclosures related to debt and equity securities. Under the new guidance, an impairment is other-than-temporary if any of the following conditions exist: (1) the entity intends to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis or (3) the entity does not expect to recover the security’s entire amortized cost basis, even if the entity does not intend to sell. Additionally, the guidance requires that for impaired securities that an entity does not intend to sell that it is not more-likely-than-not that it will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. The guidance discusses the proper interaction with other authoritative guidance, including the additional factors that must be considered in an other-than-temporary impairment analysis. The additional disclosure requirements include a roll-forward of amounts recognized in earnings for debt securities for which an other-than-temporary impairment has been recognized and the noncredit portion of the other-than-temporary impairment that has been recognized in other comprehensive income. The adoption did not impact the Company’s consolidated financial statements.

Effective March 31, 2009, the Company first applied the provisions of the FASB ASC 820-10, “Fair Value Measurements and Disclosures,” that was issued in April 2009. The update provides factors that an entity should consider when determining whether a market for an asset is not active. If, after evaluating the relevant factors, the evidence indicates that a market is not active, the guidance provides an additional list of factors that an entity must consider when determining whether events and circumstances indicate that a transaction which occurred in an inactive market is orderly. The guidance requires that entities place more weight on observable transactions determined to be orderly and less weight on transactions for which there is insufficient information to determine whether the transaction is orderly when determining the fair value of an asset or liability under applicable authoritative guidance. The guidance also requires enhanced disclosures, including disclosure of a change in valuation technique that results from its application and disclosure of fair value measurements for debt and equity securities by major security types. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of the Codification update to ASC 815-10-50 which requires expanded disclosures about an entity’s derivative instruments and hedging activities, but does not change previous authoritative guidance on scope or accounting. This updated guidance requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under GAAP and its related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. To meet those objectives, this guidance requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures in a tabular format about fair value amounts and gains and losses on derivative instruments including specific disclosures regarding the location and amounts of derivative instruments in the financial statements, and disclosures about credit-risk-related contingent features in derivative agreements. The guidance also clarifies derivative instruments that are subject to the concentration of credit-risk disclosures. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 805. This update establishes principles and requirements for how an acquirer in a business combination: recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and discloses information to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The adoption did not impact the Company’s consolidated financial statements.

 

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

 

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 805, which requires that an acquirer recognize at fair value as of the acquisition date an asset acquired or liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of the asset or liability can be determined during the measurement period. The guidance provides that if the acquisition-date fair value of an asset acquired or liability assumed in a business combination that arises from a contingency cannot be determined during the measurement period, the asset or liability should be recognized at the acquisition date if information available before the end of the measurement period indicates that it is probable that an asset existed or a liability had been incurred at the acquisition date and the amount of the asset or liability can be reasonably estimated. Additionally, the guidance requires enhanced disclosures regarding assets and liabilities arising from contingencies which are recognized at the acquisition date of a business combination, including the nature of the contingencies, the amounts recognized at the acquisition date and the measurement basis applied. The adoption did not impact the Company’s consolidated financial statements.

Effective January 1, 2009, the Company adopted the provisions of a Codification update to ASC 810, as amended. The update establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This guidance clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be clearly reported as equity in the consolidated financial statements. Additionally, the guidance requires that the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated income statement. The adoptions did not impact the Company’s consolidated financial statements.

NOTE 13 – REGULATORY ACTION

On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order (Order), FSGBank, N.A. (Bank), the Company’s wholly-owned subsidiary, consented and agreed to the issuance of a Consent Order by the Office of the Comptroller of the Currency (OCC), the Bank’s primary regulator.

The Bank and the OCC agreed as to the areas of the Bank’s operations that warrant improvement and a plan for making those improvements. The Order required the Bank to develop and submit written strategic and capital plans covering at least a three-year period. The Bank is required to review and revise various policies and procedures, including those associated with concentration management, the allowance for loan and lease losses, liquidity management, criticized asset, loan review and credit.

Within 120 days of the effective date of the Order, the Bank is required to achieve and thereafter maintain total capital at least equal to 13 percent of risk-weighted assets and Tier 1 capital at least equal to 9 percent of adjusted total assets. As of June 30, 2010, the Bank’s total capital to risk-weighted assets was in compliance with the Order with a ratio of 14.29 percent. The Bank’s Tier 1 capital to adjusted total assets was out of compliance with the Order with a ratio of 8.78 percent.

Because the Order established specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” for capital adequacy purposes, even if the Bank exceeds the levels of capital set forth in the Order. As an adequately capitalized institution, the Bank may not pay interest on deposits that are more than 75 basis points above the rate applicable to the applicable market of the Bank as determined by the FDIC. Additionally, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.

On April 29, 2010, the Company filed a current report on Form 8-K describing the Order and the Bank’s actions to date. The Form 8-K also provides the final, executed Order.

NOTE 14 – SUBSEQUENT EVENTS

On July 21, 2010, the Board of Directors of the Company increased the size of the Board to six and elected Ralph E. Mathews, Jr. to the Board of the Company. Mr. Mathews was elected to the Board of FSGBank on June 23, 2010.

On July 22, 2010, the Company filed with the State of Tennessee, Articles of Amendment to the Charter of Incorporation to increase the number of authorized shares of common stock from 50 million to 150 million, in accordance with shareholder approval obtained on June 30, 2010.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In this Form 10-Q, “First Security,” “we,” “us,” “the Company” and “our” refer to First Security Group, Inc.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain of the statements made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this Form 10-Q are forward-looking statements for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934. Forward-looking statements relate to future events or our future financial performance and may involve known or unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of First Security to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements. Forward-looking statements include statements using the words such as “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “intend,” “seeks,” or other similar words and expressions of the future.

These forward-looking statements involve risks and uncertainties, and may not be realized due to a variety of factors, including, without limitation: the effects of future economic conditions, governmental monetary and fiscal policies, as well as legislative and regulatory changes; the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities; the costs of evaluating possible acquisitions and the risks inherent in integrating acquisitions; the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in First Security’s market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the Internet; and, the failure of assumptions underlying the establishment of reserves for possible loan losses. All written or oral forward-looking statements attributable to First Security are expressly qualified in their entirety by this Special Note.

SECOND QUARTER 2010 AND RECENT EVENTS

The following discussion and analysis sets forth the major factors that affected results of operations and financial condition reflected in the unaudited financial statements for the three and six month periods ended June 30, 2010 and 2009. Such discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and the notes attached thereto.

Company Overview

First Security Group, Inc. is a bank holding company headquartered in Chattanooga, Tennessee, with $1.3 billion in assets as of June 30, 2010. Founded in 1999, First Security’s community bank subsidiary, FSGBank, N.A. has 38 full-service banking offices, including the headquarters, along the interstate corridors of eastern and middle Tennessee and northern Georgia and 333 full-time equivalent employees. In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank; along the Interstate 40 corridor in Tennessee, FSGBank operates under the name of Jackson Bank & Trust. FSGBank provides retail and commercial banking services, trust and investment management, mortgage banking, financial planning and internet banking (www.FSGBank.com) services.

