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EX-32 - FIRST FINANCIAL SERVICE CORPv223349_ex32.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended March 31, 2011

OR

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

Commission File Number 0-18832

First Financial Service Corporation
(Exact Name of Registrant as specified in its charter)

Kentucky
 
61-1168311
(State or other jurisdiction
 
(IRS Employer Identification No.)
of incorporation or organization)
   

2323 Ring Road
 
(270) 765-2131
Elizabethown, Kentucky 42701
 
(Registrant's telephone number,
(Address of principal executive offices)
 
including area code)
(Zip Code)
   
 
(270) 765-2131
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ 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 “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer ¨  Accelerated Filer ¨ Non-Accelerated Filer x   Smaller Reporting Company ¨

Indicate by a 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.

Class
 
Outstanding as of April 30, 2011
     
Common Stock
  
4,739,622 shares
 
 
 

 
 
FIRST FINANCIAL SERVICE CORPORATION
FORM 10-Q
TABLE OF CONTENTS

PART IFINANCIAL INFORMATION
 
   
Preliminary Note Regarding Forward-Looking Statements
  3
   
Item 1.
Consolidated Financial Statements and Notes to Consolidated Financial Statements
  4
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
31
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
46
     
Item 4.
Controls and Procedures
48
   
PART II – OTHER INFORMATION
 
   
Item 1.
Legal Proceedings
48
     
Item 1A.
Risk Factors
48
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
49
     
Item 3.
Defaults upon Senior Securities
49
     
Item 4.
[Removed and Reserved]
49
     
Item 5.
Other Information
49
     
Item 6.
Exhibits
49
     
SIGNATURES
50
 
 
2

 

PRELIMINARY NOTE REGARDING
FORWARD-LOOKING STATEMENTS

Statements in this report that are not statements of historical fact are forward-looking statements. First Financial Service Corporation (the “Corporation”) may make forward-looking statements in future filings with the Securities and Exchange Commission (“SEC”), in press releases, and in oral and written statements made by or with the approval of the Corporation.  Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements.  Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.

Various risks and uncertainties may cause actual results to differ materially from those indicated by our forward-looking statements.  In addition to those risks described under “Item 1A Risk Factors,” of this report and our Annual Report on Form 10-K, the following factors could cause such differences: changes in general economic conditions and economic conditions in Kentucky and the markets we serve, any of which may affect, among other things, our level of non-performing assets, charge-offs, and provision for loan loss expense; changes in interest rates that may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposits; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”); competition with other local and regional commercial banks, savings banks, credit unions and other non-bank financial institutions; our ability to grow core businesses; our ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks.

Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of the statement to reflect the occurrence of unanticipated events.
 
 
3

 
 
Item 1.
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Balance Sheets
(Unaudited)
 
   
March 31,
   
December 31,
 
(Dollars in thousands, except per share data)
 
2011
   
2010
 
             
ASSETS:
           
Cash and due from banks
  $ 9,759     $ 14,840  
Interest bearing deposits
    101,170       151,336  
Total cash and cash equivalents
    110,929       166,176  
                 
Securities available-for-sale
    243,395       196,029  
Securities held-to-maturity, fair value of $122 Mar (2011) and $126 Dec (2010)
    120       124  
Total securities
    243,515       196,153  
                 
Loans held for sale
    4,055       6,388  
Loans, net of unearned fees
    858,350       881,934  
Allowance for loan losses
    (24,591 )     (22,665 )
Net loans
    837,814       865,657  
                 
Federal Home Loan Bank stock
    4,909       4,909  
Cash surrender value of life insurance
    9,439       9,354  
Premises and equipment, net
    31,773       31,988  
Real estate owned:
               
Acquired through foreclosure
    24,908       25,807  
Held for development
    45       45  
Other repossessed assets
    39       40  
Core deposit intangible
    917       994  
Accrued interest receivable
    7,727       6,404  
Accrued income taxes
    3,005       2,161  
Deferred income taxes
    1,801       2,982  
Prepaid FDIC Insurance
    3,516       4,449  
Other assets
    5,844       2,388  
                 
