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EX-32 - EXHIBIT 32 - FIRST FINANCIAL SERVICE CORPv229841_ex32.htm
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EX-31.1 - EXHIBIT 31.1 - FIRST FINANCIAL SERVICE CORPv229841_ex31-1.htm

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 June 30, 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  x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

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 July 31, 2011
     
Common Stock
 
4,749,055 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
32
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
50
     
Item 4.
Controls and Procedures
52
     
PART II – OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
52
     
Item 1A.
Risk Factors
52
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
54
     
Item 3.
Defaults upon Senior Securities
54
     
Item 4.
[Removed and Reserved]
54
     
Item 5.
Other Information
54
     
Item 6.
Exhibits
54
     
SIGNATURES
55

 
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)

   
June 30,
   
December 31,
 
(Dollars in thousands, except per share data)
 
2011
   
2010
 
             
ASSETS:
           
Cash and due from banks
  $ 14,284     $ 14,840  
Interest bearing deposits
    60,904       151,336  
Total cash and cash equivalents
    75,188       166,176  
                 
Securities available-for-sale
    281,562       196,029  
Securities held-to-maturity, fair value of $22 Jun (2011) and $126 Dec (2010)
    22       124  
Total securities
    281,584       196,153  
                 
Loans held for sale
    5,708       6,388  
Loans, net of unearned fees
    799,415       881,934  
Allowance for loan losses
    (17,708 )     (22,665 )
Net loans
    787,415       865,657  
                 
Federal Home Loan Bank stock
    4,805       4,909  
Cash surrender value of life insurance
    9,525       9,354  
Premises and equipment, net
    31,418       31,988  
Real estate owned:
               
Acquired through foreclosure
    26,459       25,807  
Held for development
    45       45  
Other repossessed assets
    34       40  
Core deposit intangible
    841       994  
Accrued interest receivable
    7,949       6,404  
Accrued income taxes
    6,030       2,161  
Deferred income taxes
    -       2,982  
Prepaid FDIC Insurance
    2,643       4,449  
Other assets
    8,160       2,388  
                 
TOTAL ASSETS
  $ 1,242,096     $ 1,319,507  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
LIABILITIES:
               
Deposits:
               
Non-interest bearing
  $ 74,305     $ 73,566  
Interest bearing
    1,052,877       1,100,342  
Total deposits
    1,127,182       1,173,908  
                 
Advances from Federal Home Loan Bank
    27,805       52,532  
Subordinated debentures
    18,000       18,000  
Accrued interest payable
    1,170       594  
Accounts payable and other liabilities
    3,971       3,162  
Deferred income taxes
    2,937       -  
                 
TOTAL LIABILITIES
    1,181,065       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
    19,862       19,835  
Common stock, $1 par value per share; authorized 35,000,000 shares; issued and outstanding, 4,739,622 shares Jun (2011), and 4,726,329 shares Dec (2010)
    4,740       4,726  
Additional paid-in capital
    35,338       35,201  
Retained earnings
    1,763       16,264  
Accumulated other comprehensive loss
    (672 )     (4,715 )
                 
TOTAL STOCKHOLDERS' EQUITY
    61,031       71,311  
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 1,242,096     $ 1,319,507  

See notes to the unaudited consolidated financial statements.

 
4

 

FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Income
(Unaudited)

   
Three Months Ended
   
Six Months Ended
 
(Dollars in thousands, except per share data)
 
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Interest and Dividend Income:
                       
Loans, including fees
  $ 11,692     $ 14,267     $ 24,035     $ 28,314  
Taxable securities
    1,703       878       3,269       1,371  
Tax exempt securities
    265       202       522       373  
Total interest income
    13,660       15,347       27,826       30,058  
                                 
Interest Expense:
                               
Deposits
    4,674       4,890       9,588       9,759  
Short-term borrowings
    -       11       -       32  
Federal Home Loan Bank advances
    280       596       575       1,189  
Subordinated debentures
    350       331       691       658  
Total interest expense
    5,304       5,828       10,854       11,638  
                                 
Net interest income
    8,356       9,519       16,972       18,420  
Provision for loan losses
    9,517       3,274       12,982       5,026  
Net interest income after provision for loan losses
    (1,161 )     6,245       3,990       13,394  
                                 
Non-interest Income:
                               