 

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Recent Regulatory Events

Effective April 28, 2010, FSGBank reached an agreement with its primary regulatory, the Office of the Controller of the Currency (OCC), regarding the issuance of a Consent Order (Order). The Order is a result of the OCC’s regular examination of the Bank in the fall of 2009 and directs the Bank to take actions intended to strengthen its overall condition. All customer deposits remain fully insured by the FDIC to the maximum extent allowed by law; the Order does not impact this coverage in any manner. On April 29, 2010, First Security filed a current report on Form 8-K describing the Order and the related actions taken by the Bank to date. The Form 8-K also provides a copy of the fully executed Order.

Prior to and following the OCC’s regularly scheduled exam in the fall of 2009, we developed and began implementing a number of strategic initiatives designed to improve both the operations and the financial performance of First Security. The Order establishes a framework and timeline for fully implementing certain of our strategic initiatives. We believe the successful execution of our initiatives will result in full compliance with the Order and position us for long-term growth and a return to profitability.

Strategic Initiatives

During 2009 and 2010, we initiated a set of strategic initiatives to position us appropriately for both short-term stability and long-term success. The following are the primary initiatives with associated target dates for implementation:

 

Strategic Initiative

  

Current and/or Potential Impact

  

Actual/Expected

Implementation

Capital

     

•      CPP participation

  

Received $33 million in Preferred Stock capital

   1st quarter 2009

•      Capital stress test

  

Outsourced a SCAP capital stress test to assist in capital planning

   4th quarter 2009

Liquidity

     

•      Liquidity enhancement

  

Increased longer term brokered deposits and excess cash to fund future contractual obligations and prudent investments

   1st quarter 2010

Asset Quality

     

•      Loan review department expansion

  

Added resources to increase frequency and coverage of the review of our portfolio

   4th quarter 2009

•      Extensive loan review

  

Outsourced an extensive loan review prior to year-end 2009

   4th quarter 2009

Credit Administration

     

•      Lines of business

  

Credit functions aligned by retail and commercial lines of business with dedicated credit officers and staff supporting each portfolio

   4th quarter 2009

•      Loan underwriting centralization

  

Ensures consistency in underwriting, pricing, loan structure and policy compliance

   2nd quarter 2010

•      Collections centralization

  

Dedicated collections department created to focus on collection of past due loans and recovery of prior charge-offs

   2nd quarter 2010

•      Loan document preparation centralization

  

Operational efficiencies and reduction of loan policy exceptions

   2nd quarter 2010

•      Loan policy

  

Amended existing loan policy to provide the framework and guidelines for current and future loans

   2nd quarter 2010

Management

     

•      Chief risk officer

  

Elevated risk manager to executive level with expanded responsibilities

   1st quarter 2010

•      Chief credit officer

  

Hired experienced credit officer to oversee credit administration

   2nd quarter 2010

•      Retail banking president

  

Created new executive level position that will be responsible for customer and small-business loan relationships and associated lenders

   3rd quarter 2010

•      Commercial banking president

  

Created new executive level position that will be responsible for commercial loan relationships and associated commercial lenders

   3rd quarter 2010

The above initiatives are discussed in additional detail throughout MD&A.

 

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Overview

Market Conditions

Most indicators point toward the overall U.S. economy transitioning to a gradual recovery period over the balance of 2010. Some economists have indicated that the future recovery may bring with it few new jobs. As our financial results can be a reflection of our regional economy, we closely monitor and evaluate local and regional economic trends.

Announced in 2008, the $1 billion Volkswagen automotive production facility is currently under construction and hiring has commenced. The Volkswagen plant will bring about 2,000 direct jobs, including approximately 400 white-collar jobs, and up to 12,000 indirect jobs to the region. We believe the positive economic impact on Chattanooga and the surrounding region from Volkswagen and other recently announced large economic investments will be significant, and it may stabilize and possibly increase real estate values and enhance economic activity within our market area.

While the economic recession has resulted in higher unemployment across the country, our market areas benefit from more stable rates of employment. Our major market areas of Chattanooga and Knoxville have a lower unemployment rate of 8.7% and 7.9%, respectively (as of May 2010, the most recent available data), than the Tennessee rate of 9.8%. The economy of the Dalton, Georgia MSA is primarily centered on the carpet and floor-covering industries. With the decline in housing starts and the overall economy, Dalton has been the most negatively impacted region in our footprint. The unemployment rate in the Dalton MSA is 11.5% (as of May 2010) compared to the Georgia rate of 9.8%. For the Chattanooga and Knoxville MSAs, the number of unemployed workers is decreasing and, as of May 2010, has declined by 14.5% in Chattanooga and 16.3% in Knoxville since the peak in June 2009. We believe these positive employment trends will continue throughout 2010.

Our market area has also benefited from a relatively stable housing market. According to the National Association of REALTORS, the median sales prices of existing single-family homes declined 5.0% and 5.2% for the Chattanooga and Knoxville MSAs, respectively, from 2008 to 2009 compared to 12.5% decline for the nation and a 8.5% decline for the census region identified as the South. While residential real estate values may continue to decline, we are hopeful that housing prices will begin to stabilize.

Financial Results

As of June 30, 2010, we had total consolidated assets of $1.3 billion, total loans of $851.4 million, total deposits of $1.2 billion and stockholders’ equity of $137.1 million. For the three and six months ended June 30, 2010, our net loss available to common shareholders was $2.7 million and $4.3 million, respectively, resulting in basic and diluted net loss of $0.17 per share for the quarter and $0.28 per share for the year-to-date period.

As of June 30, 2009, we had total consolidated assets of $1.2 billion, total loans of $968.5 million, total deposits of $1.0 billion and stockholders’ equity of $172.5 million. For the three and six months ended June 30, 2009, our net loss available to common shareholders was $1.9 million and $3.2 million, respectively, resulting in basic and diluted net loss of $0.12 per share for the quarter and $0.21 per share for the year-to-date period.

For the three and six month periods ended June 30, 2010, net interest income decreased by $1.5 million and $2.1 million, respectively, and noninterest income decreased by $86 thousand and $233 thousand, respectively, compared to the same periods in 2009. For the three and six months ended June 30, 2010, noninterest expense increased by $2.1 million and $2.5 million, respectively, compared to the same periods in 2009. The decline in net interest income is primarily attributable to the shift in earning assets from loans to noninterest cash partially offset by reductions in rates on interest bearing liabilities. Noninterest income decreased primarily due to lower deposit fees while noninterest expense increased primarily due to higher expenses associated with nonperforming assets, including write-downs, losses and holding costs. These increases were partially offset by reductions in salary and benefit expense. Full-time equivalent employees were 333 at June 30, 2010, compared to 353 at June 30, 2009.

 

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The provision for loan and lease losses decreased $2.7 million and $3.3 million for the three and six month periods ended June 30, 2010, respectively, compared to the same periods in 2009.

Our efficiency ratio increased in the second quarter of 2010 to 104.0% compared to 75.3% in the same period of 2009 primarily due to reductions in net interest income and noninterest income and increases to noninterest expense. We anticipate our efficiency ratio to begin to improve during the second half of 2010 as we focus on enhancing revenue while reducing certain overhead expenses. However, the stabilization and possible improvement of our efficiency ratio in the second half of 2010 is contingent on both macro-economic factors, such as potential changes to the federal funds target rate, and micro-economic factors, such as local unemployment and real estate values.