TOTAL ASSETS
  $ 1,286,181     $ 1,319,507  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
LIABILITIES:
               
Deposits:
               
Non-interest bearing
  $ 71,869     $ 73,566  
Interest bearing
    1,094,919       1,100,342  
Total deposits
    1,166,788       1,173,908  
                 
Advances from Federal Home Loan Bank
    27,500       52,532  
Subordinated debentures
    18,000       18,000  
Accrued interest payable
    835       594  
Accounts payable and other liabilities
    2,930       3,162  
                 
TOTAL LIABILITIES
    1,216,053       1,248,196  
Commitments and contingent liabilities
    -       -  
                 
STOCKHOLDERS' EQUITY:
               
Serial preferred stock, $1 par value per share; authorized 5,000,000 shares; issued and outstanding, 20,000 shares with a liquidation preference of $20,000
    19,849       19,835  
Common stock, $1 par value per share; authorized 35,000,000 shares; issued and outstanding, 4,739,622 shares Mar (2011), and 4,726,329 shares Dec (2010)
    4,740       4,726  
Additional paid-in capital
    35,290       35,201  
Retained earnings
    13,930       16,264  
Accumulated other comprehensive loss
    (3,681 )     (4,715 )
                 
TOTAL STOCKHOLDERS' EQUITY
    70,128       71,311  
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 1,286,181     $ 1,319,507  
 
See notes to the unaudited consolidated financial statements.
 
 
4

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Income
(Unaudited)
 
   
Three Months Ended
 
(Dollars in thousands, except per share data)
 
March 31,
 
   
2011
   
2010
 
Interest and Dividend Income:
           
Loans, including fees
  $ 12,343     $ 14,047  
Taxable securities
    1,566       493  
Tax exempt securities
    257       171  
Total interest income
    14,166       14,711  
                 
Interest Expense:
               
Deposits
    4,914       4,869  
Short-term borrowings
    -       21  
Federal Home Loan Bank advances
    295       593  
Subordinated debentures
    341       327  
Total interest expense
    5,550       5,810  
                 
Net interest income
    8,616       8,901  
Provision for loan losses
    3,465       1,752  
Net interest income after provision for loan losses
    5,151       7,149  
                 
Non-interest Income:
               
Customer service fees on deposit accounts
    1,445       1,525  
Gain on sale of mortgage loans
    265       299  
Gain on sale of investments
    69       -  
Loss on sale of investments
    -       (23 )
Other than temporary impairment loss:
               
Total other-than-temporary impairment losses
    (37 )     (172 )
Portion of loss recognized in other comprehensive income/(loss) (before taxes)
    -       -  
Net impairment losses recognized in earnings
    (37 )     (172 )
Loss on sale and write downs on real estate acquired through foreclosure
    (235 )     (26 )
Brokerage commissions
    107       93  
Other income
    379       442  
Total non-interest income
    1,993       2,138  
                 
Non-interest Expense:
               
Employee compensation and benefits
    4,329       4,090  
Office occupancy expense and equipment
    811       804  
Marketing and advertising
    225       225  
Outside services and data processing
    797       730  
Bank franchise tax
    314       350  
FDIC insurance premiums
    970       660  
Amortization of core deposit intangible
    77       64  
Real estate acquired through foreclosure expense
    382       155  
Other expense
    1,501       1,196  
Total non-interest expense
    9,406       8,274  
                 
Income/(loss) before income taxes
    (2,262 )     1,013  
Income taxes/(benefits)
    (192 )     258  
Net Income/(Loss)
    (2,070 )     755  
Less:
               
Dividends on preferred stock
    (250 )     (250 )
Accretion on preferred stock
    (14 )     (14 )
Net income (loss) attributable to common shareholders
  $ (2,334 )   $ 491  
                 
Shares applicable to basic income per common share
    4,736,287       4,715,721  
Basic income (loss) per common share
  $ (0.49 )   $ 0.10  
                 
Shares applicable to diluted income per common share
    4,736,287       4,715,721  
Diluted income (loss) per common share
  $ (0.49 )   $ 0.10  
                 
Cash dividends declared per common share
  $ -     $ -  
 
See notes to the unaudited consolidated financial statements.
 