Customer service fees on deposit accounts
    1,554       1,739       2,999       3,264  
Gain on sale of mortgage loans
    291       415       556       714  
Gain on sale of investments
    162       -       231       -  
Loss on sale of investments
    (38 )     -       (38 )     (23 )
Other than temporary impairment loss:
                               
Total other-than-temporary impairment losses
    (67 )     (11 )     (104 )     (183 )
Portion of loss recognized in other comprehensive income/(loss) (before taxes)
    -       -       -       -  
Net impairment losses recognized in earnings
    (67 )     (11 )     (104 )     (183 )
Loss on sale and write downs on real estate acquired through foreclosure
    (4,651 )     (438 )     (4,886 )     (464 )
Brokerage commissions
    108       107       215       200  
Other income
    476       369       855       811  
Total non-interest income
    (2,165 )     2,181       (172 )     4,319  
                                 
Non-interest Expense:
                               
Employee compensation and benefits
    3,958       3,905       8,287       7,995  
Office occupancy expense and equipment
    832       768       1,643       1,572  
Marketing and advertising
    164       225       389       450  
Outside services and data processing
    1,056       668       1,853       1,398  
Bank franchise tax
    342       566       656       916  
FDIC insurance premiums
    906       694       1,876       1,354  
Amortization of core deposit intangible
    76       88       153       152  
Real estate acquired through foreclosure expense
    646       458       1,028       614  
Other expense
    1,936       1,262       3,437       2,457  
Total non-interest expense
    9,916       8,634       19,322       16,908  
                                 
Income/(loss) before income taxes
    (13,242 )     (208 )     (15,504 )     805  
Income taxes/(benefits)
    (1,338 )     (146 )     (1,530 )     112  
Net Income/(Loss)
    (11,904 )     (62 )     (13,974 )     693  
Less:
                               
Dividends on preferred stock
    (250 )     (250 )     (500 )     (500 )
Accretion on preferred stock
    (13 )     (13 )     (27 )     (27 )
Net income (loss) attributable to common shareholders
  $ (12,167 )   $ (325 )   $ (14,501 )   $ 166  
                                 
Shares applicable to basic income per common share
    4,739,700       4,718,021       4,737,761       4,716,755  
Basic income (loss) per common share
  $ (2.57 )   $ (0.07 )   $ (3.06 )   $ 0.04  
                                 
Shares applicable to diluted income per common share
    4,739,700       4,718,021       4,737,761       4,716,755  
Diluted income (loss) per common share
  $ (2.57 )   $ (0.07 )   $ (3.06 )   $ 0.04  
                                 
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
   
Six Months Ended
 
   
June 30,
   
June 30,
 
(Dollars in thousands)
 
2011
   
2010
   
2011
   
2010
 
                         
Net Income/(Loss)
  $ (11,904 )   $ (62 )   $ (13,974 )   $ 693  
Other comprehensive income (loss):
                               
Change in unrealized gain (loss) on securities available-for-sale
    4,716       1,381       5,923       1,448  
Change in unrealized gain (loss) on securities available-for-sale for which a portion of other-than-temporary impairment has been recognized into earnings
    (100 )     (19 )     293       (47 )
Reclassification of realized amount on securities available-for-sale losses (gains)
    (124 )     11       (168 )     157  
Reclassification of unrealized loss on held-to-maturity security recognized in income
    67       20       79       49  
Accretion (amortization) of non-credit component of other-than-temporary impairment on held-to-maturity securities
    -       (1 )     (1 )     (1 )
Net unrealized gain (loss) recognized in comprehensive income
    4,559       1,392       6,126       1,606  
Tax effect
    (1,550 )     (473 )     (2,083 )     (546 )
Total other comphrehensive income
    3,009       919       4,043       1,060  
                                 
Comprehensive Income/(Loss)
  $ (8,895 )   $ 857     $ (9,931 )   $ 1,753  

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
   
6/30/2011
 
Unrealized gains (losses) on securities available-for-sale
  $ (5,691 )   $ 3,782     $ (1,909 )
Unrealized gains (losses) on available-for-sale  securities for which OTTI has been recorded,
    1,082       209       1,291  
Unrealized gains (losses) on held-to-maturity securities for which OTTI has been recorded, net of accretion
    (106 )     52       (54 )
                         
Total
  $ (4,715 )   $ 4,043     $ (672 )

See notes to the unaudited consolidated financial statements.