Net interest margin in the first quarter of 2010 was 2.93%, or 84 basis points lower than the prior year period of 3.77%. We believe that our net interest margin will stabilize and possibly improve in the second half of 2010. The projected stabilization of our net interest margin is dependent on multiple factors including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, maturities of brokered deposits, and any possible further action by the Federal Reserve Board.

During the second quarter, our Board of Directors again elected to defer payment on the Series A Preferred Stock (Preferred Stock). To date, the Company has deferred two consecutive Preferred Stock dividend payments. First Security may not pay dividends on common stock unless all dividends have been paid on the Preferred Stock.

RESULTS OF OPERATIONS

We reported a net loss to common stockholders for the three and six month periods ended June 30, 2010 of $2.7 million and $4.3 million compared to a net loss for the same periods in 2009 of $1.9 million and $3.2 million, respectively. In the second quarter of 2010, basic and diluted net loss per share was $0.17 on approximately 15.7 million weighted average shares outstanding. On a year-to-date basis, basic and diluted net loss per share was $0.28 on approximately 15.7 million weighted average shares outstanding.

Net income on a quarterly and year-to-date basis in 2010 was below the comparable amounts in 2009 as a result of the contraction in the net interest margin and higher expenses associated with nonperforming assets. As of June 30, 2010, we had 38 banking offices, including the headquarters, and 333 full-time equivalent employees.

 

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The following table summarizes the components of income and expense and the changes in those components for the three and six month periods ended June 30, 2010 compared to the same periods in 2009.

CONDENSED CONSOLIDATED INCOME STATEMENT

 

     For the Three
Months Ended
June 30,
    Change from Prior Year     For the Six
Months Ended
June 30,
    Change from Prior Year  
   2010     Amount     Percentage     2010     Amount     Percentage  
     (in thousands, except percentages)  

Interest income

   $ 14,290      $ (1,809   -11.2   $ 29,331      $ (3,243   -10.0

Interest expense

     5,329        (270   -4.8     10,695        (1,142   -9.6
                                            

Net interest income

     8,961        (1,539   -14.7     18,636        (2,101   -10.1

Provision for loan and lease losses

     3,544        (2,652   -42.8     7,919        (3,270   -29.2
                                            

Net interest income after provision for loan and lease losses

     5,417        1,113      25.9     10,717        1,169      12.2

Noninterest income

     2,558        (86   -3.3     4,862        (233   -4.6

Noninterest expense

     11,983        2,091      21.1     21,855        2,503      12.9
                                            

Net loss before income taxes

     (4,008     (1,064   -36.1     (6,276     (1,567   -33.3

Income tax benefit

     (1,812     (276   18.0     (2,966     (517   21.1
                                            

Net loss

     (2,196     (788   -56.0     (3,310     (1,050   -46.5

Preferred stock dividends and discount accretion

     506        6      1.2     1,011        63      6.6
                                            

Net loss available to common stockholders

   $ (2,702   $ (794   -41.2   $ (4,321   $ (1,113   -34.0
                                            

Net Interest Income

Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. For the three months ended June 30, 2010, net interest income decreased by $1.5 million, or 14.7%, to $9.0 million compared to $10.5 million for the same period in 2009. For the six months ended June 30, 2010, net interest income decreased by $2.1 million, or 10.1%, to $18.6 million for the period ended June 30, 2010, compared to $20.7 million for the same period in 2009.

We monitor and evaluate the effects of certain risks on our earnings and seek balance between the risks assumed and returns sought. Some of these risks include interest rate risk, credit risk and liquidity risk.

The level of net interest income is determined primarily by the average balances (volume) of interest earning assets and the various rate spreads between our interest earning assets and our funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest earning assets and interest bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits.

 

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The following tables summarize net interest income and average yields and rates paid for the quarters ended June 30, 2010 and 2009.

AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS

FULLY TAX EQUIVALENT BASIS

 

     For the Three Months Ended June 30,  
     2010     2009  
     Average
Balance
    Income/
Expense
   Yield/
Rate
    Average
Balance
    Income/
Expense
   Yield/
Rate
 
     (in thousands, except percentages)  

ASSETS

              

Earning assets:

              

Loans, net of unearned income (1) (2)

   $ 873,418      $ 12,734    5.85   $ 984,210      $ 14,527    5.92

Debt securities – taxable

     109,078        1,007    3.70     97,282        1,169    4.82

Debt securities – non-taxable (2)

     38,193        533    5.60     43,227        611    5.67

Other earning assets

     231,707        216    0.37     17,619        21    0.48
                                          

Total earning assets

     1,252,396        14,490    4.64     1,142,338        16,328    5.73
                              

Allowance for loan and lease losses

     (26,339          (19,388     

Intangible assets

     1,748             29,365        

Cash & due from banks

     7,726             18,873        

Premises & equipment

     32,541             33,972        

Other assets

     80,581             53,203        
                          

TOTAL ASSETS

   $ 1,348,653           $ 1,258,363        
                          

LIABILITIES AND STOCKHOLDERS’ EQUITY

              

Interest bearing liabilities:

              

Interest bearing demand deposits

   $ 68,743        50    0.29   $ 63,118        50    0.32

Money market accounts

     133,524        330    0.99     124,750        373    1.20

Savings deposits

     39,179        26    0.27     36,054        26    0.29

Time deposits of less than $100 thousand

     235,766        1,248    2.12     245,233        1,900    3.11

Time deposits of $100 thousand or more

     194,408        1,097    2.26     201,923        1,644    3.27

Brokered CDs and CDARS®

     352,915        2,456    2.79     150,371        1,327    3.54

Brokered money markets and NOWs

     —          —      —       77,498        161    0.83

Federal funds purchased

     —          —      —       9        —      1.00

Repurchase agreements

     18,992        120    2.53     21,999        116    2.11

Other borrowings

     87        2    7.66     367        2    2.19
                                          

Total interest bearing liabilities

     1,043,614        5,329    2.05     921,322        5,599    2.44
                              

Net interest spread

     $ 9,161    2.59     $ 10,729    3.29
                      

Noninterest bearing demand deposits

     156,542             148,918        

Accrued expenses and other liabilities

     9,152             12,555        

Stockholders’ equity

     133,648             169,125        

Accumulated other comprehensive income

     5,697             6,443        
                          

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,348,653           $ 1,258,363        
                          

Impact of noninterest bearing sources and other changes in balance sheet composition

        0.34        0.48
                      

Net interest margin

        2.93        3.77
                      

 

(1)

Nonaccrual loans have been included in the average balance. Only the interest collected on such loans has been included as income.

(2)

Interest income from securities and loans includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for both years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $200 thousand and $229 thousand for the three months ended June 30, 2010 and 2009, respectively.

 

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The following table presents the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.

CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS

FOR THE THREE MONTHS ENDED JUNE 30, 2010 COMPARED TO 2009

 

     Increase (Decrease) in Interest Income  and
Expense Due to Changes in:
 
     Volume     Rate     Total  
     (in thousands)  

Interest earning assets:

      

Loans, net of unearned income

   $ (1,635   $ (158   $ (1,793

Debt securities – taxable

     142        (304     (162

Debt securities – non-taxable

     (71     (7     (78

Other earning assets

     255        (60     195   
                        

Total earning assets

     (1,309     (529     (1,838
                        

Interest bearing liabilities:

      

Interest bearing demand deposits

     4        (4     —     

Money market accounts

     26        (69     (43

Savings deposits

     2        (2     —     

Time deposits of less than $100 thousand

     (73     (579     (652

Time deposits of $100 thousand or more

     (61     (486     (547

Brokered CDs and CDARS®

     1,787        (658     1,129   

Brokered money markets and NOWs

     (161     —          (161

Federal funds purchased

     —          —          —     

Repurchase agreements

     (16     20        4   

Other borrowings

     (2     2        —     
                        

Total interest bearing liabilities

     1,506        (1,776     (270
                        

Increase (decrease) in net interest income

   $ (2,815   $ 1,247      $ (1,568
                        

 

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The following tables summarize net interest income and average yields and rates paid for the year-to-date periods ended June 30, 2010 and 2009.

AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS

FULLY TAX EQUIVALENT BASIS

 

     For the Six Months Ended June 30,  
     2010     2009  
     Average
Balance
    Income/
Expense
   Yield/
Rate
    Average
Balance
    Income/
Expense
   Yield/
Rate
 
     (in thousands, except percentages)  

ASSETS

              

Earning assets:

              

Loans, net of unearned income (1) (2)

   $ 902,332      $ 26,186    5.85   $ 992,039      $ 29,404    5.98

Debt securities – taxable

     107,230        2,111    3.97     95,977        2,368    4.98

Debt securities – non-taxable (2)

     39,732        1,111    5.64     43,576        1,228    5.68

Other earning assets

     210,218        339    0.33     23,569        35    0.30
                                          

Total earning assets

     1,259,512        29,747    4.76     1,155,161        33,035    5.77
                              

Allowance for loan and lease losses

     (26,556          (18,792     

Intangible assets

     1,805             29,431        

Cash & due from banks

     8,320             17,625        

Premises & equipment

     32,771             33,876        

Other assets

     79,539             54,988        
                          

TOTAL ASSETS

   $ 1,355,391           $ 1,272,289        
                          

LIABILITIES AND STOCKHOLDERS’ EQUITY

              

Interest bearing liabilities:

              

Interest bearing demand deposits

   $ 65,855        95    0.29   $ 62,383        101    0.33

Money market accounts

     135,881        713    1.06     125,025        821    1.32

Savings deposits

     38,193        51    0.27     35,242        50    0.29

Time deposits of less than $100 thousand

     239,837        2,591    2.18     244,921        3,949    3.25

Time deposits of $100 thousand or more

     200,386        2,291    2.31     201,428        3,404    3.41

Brokered CDs and CDARS®

     338,363        4,653    2.77     165,742        2,926    3.56

Brokered money markets and NOWs

     13,231        57    0.87     78,122        327    0.84

Federal funds purchased

     —          —      —       629        4    1.28

Repurchase agreements

     19,434        241    2.50     22,173        243    2.21

Other borrowings

     89        3    6.80     893        12    2.71
                                          

Total interest bearing liabilities

     1,051,269        10,695    2.05     936,558        11,837    2.55
                              

Net interest spread

     $ 19,052    2.71     $ 21,198    3.22
                      

Noninterest bearing demand deposits

     153,511             148,651        

Accrued expenses and other liabilities

     9,871             12,881        

Stockholders’ equity

     134,844             167,605        

Accumulated other comprehensive income

     5,896             6,594        
                          

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 1,355,391           $ 1,272,289        
                          

Impact of noninterest bearing sources and other changes in balance sheet composition

        0.34        0.48
                      

Net interest margin

        3.05        3.70
                      

 

(1)

Nonaccrual loans have been included in the average balance. Only the interest collected on such loans has been included as income.

(2)

Interest income from securities and loans includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for both years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $416 thousand and $461 thousand for the six months ended June 30, 2010 and 2009, respectively.

 

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The following table presents the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.

CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS

FOR THE SIX MONTHS ENDED JUNE 30, 2010 COMPARED TO 2009

 

     Increase (Decrease) in Interest Income  and
Expense Due to Changes in:
 
     Volume     Rate     Total  
     (in thousands)  

Interest earning assets:

      

Loans, net of unearned income

   $ (2,732   $ (486   $ (3,218

Debt securities – taxable

     270        (527     (257

Debt securities – non-taxable

     (111     (6     (117

Other earning assets

     276        28        304   
                        

Total earning assets

     (2,297     (991     (3,288
                        

Interest bearing liabilities:

      

Interest bearing demand deposits

     5        (11     (6

Money market accounts

     69        (177     (108

Savings deposits

     4        (3     1   

Time deposits of less than $100 thousand

     (93     (1,265     (1,358

Time deposits of $100 thousand or more

     (27     (1,086     (1,113

Brokered CDs and CDARS®

     3,031        (1,304     1,727   

Brokered money markets and NOWs

     (272     2        (270

Federal funds purchased

     (4     —          (4

Repurchase agreements

     (31     29        (2

Other borrowings

     (11     2        (9
                        

Total interest bearing liabilities

     2,671        (3,813     (1,142
                        

Increase (decrease) in net interest income

   $ (4,968   $ 2,822      $ (2,146
                        

Net Interest Income – Volume and Rate Changes

Interest income for the second quarter of 2010 was $14.3 million, an 11.2% decrease compared to the same period in 2009. Average earning assets increased $110.1 million, or 9.6%, in the second quarter of 2010 compared to the same period in 2009. Average loans declined in the second quarter of 2010 by $110.8 million, offset by a $214.1 million increase in other earning assets and a $6.8 million increase in investment securities. Average loans declined primarily due to reducing certain concentration risks along with the current economic conditions, while other earning assets increased as we maintained over $225 million in an interest bearing account at the Federal Reserve Bank of Atlanta. The yield on this account is approximately 25 basis points. The increase in this account was primarily funded by an increase in brokered deposits, as well as reductions from the loan portfolio. The purpose of the increase in liquid assets was to reduce liquidity risk, which we describe more fully below in the Liquidity section, resulting from deteriorating asset quality and the Consent Order. We anticipate average loans to decline as loan reductions continue to exceed new loan demand. In addition, we anticipate average earning assets to decline as brokered deposits mature and are not replaced.

Interest income for the six months ended June 30, 2010 was $29.3 million, a 10.0% decrease compared to the same period in 2009. Average earning assets increased $104.4 million, or 9.0%, in 2010 compared to 2009. On a year-to-date basis, average other earning assets increased $186.6 million, average investment securities increased $7.4 million while loans decreased $89.7 million. The change in mix of earning assets, particularly from loans to interest bearing cash, reduced interest income by $2.3 million.

The tax equivalent yield on earning assets decreased by 109 basis points and 101 basis points for the three and six month periods ended June 30, 2010, respectively, compared to the same periods in 2009. Comparing the second quarter of 2010 to 2009, the yield on loans declined 7 basis points from 5.92% to 5.85%. We anticipate the yield on loans to stabilize or improve in 2010 as we have instituted higher loan pricing floors on new and renewing loans. During the first quarter of 2010, we conducted a bond swap by

 

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selling approximately $14.8 million of investment securities with an average tax-equivalent yield of 5.20% and replacing with $14.6 million of bonds with an average tax-equivalent yield of 3.17%. The transactions eliminated the credit risk associated with our private-label CMO securities, as well as certain municipal securities. We anticipate the yield on investment securities for the remaining quarters of 2010 will be consistent with the yield for second quarter 2010 and lower than the comparable 2009 periods. We are maintaining an asset-sensitive balance sheet and will benefit from an eventual increase in the federal funds rate. As of June 30, 2010, our loan portfolio is approximately 57% fixed rate, 41% variable rate and 2% adjustable rate. The variable rate loans reprice simultaneously with changes in the associated index, such as the Prime, LIBOR or Treasury bond rates, while the repricing of adjustable rate loans are based on a time component in addition to changes in the associated index. Accordingly, changes in the target federal funds rate have an immediate impact on the yield of our earning assets.