 
5

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Comprehensive Income
(Unaudited)

   
Three Months Ended
 
   
March 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Net Income/(Loss)
  $ (2,070 )   $ 755  
Other comprehensive income (loss):
               
Change in unrealized gain (loss) on securities available-for-sale
    1,207       67  
Change in unrealized gain (loss) on securities available-for-sale for which a portion of other-than-temporary impairment has been recognized into earnings
    393       (28 )
Reclassification of realized amount on securities available-for-sale losses (gains)
    (44 )     146  
Reclassification of unrealized loss on held-to-maturity security recognized in income
    12       29  
Accretion (amortization) of non-credit component of other-than-temporary impairment on held-to-maturity securities
    (1 )     -  
Net unrealized gain (loss) recognized in comprehensive income
    1,567       214  
Tax effect
    (533 )     (73 )
Total other comphrehensive income
    1,034       141  
                 
Comprehensive Income/(Loss)
  $ (1,036 )   $ 896  
 
The following is a summary of the accumulated other comprehensive income balances, net of tax:

 
   
Balance
   
Current
   
Balance
 
   
at
   
Period
   
at
 
   
12/31/2010
   
Change
   
3/31/2011
 
Unrealized gains (losses) on securities available-for-sale
  $ (5,691 )   $ 750     $ (4,941 )
Unrealized gains (losses) on available-for-sale  securities for which OTTI has been recorded,
     1,082        276        1,358  
Unrealized gains (losses) on held-to-maturity securities for which OTTI has been recorded, net of accretion
       (106 )        8          (98 )
                         
Total
  $ (4,715 )   $ 1,034     $ (3,681 )

See notes to the unaudited consolidated financial statements.
 
 
6

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Changes in Stockholders' Equity
Three Months Ended March 31, 2011
(Dollars In Thousands, Except Per Share Amounts)
(Unaudited)
 
   
Shares
   
Amount
   
Additional
Paid-in
   
Retained
   
Accumulated
Other
Comprehensive
(Loss), Net of
       
   
Preferred
   
Common
   
Preferred
   
Common
   
Capital
   
Earnings
   
Tax
   
Total
 
                                                                 
Balance, January 1, 2011
    20,000       4,726     $ 19,835     $ 4,726     $ 35,201     $ 16,264     $ (4,715 )   $ 71,311  
Net loss
                                            (2,070 )             (2,070 )
Shares issued under dividend reinvestment program
            1               1       1                       2  
Stock issued for employee benefit plans
            13               13       40                       53  
Stock-based compensation expense
                                    48                       48  
Net change in unrealized gains (losses) on securities available-for-sale,
                                                    750       750  
Change in unrealized gains (losses) on held-to-maturity securities for which an other-than-temporary impairment charge has been recorded,
                                                    8       8  
Change in unrealized gains (losses) on securities available-for-sale for which a portion of an other-than-temporary impairment charge has been recognized into earnings, net of reclassification
                                                    276       276  
Dividends on preferred stock
                                            (250 )             (250 )
Accretion of preferred stock discount
    -       -       14       -       -       (14 )     -       -  
Balance, March 31, 2011
    20,000       4,740     $ 19,849     $ 4,740     $ 35,290     $ 13,930     $ (3,681 )   $ 70,128  

See notes to the unaudited consolidated financial statements.
 
 
7

 
 
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Cash Flows
(Dollars In Thousands)
(Unaudited)

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Operating Activities:
           
Net income/(loss)
  $ (2,070 )   $ 755  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    3,465       1,752  
Depreciation on premises and equipment
    449       427  
Core deposit intangible amortization
    77       64  
Net amortization (accretion) available-for-sale
    439       (148 )
Impairment loss on securities available-for-sale
    25       123  
Impairment loss on securities held-to-maturity
    12       49  
Loss on sale of investments available-for-sale
    -       23  
Gain on sale of investments available-for-sale
    (69 )     -  
Gain on sale of mortgage loans
    (265 )     (299 )
Origination of loans held for sale
    (14,572 )     (24,629 )
Proceeds on sale of loans held for sale
    17,170       27,884  
Stock-based compensation expense
    48       24  
Prepaid FDIC premium
    933       614  
Changes in:
               
Cash surrender value of life insurance
    (85 )     (88 )
Interest receivable
    (1,323 )     (204 )
Other assets
    (2,803 )     (458 )
Interest payable
    241       (46 )
Accounts payable and other liabilities
    (232 )     746  
Net cash from operating activities
    1,440       6,589  
                 
Investing Activities:
               
Sales of securities available-for-sale
    16,271       500  
Purchases of securities available-for-sale
    (70,000 )     (34,614 )
Maturities of securities available-for-sale
    7,524       553  
Maturities of securities held-to-maturity
    3       785  
Net change in loans
    22,096       26,172  
Net purchases of premises and equipment
    (234 )     (774 )
Net cash from investing activities
    (24,340 )     (7,378 )
                 
Financing Activities
               
Net change in deposits
    (7,120 )     42,399  
Change in short-term borrowings
    -       (658 )
Maturity of Federal Home Loan Bank advance
    (25,000 )     -  
Repayments to Federal Home Loan Bank
    (32 )     (118 )
Issuance of common stock under dividend reinvestment program
    2       8  
Issuance of common stock for employee benefit plans
    53       63  
Dividends paid on preferred stock
    (250 )     (250 )
Net cash from financing activities
    (32,347 )     41,444  
                 
(Decrease) Increase in cash and cash equivalents
    (55,247 )     40,655  
Cash and cash equivalents, beginning of period
    166,176       98,533  
Cash and cash equivalents, end of period
  $ 110,929     $ 139,188  
                 
Supplemental noncash disclosures:
               
Transfers from loans to real estate owned
  $ 1,932     $ 2,337  

See notes to the unaudited consolidated financial statements.

 
8

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank.  First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, Heritage Properties, LLC and First Federal Office Park, LLC.  Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its direct and indirect wholly-owned subsidiaries.  All significant intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles 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 U.S. generally accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three-month period ending March 31, 2011 are not necessarily indicative of the results that may occur for the year ending December 31, 2011.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2010, as amended by Form 10-K/A filed May 13, 2011.

Adoption of New Accounting Standards – FASB ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, was issued in July 2010.  The new disclosure guidance significantly expands the existing requirements and leads to greater transparency into a company’s exposure to credit losses from lending arrangements.  The extensive new disclosures of information as of the end of a reporting period became effective for both interim and annual reporting periods ending after December 15, 2010.  Specific items regarding activity that occurred before the issuance of the ASU, such as the allowance roll-forward and modification disclosures were required for periods beginning after December 15, 2010.  The new standard did not have a material impact.

On April 5, 2011, the FASB issued ASU 2011-02 “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”, which clarifies when creditors should classify loan modifications as troubled debt restructurings. The guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the year. The guidance on measuring the impairment of a receivable restructured in a troubled debt restructuring, as clarified, is effective on a prospective basis. The adoption of this ASU is not expected to have a material impact.

2.
REGULATORY MATTERS

On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of 8.5% and a total risk-based capital ratio of 11.5% by March 31, 2011 and achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011.   At March 31, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements.  We notified the bank regulatory agencies that the increased capital levels would not be achieved and as we remain in regular contact with the FDIC and KDFI, we expect the agencies will reevaluate our progress toward the higher capital ratios at June 30, 2011.  On April 20, 2011, the Corporation entered into a Consent Order with the Federal Reserve Bank of St. Louis which requires the Corporation to obtain regulatory approval before declaring any dividends.  We also may not redeem shares or obtain additional borrowings without prior approval.

In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies including the following:

 
·
Raising capital by selling capital stock through a public offering or private placement.
 