Total interest expense was $5.3 million in the second quarter of 2010, or 4.8% lower than the same period in 2009. On a year-to-date basis, total interest expense was $10.7 million, or 9.6% lower than the same period in 2009. Average interest bearing liabilities increased by $122.3 million and $114.7 million for the three and six month periods of 2010, respectively, compared to the same periods in 2009. Fully offsetting the additional interest expenses associated with higher volumes was the reductions in the average rates paid on deposits. The decrease in rates is due primarily to term deposits maturing and repricing at lower current market rates. The growth in interest-bearing liabilities was primarily a result of increases in brokered deposits that improved our contingent funding capacity.

We expect average loans to decline before beginning to stabilize over the remainder of 2010 as the regional economy begins to enter into some measure of recovery. Investment securities will continue to grow as earnings are reinvested into new securities. We expect other earning assets to begin to decline during the remainder of 2010 as brokered deposits mature without being replaced. For the remainder of 2010, we expect average interest bearing liabilities to be comparable to the second quarter 2010 results. Rates paid on deposits for the remainder of the year are expected to be consistent with second quarter results.

Net Interest Income – Net Interest Spread and Net Interest Margin

The banking industry uses two key ratios to measure profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The net interest rate spread does not consider the impact of noninterest bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest bearing deposits in earning assets.

Our net interest rate spread (on a tax equivalent basis) was 2.59% and 2.71% for the three and six months ended June 30, 2010, respectively, compared to 3.29% and 3.22% for the same periods in 2009, respectively. Our net interest margin (on a tax equivalent basis) was 2.93% and 3.05% for the three and six months ended June 30, 2010, respectively, compared to 3.77% and 3.70% for the same periods in 2009, respectively. The reductions in our net interest spread and margin are the result of the combination of lower loan volumes and higher brokered deposit volumes partially offset by deposit rates reducing faster than assets. During December of 2009 and the first quarter of 2010, we issued over $180.0 million in brokered deposits to improve our contingent funding capacity. A portion of these funds was utilized to pay off our variable-rate brokered money market account during the first quarter of 2010. The remaining funds were placed in our interest bearing account at the Federal Reserve Bank of Atlanta. As of June 30, 2010, our balance at the Federal Reserve Bank was approximately $232 million. The negative spread associated between the interest bearing cash and the brokered deposits will continue to negatively impact our net interest spread and margin. Average interest bearing liabilities as a percentage of average earning assets was 83.3% for the three-month period ended June 30, 2010 compared to 80.7% for the same period in 2009. Noninterest bearing funding sources contributed 34 basis points to the net interest margin during the second quarter of 2010 compared to 48 basis points in the same period in 2009.

 

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In prior years, we terminated two sets of interest rate swaps. The combined gains at termination were $7.8 million, which are being accreted into interest income over the remaining life of the originally hedged items. For the three and six months ended June 30, 2010, the accretion of the swaps added approximately $523 thousand and $1.0 million, respectively, to interest income compared to $553 thousand and $1.3 million for the same periods in 2009.

We anticipate our net interest margin will stabilize and improve during the remainder of 2010. However, improvement is dependent on multiple factors including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, maturities of brokered deposits, and any possible further action by the Federal Reserve Board.

Provision for Loan and Lease Losses

The provision for loan and lease losses charged to operations during the three and six month periods ended June 30, 2010 were $3.5 million and $7.9 million, respectively, compared to $6.2 million and $11.2 million, respectively, for the same periods in 2009. Net charge-offs for the three and six months ended June 30, 2010 were $2.8 million and $7.6 million, respectively, compared to net charge-offs of $6.9 million and $9.3 million, respectively, for the same periods in 2009. Annualized net charge-offs as a percentage of average loans were 1.68% for the six months ended June 30, 2010 compared to 1.87% for the same period in 2009. Our peer group’s average annualized net charge-offs (as reported in the March 31, 2010 Uniform Bank Performance Report) were 1.04%.

The decrease in our provision for loan and lease losses for both the three and six month periods of 2010 compared to the same periods in 2009 resulted from our analysis of inherent risks in the loan portfolio in relation to the reduction of our portfolio, the level of past due, charged-off, classified and nonperforming loans, as well as general economic conditions. As of June 30, 2010, management determined our allowance of $26.8 million was adequate to provide for credit losses, which we describe more fully below in the Allowance for Loan and Lease Losses section. We will reanalyze the allowance on at least a quarterly basis, and the next review will be at September 30, 2010, or sooner if needed, and the provision expense will be adjusted accordingly, if necessary.

We will continue to provide provision expense to maintain an allowance level adequate to absorb known and estimated losses inherent in our loan portfolio. As the determination of provision expense is a function of the adequacy of the allowance for loan and lease losses, we cannot reasonably estimate the provision expense for the remainder of 2010. Furthermore, the provision expense could materially increase or decrease in 2010 depending on a number of factors, including, among others, the level of net charge-offs, the amount of classified loans and the value of collateral associated with impaired loans.

Noninterest Income

Noninterest income totaled $2.6 million for the second quarter of this year, a decrease of $86 thousand, or 3.3%, from the same period in 2009. On a year-to-date basis, noninterest income totaled $4.9 million, a decrease of $233 thousand, or 4.6%, from the 2009 level. The quarterly and year-to-date declines are primarily a result of lower deposit fees.

 

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The following table presents the components of noninterest income for the periods ended June 30, 2010 and 2009.

NONINTEREST INCOME

 

     Three Months Ended June 30,    Six Months Ended June 30,
     2010    Percent
Change
    2009    2010    Percent
Change
    2009
     (in thousands, except percentages)

Non-sufficient funds (NSF) fees

   $ 799    -10.5   $ 893    $ 1,558    -11.1   $ 1,753

Service charges on deposit accounts

     249    -10.1     277      490    -13.1     564

Point-of-sale (POS) fees

     340    19.7     284      626    17.2     534

Bank-owned life insurance income

     251    0.0     251      503    0.0     503

Mortgage loan and related fees

     236    18.6     199      385    -12.7     441

Trust fees

     192    4.9     183      377    9.0     346

Net gain on sale of available-for-sale securities

     —      —          —        57    100.0     —  

Other income

     491    11.8     557      866    -9.2     954
                                       

Total noninterest income

   $ 2,558    -3.3   $ 2,644    $ 4,862    -4.6   $ 5,095
                                       

Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including non-sufficient funds (NSF) fees, were $1.0 million for the second quarter of 2010, a decrease of $122 thousand, or 10.4%, from the same period in 2009. While service charges and fees on deposit accounts typically correspond to the level and mix of our customer deposits, the recently-enacted Dodd Frank financial reform bill may directly or indirectly impact the fee structure of our deposit products; therefore, we cannot reasonably estimate deposit fees for the remainder of 2010.