 
9

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

2.
REGULATORY MATTERS – (Continued)

 
·
Continuing to operate the Company and the Bank in a safe and sound manner.  Until we can complete a capital raise, this will most likely require us to reduce lending concentrations, potentially sell loans, and take significant operating expense reductions and other cost cutting measures aimed at lowering expenses.  Additionally, we would adjust the mix of our assets to reduce the total risk weight of our assets, reduce total assets over time and potentially sell branches, deposits and loans.

 
·
Evaluating other strategic alternatives, such as a sale of assets, one or more branches, or the institution.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order.  The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances.

 
10

 
 
3. 
SECURITIES

The amortized cost basis and fair values of securities are as follows:
 
         
Gross
   
Gross
       
(Dollars in thousands)
 
Amortized
   
Unrealized
   
Unrealized
       
   
Cost
   
Gains
   
Losses
   
Fair Value
 
Securities available-for-sale:
                       
March 31, 2011:
                       
U.S. Treasury and agencies
  $ 174,347     $ 197     $ (3,792 )   $ 170,752  
Government-sponsored mortgage-backed residential
    48,679       464       (263 )     48,880  
Equity
    299       -       (5 )     294  
State and municipal
    22,555       531       (89 )     22,997  
Trust preferred securities
    1,073       -       (601 )     472  
                                 
Total
  $ 246,953     $ 1,192     $ (4,750 )   $ 243,395  
                                 
December 31, 2010:
                               
U.S. Treasury and agencies
  $ 117,886     $ 97     $ (4,090 )   $ 113,893  
Government-sponsored mortgage-backed residential
    59,320       448       (598 )     59,170  
Equity
    299       -       (6 )     293  
State and municipal
    22,564       264       (210 )     22,618  
Trust preferred securities
    1,074       -       (1,019 )     55  
                                 
Total
  $ 201,143     $ 809     $ (5,923 )   $ 196,029  
 
         
Gross
   
Gross
       
   
Amortized
   
Unrecognized
   
Unrecognized
       
   
Cost
   
Gains
   
Losses
   
Fair Value
 
Securities held-to-maturity:
                       
March 31, 2011:
                       
Government-sponsored mortgage-backed residential
  $ 97     $ 2     $ -     $ 99  
Trust preferred securities
    23       -       -       23  
                                 
Total
  $ 120     $ 2     $ -     $ 122  
                                 
December 31, 2010:
                               
Government-sponsored mortgage-backed residential
  $ 102     $ 2     $ -     $ 104  
Trust preferred securities
    22       -       -       22  
                                 
Total
  $ 124     $ 2     $ -     $ 126  
 
 
11

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3.
SECURITIES – (Continued)

The amortized cost and fair value of securities at March 31, 2011, by contractual maturity, are shown below.  Securities not due at a single maturity date, primarily mortgage-backed and equity securities, are shown separately.
 
   
Available for Sale
   
Held-to-Maturity
 
   
Amortized
   
Fair
   
Amortized
   
Fair
 
(Dollars in thousands)
 
Cost
   
Value
   
Cost
   
Value
 
                         
Due in one year or less
  $ 115     $ 116     $ -     $ -  
Due after one year through five years
    62,044       62,030       -       -  
Due after five years through ten years
    23,737       23,395       -       -  
Due after ten years
    112,079       108,680       23       23  
Government-sponsored mortgage-backed residential
    48,679       48,880       97       99  
Equity
    299       294       -       -  
    $ 246,953     $ 243,395     $ 120     $ 122  

For the March 31, 2011 quarter, proceeds from sales of available-for-sale debt securities were $16.3 million and for the 2010 quarter, proceeds from sales of available-for-sale equity securities were $500,000.  Gross realized gains recognized in income in 2011 were $69,000.  Gross realized losses recognized in income in 2010 were $23,000.

Investment securities pledged to secure public deposits and FHLB advances had an amortized cost of $62.7 million and fair value of $61.2 million at March 31, 2011 and a $66.8 million amortized cost and fair value of $65.1 million at December 31, 2010.