Point-of-sale fees (POS fees) increased 19.7% and 17.2% to $340 thousand and $626 thousand for the three and six months ended June 30, 2010, respectively, compared to the same periods in 2009. POS fees are primarily generated when our customers use their debit cards for retail purchases. We anticipate POS fees to continue to grow as customer trends show increased use of debit cards, although it is unclear if certain provisions affecting interchange fees for card issuers included in the recently-enacted Dodd Frank financial reform bill will have a future material impact on this product and its revenue.

Bank-owned life insurance income was $251 thousand and $503 thousand for the three and six months ended June 30, 2010, respectively, remaining consistent with 2009 levels. The Company is the owner and beneficiary of these contracts. The income generated by the cash value of the insurance policies accumulates on a tax-deferred basis and is tax-free to maturity. In addition, the insurance death benefit will be a tax-free payment to the Company. This tax-advantaged asset enables us to provide benefits to our employees. On a fully tax-equivalent basis, the weighted average interest rate earned on the policies was 6.03% through June 30, 2010.

Mortgage loan and related fees for the second quarter of 2010 increased $37 thousand, or 18.6%, to $236 thousand compared to $199 thousand in the second quarter of 2009. For the six months ended June 30, 2010, mortgage income decreased $56 thousand, or 12.7%, compared to the same period in 2009. As discussed in Note 10 to our consolidated financial statements, we elect the fair value option for all held for sale loan originations. This election impacts the timing and recognition of origination fees and costs, as well as the value of servicing rights. The recognition of the income and fees is concurrent with the origination of the loan.

Our process to originate and sell a conforming mortgage in the secondary market typically takes 30 to 60 days from the date of mortgage origination to the date the mortgage is sold to an investor in the secondary market. Due to the normal processing time, we will have a certain amount of held for sale loans at any time. Mortgages originated in the secondary market totaled $7.9 million and $17.8 million for the three and six months ended June 30, 2010, respectively. Mortgages sold in the secondary market for the three and six months ended June 30, 2010 totaled $7.4 million and $16.3 million, respectively. Mortgages originated for sale in the secondary markets totaled $23.1 million and $36.0 million for the three and six months ended June 30, 2009, respectively. Mortgages sold in the secondary market totaled $23.2 million

 

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and $33.8 million for the first three and six months of 2009, respectively. We sold these loans with the right to service the loan being released to the purchaser for a fee. Mortgage income for the remainder of the year is dependent on mortgage rates as well as our ability to generate higher levels of held for sale loans.

Trust fees increased $9 thousand and $31 thousand for the three and six months ended June 30, 2010 compared to 2009. As of June 30, 2010, our trust and wealth management department had 462 accounts with assets held under management of $191.5 million compared to 410 accounts with assets held under management of $165.6 million as of June 30, 2009. For the remainder of 2010, we anticipate increased trust fees compared to the first half of the year, as we continue to add additional accounts.

During the first quarter of 2010, we conducted a bond swap that resulted in a $57 thousand gain on sale of available-for-sale securities. This transaction is discussed above in the Net Interest Income – Volume and Rate Change section of MD&A.

Other income for the second quarter of 2010 was $491 thousand compared to $557 thousand for the same period in 2009. For the six months ended June 30, 2010, other income decreased $88 thousand to $866 thousand compared to the same period in 2009. The components of other income primarily consist of ATM fee income, gains on sales of other real estate owned (OREO) and repossessions, underwriting revenue, and safe deposit box fee income.

Noninterest Expense

Noninterest expense for the second quarter of 2010 increased $2.1 million, or 21.1%, to $12.0 million compared to $9.9 million for the same period in 2009. On a year-to-date basis, noninterest expense increased $2.5 million, or 12.9%, to $21.9 million compared to $19.4 million for the same period in 2009. The increases for both periods are primarily due to higher nonperforming asset costs, including write-downs, losses and holding costs associated with other real estate owned and repossessions, partially offset by lower salaries and benefits costs.

The following table represents the components of noninterest expense for the three and six month periods ended June 30, 2010 and 2009.

NONINTEREST EXPENSE

 

     Three Months Ended June 30,    Six Months Ended June 30,
     2010    Percent
Change
    2009    2010    Percent
Change
    2009
     (in thousands, except percentages)

Salaries & benefits

   $ 4,703    -6.7   $ 5,043    $ 9,651    -7.2   $ 10,400

Occupancy

     872    -0.6     877      1,725    -1.4     1,749

Furniture and equipment

     502    -20.9     635      1,032    -19.6     1,283

FDIC insurance

     1,090    43.8     758      1,537    62.1     948

Professional fees

     916    134.9     390      1,408    89.0     745

Write-downs on OREO and repossessions

     1,337    555.4     204      1,343    247.0     387

Losses on OREO and repossessions

     383    361.4     83      675    378.7     141

OREO and repossession holding costs

     561    276.5     149      913    192.6     312

Data processing

     363    2.5     354      735    5.9     694

Communications

     132    -25.8     178      292    -12.3     333

Intangible asset amortization

     115    -10.9     129      233    -11.7     264

Printing & supplies

     87    -4.4     91      176    -11.1     198

Advertising

     33    -51.5     68      86    -33.8     130

Other expense

     889    -4.7     933      2,049    15.9     1,768
                                       

Total noninterest expense

   $ 11,983    21.1   $ 9,892    $ 21,855    12.9   $ 19,352
                                       

Salaries and benefits for the second quarter of 2010 decreased $340 thousand, or 6.7%, compared to the same period in 2009 and $749 thousand, or 7.2%, on a year-to-date basis. The decrease in salaries and benefits is primarily related to our reductions in staffing. As of June 30, 2010, we had 333 full time equivalent employees compared to 353 as of June 30, 2009. As of June 30, 2010, we operated 38 full-service banking offices.

 

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Occupancy expense for the second quarter and year-to-date period of 2010 was comparable to the same periods in 2009. As of June 30, 2010, First Security leased nine facilities and the land for five branches. As a result, current period occupancy expense is higher than if we owned these facilities, including the real estate, but due to market conditions, property availability and favorable lease terms, we leased these locations to execute our growth strategy. Furthermore, we have been able to deploy the capital into earning assets rather than capital expenditures for facilities.

Furniture and equipment expense decreased on a quarterly and year-to-date basis $133 thousand, or 20.9%, and $251 thousand, or 19.6%, respectively, primarily due to lower equipment depreciation expense.

FDIC deposit premium insurance increased $332 thousand and $589 thousand to $1.1 million and $1.5 million for the three and six months ended June 30, 2010, respectively, compared to the same periods in 2009. For the remaining quarters of the 2010, we anticipate FDIC insurance to be comparable to the second quarter expense.

Professional fees increased $526 thousand for the second quarter of 2010 compared to the same period in 2009 and $663 thousand on a year-to-date basis. The increase is primarily due to consulting costs related to complying with the Consent Order, as well as additional legal costs associated with higher levels of nonperforming assets. Professional fees include fees related to investor relations, outsourcing compliance and internal audit to Professional Bank Services, as well as external audit, tax services and legal and accounting advice related to, among other things, foreclosures, lending activities, employee benefit programs, prospective capital offerings and regulatory matters.