Securities with unrealized losses at March 31, 2011 and December 31, 2010 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

March 31, 2011
 
Less than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
Description of Securities
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
   
                                   
U.S. Treasury and agencies  
  $ 101,127     $ (3,792 )   $ -     $ -     $ 101,127     $ (3,792 )
Government-sponsored  mortgage-backed residential
    21,660       (263 )     -       -       21,660       (263 )
Equity  
    3       (5 )     -       -       3       (5 )
State and municipal  
    2,602       (58 )     548       (31 )     3,150       (89 )
Trust preferred securities
    -       -       472       (601 )     472       (601 )
                                                 
Total temporarily impaired
  $ 125,392     $ (4,118 )   $ 1,020     $ (632 )   $ 126,412     $ (4,750 )
 
December 31, 2010
 
Less than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
Description of Securities
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
   
                                   
U.S. Treasury and agencies
  $ 70,896     $ (4,090 )   $ -     $ -     $ 70,896     $ (4,090 )
Government-sponsored mortgage-backed residential
    22,084       (598 )     -       -       22,084       (598 )
Equity  
    3       (6 )     -       -       3       (6 )
State and municipal  
    11,095       (157 )     527       (53 )     11,622       (210 )
Trust preferred securities
    -       -       55       (1,019 )     55       (1,019 )
   
                                               
Total temporarily impaired
  $ 104,078     $ (4,851 )   $ 582     $ (1,072 )   $ 104,660     $ (5,923 )
 
 
12

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3. 
SECURITIES – (Continued)
 
We evaluate investment securities with significant declines in fair value on a quarterly basis to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary.

Accounting guidance requires entities to split other than temporary impairment charges between credit losses (i.e., the loss based on the entity’s estimate of the decrease in cash flows, including those that result from expected voluntary prepayments), which are charged to earnings, and the remainder of the impairment charge (non-credit component) to accumulated other comprehensive income. This requirement pertains to both securities held to maturity and securities available for sale.

The unrealized losses on our U. S. Treasury and agency securities and our government sponsored mortgage-backed residential securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities.  Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at March 31, 2011.

The unrealized losses on the state and municipal securities were caused primarily by interest rate decreases.  The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment.  Because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these investments to be other-than-temporarily impaired at March 31, 2011.  We also considered the financial condition and near term prospects of the issuer and identified no matters that would indicate less than full recovery.

As discussed in Note 8 - Fair Value, the fair value of our portfolio of trust preferred securities, has decreased significantly as a result of the current credit crisis and lack of liquidity in the financial markets.  There are limited trades in trust preferred securities and the majority of holders of such instruments have elected not to participate in the market unless they are required to sell as a result of liquidation, bankruptcy, or other forced or distressed conditions.

To determine if the five trust preferred securities were other than temporarily impaired as of March 31, 2011, we used a discounted cash flow analysis.  The cash flow models were used to determine if the current present value of the cash flows expected on each security were still equivalent to the original cash flows projected on the security when purchased.   The cash flow analysis takes into consideration assumptions for prepayments, defaults and deferrals for the underlying pool of banks, insurance companies and REITs.

Management works with independent third parties to identify its best estimate of the cash flow expected to be collected. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed included the following general assumptions:

 
·
We assume default rates on individual entities behind the pools based on Fitch ratings for financial institutions and A.M. Best ratings for insurance companies.  These ratings are used to predict the default rates for the next several quarters.  Two of the trust preferred securities hold a limited number of real estate investment trusts (REITs) in their pools.  REITs are evaluated on an individual basis to predict future default rates.
 
·
We assume that annual defaults for the remaining life of each security will be 37.5 basis points.
 
·
We assume a recovery rate of 15% on deferrals after two years.

 
13

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
3. 
SECURITIES – (Continued)

 
·
We assume 2% prepayments through the five year par call and then 2% per annum for the remaining life of the security.
 
·
Our securities have been modeled using the above assumptions by FTN Financial using the forward LIBOR curve plus original spread to discount projected cash flows to present values.