Write-downs on OREO and repossessions increased $1.1 million and $956 thousand for the three and six month periods ended June 30, 2010 compared to the same periods in 2009. At foreclosure or repossession, the fair value of the property is determined and a charge-off to the allowance is recorded, if applicable. Any decreases in value subsequent to the initial determination of fair value are recorded as a write-down. As a general policy, we re-assess the fair value of OREO and repossessions on at least an annual basis or sooner if indications exist that deterioration in value has occurred. Write-downs are based on property-specific appraisals or valuations. During the second quarter of 2010, we recorded write-downs on 48 OREO properties for a total of $1.3 million, including $567 thousand on commercial real estate properties, $532 thousand on construction and development properties and $233 thousand on 1-4 family residential properties. Write-downs for the remainder of 2010 are dependent on real estate market conditions and our ability to liquidate properties.

Losses on OREO and repossessions totaled $383 thousand and $675 thousand for the three and six months ending June 30, 2010, respectively, compared to $83 thousand and $141 thousand for the same periods in 2009. The increase is primarily a result of higher levels of OREO properties and repossessions. We anticipate increases in losses for the remainder of 2010 as nonperforming assets continue to increase and we seek to liquidate existing properties and repossessions in a timely manner.

OREO and repossession holding costs include, among other items, maintenance, repairs, utilities, taxes and storage costs. Holding costs increased $412 thousand and $601 thousand for the three and six months ended June 30, 2010 compared to the same periods in 2009. We anticipate the level of holding costs to remain elevated for 2010.

Data processing fees increased 2.5% for the second quarter of 2010 compared to the same period in 2009 and 5.9% on a year-to-date basis. The monthly fees associated with data processing are typically based on transaction volume.

We anticipate communications, printing and supplies and advertising expenses to remain stable or decline for the remainder of 2010 as we continue to reduce discretionary expenses.

 

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Intangible asset amortization expense decreased $14 thousand, or 10.9%, in the second quarter of 2010 compared to the same period in 2009 and 11.7% on a year-to-date basis. Our core deposit intangible assets amortize on an accelerated basis in which the expense recognized declines over the estimated useful life of ten years. We anticipate further decreases in amortization expense throughout the remainder of 2010.

Other expense increased $281 thousand for the six months ended June 30, 2010 compared to the same period in 2009. The increase is primarily due to a legal settlement.

Income Taxes

We recorded an income tax benefit of $1.8 million and $3.0 million for the three and six months ended June 30, 2010 compared to a benefit of $1.5 million and $2.4 million for the same periods in 2009. For the six months ended June 30, 2010, our tax-exempt income from municipal securities and bank-owned life insurance was approximately $1.2 million. We also recorded low-income housing tax credits of $207 thousand. Adjusting for these items, our effective tax rate approximates 37%.

At June 30, 2010, we evaluated our significant uncertain tax positions. Under the “more-likely-than-not” threshold guidelines, we believe we have identified all significant uncertain tax benefits. We evaluate, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be accrued, in accordance with Internal Revenue Service guidelines, and recorded as a component of income tax expense in our consolidated financial statements. During the fourth quarter of 2009, we accrued $1.1 million for an uncertain tax position and approximately $155 thousand in associated interest and penalties. As of June 30, 2010, our total accrual for uncertain tax positions is $1.2 million.

At June 30, 2010, we have no valuation allowance associated with our deferred tax assets. In evaluating our deferred tax assets, we use all available information, both quantitative and qualitative. A valuation allowance is required when it is “more-likely-than-not” that some or all of the deferred tax assets will not be realized. As of June 30, 2010, our deferred tax asset is approximately $11.5 million.

STATEMENT OF FINANCIAL CONDITION

Our total assets were $1.3 billion at June 30, 2010, $1.4 billion at December 31, 2009 and $1.2 billion at June 30, 2009. For the remainder of 2010, we anticipate that our total assets will continue to decline as brokered deposits mature and are funded with our current interest bearing cash. Due to the economic recession, we anticipate loan demand to continue to remain low.

Loans

Our active efforts to reduce certain credit exposures and their related balance sheet risk, as well as the effects of the economic recession, have resulted in declining loan balances. Year-to-date, loans contracted by $100.7 million, or 10.6%. From June 30, 2009 to June 30, 2010, our loans declined by $117.1 million, or 12.1%.

 

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The following table presents our loan portfolio by type.

LOAN PORTFOLIO

 

                       Percent change from  
     June 30,
2010
    December 31,
2009
    June 30,
2009
    December 31,
2009
    June 30,
2009
 
     (in thousands, except percentages)  

Loans secured by real estate-

          

Residential 1-4 family

   $ 273,030      $ 281,354      $ 288,836      -3.0   -5.5

Commercial

     247,009        259,819        225,790      -4.9   9.4

Construction

     113,877        153,144        183,623      -25.6   -38.0

Multi-family and farmland

     40,550        37,960        33,847      6.8   19.8
                                    
     674,466        732,277        732,096      -7.9   -7.9

Commercial loans

     117,279        146,016        150,472      -19.7   -22.1

Consumer installment loans

     42,262        48,927        54,261      -13.6   -22.1

Leases, net of unearned income

     13,006        19,730        26,784      -34.1   -51.4

Other

     4,339        5,068        4,880      -14.4   -11.1
                                    

Total loans

     851,352        952,018        968,493      -10.6   -12.1

Allowance for loan and lease losses

     (26,830     (26,492     (19,275   1.3   39.2
                                    

Net loans

   $ 824,522      $ 925,526      $ 949,218      -10.9   -13.1
                                    

Year-to-date, the largest declining loan balances were construction and land development (C&D) loans of $39.3 million, or 25.6%, commercial loans of $28.7 million, or 19.7%, and commercial real estate (CRE) loans of $12.8 million, or 4.9%. Comparing June 30, 2010 to June 30, 2009, the largest declining loan balances were C&D loans of $69.7 million, or 38.0%, commercial loans of $33.2 million, or 22.1%, and residential 1-4 family loans of $15.8 million, or 5.5%. These declines were partially offset by an increase in CRE loans of $21.2 million, or 9.4%.

We will continue to extend prudent loans to creditworthy consumers and businesses. However, due to the economic environment, we anticipate our loans may remain stable or possibly decline for the remainder of 2010. Funding of future loans may be restricted by our ability to raise core deposits, although we may use current cash reserves, as necessary and appropriate. Loan growth may also be restricted by the necessity for us to maintain appropriate capital levels, as well as adequate liquidity.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses reflects our assessment and estimate of the risks associated with extending credit and our evaluation of the quality of the loan portfolio. We regularly analyze our loan portfolio in an effort to establish an allowance that we believe will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, we review the size, quality and risk of loans in the portfolio. We also consider such factors as:

 

   

our loan loss experience;

 

   

specific known risks;

 

   

the status and amount of past due and nonperforming assets;

 

   

underlying estimated values of collateral secured loans;

 

   

current and anticipated economic conditions; and

 

   

other factors which we believe affect the allowance for potential credit losses.

The allowance is composed of three primary components: (1) specific impairments for substandard/nonaccrual loans and leases, (2) general allocations for classified loan pools, including special mention and substandard/accrual loans, and (3) general allocations for the remaining pools of loans. Specific impairments are commonly referred to as SFAS 114 impairments and general allocations are commonly referred to as SFAS 5 allocations. We accumulate pools based on the underlying classification of the collateral. Each pool is assigned a loss severity rate based on historical loss experience and various qualitative and environmental factors, including, but not limited to, credit quality and economic conditions.

 

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An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan and lease losses is prepared jointly by our accounting and credit administration departments and presented to our Board of Directors or the Directors’ Loan Committee on at least a quarterly basis. Based on our analysis, we may determine that our future provision expense needs to increase or decrease in order for us to remain adequately reserved for probable loan losses. As stated earlier, we make this determination after considering both quantitative and qualitative factors under appropriate regulatory and accounting guidelines.

Our allowance for loan and lease losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance compared to a group of peer banks. During their routine examinations of banks, the regulators may require a bank to make additional provisions to its allowance for loan losses when, in the opinion of the regulators, their credit evaluations and allowance methodology differ materially from the bank’s methodology. We believe our allowance methodology is in compliance with regulatory interagency guidance as well as applicable GAAP guidance.

While it is our policy to charge-off all or a portion of certain loans in the current period when a loss is considered probable, there are additional risks of future losses that cannot be quantified precisely or attributed to particular loans or classes of loans. Because the assessment of these risks includes assumptions regarding local and national economic conditions, our judgment as to the adequacy of the allowance is necessarily approximate and imprecise.

 

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The following table presents an analysis of the changes in the allowance for loan and lease losses for the six months ended June 30, 2010 and 2009. The provision for loan and lease losses in the table below does not include our provision accrual for unfunded commitments of $11 thousand and $11 thousand for the six month periods ended June 30, 2010 and 2009, respectively. The reserve for unfunded commitments totaled $217 thousand and $193 thousand as of June 30, 2010 and 2009, respectively, and is included in other liabilities in the accompanying consolidated balance sheets.

ANALYSIS OF CHANGES IN ALLOWANCE FOR LOAN AND LEASE LOSSES

 

     For the six months ended June 30,  
     2010     2009  
     (in thousands, except percentages)  

Allowance for loan and lease losses –

    

Beginning of period

   $ 26,492      $ 17,385   

Provision for loan and lease losses

     7,908        11,178   
                

Sub-total

     34,400        28,563   
                

Charged-off loans:

    

Real estate – residential 1-4 family

     872        656   

Real estate – commercial

     705        1,313   

Real estate – construction

     3,077        367   

Real estate – multi-family and farmland

     130        58   

Commercial loans

     1,717        6,129   

Consumer installment and Other loans

     515        663   

Leases, net of unearned income

     940        250   
                

Total charged-off

     7,956        9,436   
                

Recoveries of charged-off loans:

    

Real estate – residential 1-4 family

     33        19   

Real estate – commercial

     152        —     

Real estate – construction

     3        9   

Real estate – multi-family and farmland

     —          3   

Commercial loans

     129        44   

Consumer installment and Other loans

     69        72   

Leases, net of unearned income

     —          1   
                

Total recoveries

     386        148   
                

Net charged-off loans

     7,570        9,288   
                

Allowance for loan and lease losses – end of period

   $ 26,830      $ 19,275   
                

Total loans – end of period

   $ 851,352      $ 968,493   

Average loans

   $ 902,332      $ 992,039   

Net loans charged-off to average loans, annualized

     1.68     1.87

Provision for loan and lease losses to average loans, annualized

     1.75     2.25

Allowance for loan and lease losses as a percentage of:

    

Period end loans

     3.15     1.99

Nonperforming loans

     45.72     63.92

 

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The following table presents the allocation of the allowance for loan and lease losses for each respective loan category with the corresponding percentage of loans in each category to total loans. The comprehensive allowance analysis developed by our financial reporting and credit administration group enables us to allocate the allowance based on risk elements within the portfolio.

ALLOCATION OF THE ALLOWANCE FOR LOAN AND LEASE LOSSES

 

     As of June 30, 2010     As of December 31, 2009     As of June 30, 2009  
     Amount    Percent  of
Portfolio1
    Amount    Percent of
Portfolio1
    Amount    Percent  of
Portfolio1
 
     (in thousands, except percentages)  

Real estate – residential 1-4 family

   $ 5,326    32.1   $ 5,037    29.6   $ 4,235    29.8

Real estate – commercial

     5,325    29.0     4,525    27.3     2,460    23.3

Real estate – construction

     4,459    13.3     6,706    16.0     4,341    19.0

Real estate – multi-family and farmland

     794    4.8     766    4.0     272    3.5

Commercial loans

     8,030    13.8     6,953    15.4     4,404    15.5

Consumer installment loans

     1,072    5.0     1,107    5.1     871    5.6

Leases, net of unearned income

     1,801    1.5     1,386    2.1     2,682    2.8

Other

     23    0.5     12    0.5     10    0.5
                                       

Total

   $ 26,830    100.0   $ 26,492    100.0   $ 19,275    100.0
                                       

 

1

Represents the percentage of loans in each category to total loans.

Over the last eighteen to twenty-four months, the allowance significantly increased because of the economic downturn and the associated decline in real estate values. These two factors have contributed to a significant increase in classified loans. From June 30, 2009 to June 30, 2010, the allowance increased $7.6 million, or 39.2%. Specific impairments increased by $3.2 million over the last twelve months, while the SFAS 5 allowance increased $4.4 million due to higher levels of risk rated loans, as well as higher associated loss factors applicable to classified loan pools.

As of June 30, 2010, the largest components of the allowance were associated with commercial loans and real estate secured loans. The allowance associated with commercial loans as of June 30, 2010, has increased $3.6 million compared to June 30, 2009. The majority of the increase is a result of higher specific impairments on commercial loans. Reduced earnings and cash flow of the associated borrowers due to the economic recession is the primary factor for the increase of classified commercial loans. The allowance associated with real estate construction loans totaled $5.3 million as of June 30, 2010. The decline in real estate values combined with the slowdown in new home sales has increased our classified loans in this category. We consider the following factors in the decision to downgrade real estate construction loans; these factors include but are not limited to, the decline in the associated collateral value, the length of time the finished home has been on the market, and the borrower’s ability to begin amortizing the loan. In many cases, a downgraded loan may not be past due or involve a borrower missing scheduled payments; a downgraded loan instead indicates a risk of future non-performance, rather than a measure of actual nonperforming loans. As of June 30, 2010, approximately 43% of our nonaccrual loans were current on all contractual interest and principal payments.

We believe that the allowance for loan and lease losses as of June 30, 2010 is sufficient to absorb losses inherent in the loan portfolio based on our assessment of the information available, including the results of extensive internal and independent reviews of our loan portfolio, as discussed in the Asset Quality and Nonperforming Asset section below. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examinations, may require additional charges to the provision for loan losses in future periods based on their reviews.

 

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Asset Quality and Nonperforming Assets

Asset Quality Strategic Initiatives for 2009 and 2010

We consider our asset quality to be of primary importance. At June 30, 2010, our loan portfolio was 61.8% of total assets. Over the past twelve months, we implemented several significant strategies to further address our asset quality. To date, we have:

 

   

hired a new Chief Credit Officer;

 

   

restructured our credit department;

 

   

developed centralized underwriting, document preparation and collections processes;

 

   

conducted a third-party loan review;

 

   

expanded our special assets department; and

 

  &