Additionally, in making our determination, we considered all available market information that could be obtained without undue cost and effort, and considered the unique characteristics of each trust preferred security individually by assessing the available market information and the various risks associated with that security including:

 
·
Valuation estimates provided by our investment broker;
 
·
The amount of fair value decline;
 
·
How long the decline in fair value has existed;
 
·
Significant rating agency changes on the issuer;
 
·
Level of interest rates and any movement in pricing for credit and other risks;
 
·
Information about the performance of the underlying institutions that issued the debt instruments, such as net income, return on equity, capital adequacy, non-performing assets, Texas ratios, etc;
 
·
Our intent to sell the security or whether it is more likely than not that we will be required to sell the security before its anticipated recovery; and
 
·
Other relevant observable inputs.

The following table details the five debt securities with other-than-temporary impairment at March 31, 2011 and the related credit losses recognized in earnings during the three months ended March 31, 2011:

        
Moody's
                             
% of Current
       
       
Credit
 
Current
                   
Current
   
Deferrals and
       
(Dollars in thousands)
     
Ratings
 
Moody's
             
Estimated
   
Deferrals
   
Defaults
   
Year to Date
 
       
When
 
Credit
 
Par
   
Amortized
   
Fair
   
and
   
to Current
   
OTTI
 
Security
 
Tranche
 
Purchased
 
Ratings
 
Value
   
Cost
   
Value
   
Defaults
   
Collateral
   
Recognized
 
                                                 
Preferred Term Securities IV
 
Mezzanine
  A3  
Ca
  $ 244     $ 180     $ 77     $ 18,000       27 %   $ 1  
Preferred Term Securities VI
 
Mezzanine
  A1  
Caa1
    259       23       23       33,000       81 %     12  
Preferred Term Securities XV B1
 
Mezzanine
  A2  
Ca
    1,004       420       187       156,050       26 %     -  
Preferred Term Securities XXI C2
 
Mezzanine
  A3  
Ca
    1,018       392       148       202,000       27 %     24  
Preferred Term Securities XXII C1
 
Mezzanine
  A3  
Ca
    503       81       60       367,500       27 %     -  
                                                             
Total
              $ 3,028     $ 1,096     $ 495                     $ 37  

The table below presents a roll-forward of the credit losses recognized in earnings for the periods ended March 31, 2011 and 2010:

(Dollars in thousands)
 
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
             
Beginning balance
  $ 1,910     $ 862  
Increases to the amount related to the credit loss for which other-than-temporary impairment was previously recognized
    37       172  
Ending balance
  $ 1,947     $ 1,034  

 
14

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS

Loans are summarized as follows:

   
March 31,
   
December 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Commercial
  $ 35,569     $ 42,265  
Commercial Real Estate:
               
Land Development
    55,487       56,086  
Building Lots
    11,237       11,333  
Other
    484,977       490,345  
Real estate construction
    7,964       11,034  
Residential mortgage
    160,610       163,975  
Consumer and home equity
    75,491       77,781  
Indirect consumer
    27,434       29,588  
Loans held for sale
    4,055       6,388  
      862,824       888,795  
Less:
               
Net deferred loan origination fees
    (419 )     (473 )
Allowance for loan losses
    (24,591 )     (22,665 )
      (25,010 )     (23,138 )
                 
Net Loans
  $ 837,814     $ 865,657  
 
The following table presents the activity in the allowance for loan losses by portfolio segment for the three months ending March 31, 2011:

March 31, 2011
       
Commercial
   
Real Estate
   
Residential
   
Consumer &
   
Indirect
       
   
Commercial
   
Real Estate
   
Construction
   
Mortgage
   
Home Equity
   
Consumer
   
Total
 
(Dollars in thousands)
                                         
Allowance for loan losses:
                                         
Beginning Balance
  $ 1,657     $ 18,595     $ 158     $ 751     $ 708     $ 796     $ 22,665  
Provision for loan losses
    22       3,351       -       43       84       (35 )     3,465  
Charge-offs
    (42 )     (1,616 )     (54 )     (19 )     (98 )     (31 )     (1,860 )
Recoveries
    42       206       -       1       48       24       321  
Total ending allowance balance
  $ 1,679     $ 20,536     $ 104     $ 776     $ 742     $ 754     $ 24,591  

The following table presents the activity in the allowance for loan losses for the three months ended March 31, 2010:

(Dollars in thousands)
     
       
Balance, beginning of period
  $ 17,719  
Provision for loan losses
    1,752  
Charge-offs
    (711 )
Recoveries
    50  
Balance, end of period
  $ 18,810  

We did not implement any changes to our accounting policies or methodology during the current period.
 
 
15

 
 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment excluding loans held for sale and based on the impairment method as of March 31, 2011 and December 31, 2010:

March 31, 2011
       
Commercial
   
Real Estate
   
Residential
   
Consumer &
   
Indirect
       
   
Commercial
   
Real Estate
   
Construction
   
Mortgage
   
Home Equity
   
Consumer
   
Total
 
(Dollars in thousands)
                                         
Allowance for loan losses:
                                         
Ending allowance balance attributable to loans:
                                         
Individually evaluated for impairment
  $ 827     $ 14,020       -     $ 385     $ 191     $ 37     $ 15,460  
Collectively evaluated for impairment
    852       6,516       104       391       551       717       9,131  
                                                         
Total ending allowance balance
  $ 1,679     $ 20,536       104     $ 776     $ 742     $ 754     $ 24,591  
                                                         
Loans:
                                                       
Loans individually evaluated for impairment
  $ 1,927     $ 97,370     $ 290     $ 1,871     $ 298     $ 137     $ 101,893  
Loans collectively evaluated for impairment
    33,642       454,331       7,674       158,739       75,193       27,297       756,876  
Loans acquired with deteriorated credit quality
    -       -       -       -       -       -       -  
                                                         
Total ending loans balance
  $ 35,569     $ 551,701     $ 7,964     $ 160,610     $ 75,491     $ 27,434     $ 858,769  
 
December 31, 2010
       
Commercial
   
Real Estate
   
Residential
   
Consumer &
   
Indirect
       
   
Commercial
   
Real Estate
   
Construction
   
Mortgage
   
Home Equity
   
Consumer
   
Total
 
(Dollars in thousands)
                                         
Allowance for loan losses:
                                         
Ending allowance balance attributable to loans:
                                         
Individually evaluated for impairment
  $ 691     $ 11,872       24     $ 334     $ 147     $ 29     $ 13,097  
Collectively evaluated for impairment
    966       6,723       134       417       561       767       9,568  
                                                         
Total ending allowance balance
  $ 1,657     $ 18,595       158     $ 751     $ 708     $ 796     $ 22,665  
                                                         
Loans:
                                                       
Loans individually evaluated for impairment
  $ 1,870     $ 86,250     $ 1,267     $ 1,609     $ 337     $ 91     $ 91,424  
Loans collectively evaluated for impairment
    40,395       471,514       9,767       162,366       77,444       29,497       790,983  
Loans acquired with deteriorated credit quality
    -       -       -       -       -       -       -  
                                                         
Total ending loans balance
  $ 42,265     $ 557,764     $ 11,034     $ 163,975     $ 77,781     $ 29,588     $ 882,407  
 
 
16

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 
4. 
LOANS– (Continued)

The following table presents loans individually evaluated for impairment by class of loans as of March 31, 2011 and December 31, 2010.  The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits:
 
March 31,2011
 
Unpaid
         
Allowance for
   
Average
   
Interest
   
Cash Basis
 
   
Principal
   
Recorded
   
Loan Losses
   
Recorded
   
Income
   
Interest
 
(Dollars in thousands)
 
Balance
   
Investment
   
Allocated
   
Investment
   
Recognized
   
Recognized
 
                                     
With no related allowance recorded:
                                   
Commercial
  $ 262     $ 263     $ -     $ 288     $ 11     $ 11  
Commercial Real Estate:
                                               
Land Development
    -       -       -       -       -       -  
Building Lots
    -       -       -       -       -       -  
Other
    42,845