 
6

 

FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Changes in Stockholders' Equity
Six Months Ended June 30, 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
                                            (13,974 )             (13,974 )
Shares issued under dividend reinvestment program
            1               1       1                       2  
Stock issued for employee benefit plans
            13               13       41                       54  
Stock-based compensation expense
                                    95                       95  
Net change in unrealized gains (losses) on securities available-for-sale,
                                                    3,782       3,782  
Change in unrealized gains (losses) on held-to-maturity securities for which an other-than-temporary impairment charge has been recorded,
                                                    52       52  
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
                                                    209       209  
Dividends on preferred stock
                                            (500 )             (500 )
Accretion of preferred stock discount
    -       -       27       -       -       (27 )     -       -  
Balance, June 30, 2011
    20,000       4,740     $ 19,862     $ 4,740     $ 35,338     $ 1,763     $ (672 )   $ 61,031  

See notes to the unaudited consolidated financial statements.

 
7

 

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

   
Six Months Ended
 
   
June 30,
 
   
2011
   
2010
 
Operating Activities:
           
Net income/(loss)
  $ (13,974 )   $ 693  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    12,982       5,026  
Depreciation on premises and equipment
    862       872  
Core deposit intangible amortization
    153       152  
Net amortization (accretion) available-for-sale
    (2,873 )     (911 )
Impairment loss on securities available-for-sale
    25       134  
Impairment loss on securities held-to-maturity
    79       49  
Loss on sale of investments held-to-maturity
    3       -  
Loss on sale of investments available-for-sale
    35       23  
Gain on sale of investments available-for-sale
    (231 )     -  
Gain on sale of mortgage loans
    (556 )     (714 )
Origination of loans held for sale
    (34,232 )     (55,617 )
Proceeds on sale of loans held for sale
    35,468       49,517  
Stock-based compensation expense
    95       47  
Prepaid FDIC premium
    1,806       1,275  
Changes in:
               
Cash surrender value of life insurance
    (171 )     (173 )
Interest receivable
    (1,545 )     (249 )
Other assets
    1,010       (868 )
Interest payable
    576       (71 )
Accounts payable and other liabilities
    309       (16 )
Net cash from operating activities
    (179 )     (831 )
                 
Investing Activities:
               
Sales of securities available-for-sale
    88,197       500  
Sales of securities held-to-maturity
    92       -  
Purchases of securities available-for-sale
    (180,139 )     (118,689 )
Maturities of securities available-for-sale
    15,500       21,504  
Maturities of securities held-to-maturity
    7       788  
Net change in loans
    57,119       46,180  
Redemption of Federal Home Loan Bank stock
    104       -  
Net purchases of premises and equipment
    (292 )     (1,232 )
Net cash from investing activities
    (19,412 )     (50,949 )
                 
Financing Activities
               
Net change in deposits
    (46,726 )     29,470  
Change in short-term borrowings
    -       (905 )
Advance from Federal Home Loan Bank
    337       -  
Maturity of Federal Home Loan Bank advance
    (25,000 )     -  
Repayments to Federal Home Loan Bank
    (64 )     (149 )
Issuance of common stock under dividend reinvestment program
    2       13  
Issuance of common stock for employee benefit plans
    54       63  
Dividends paid on preferred stock
    -       (500 )
Net cash from financing activities
    (71,397 )     27,992  
                 
(Decrease) Increase in cash and cash equivalents
    (90,988 )     (23,788 )
Cash and cash equivalents, beginning of period
    166,176       98,533  
Cash and cash equivalents, end of period
  $ 75,188     $ 74,745  
                 
Supplemental noncash disclosures:
               
Transfers from loans to real estate owned
  $ 9,438     $ 8,076  

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 and six month periods ending June 30, 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 – In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, which 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.

In April 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 provisions of the amendment will be effective for our reporting period ending September 30, 2011. The new standard is not expected to have a material impact on our consolidated financial position or results of operations.

In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income, which amends existing guidance by allowing only two options for presenting the components of net income and other comprehensive income: (1) in a single continuous financial statement, statement of comprehensive income or (2) in two separate but consecutive financial statements, consisting of an income statement followed by a separate statement of other comprehensive income. Also, items that are reclassified from other comprehensive income to net income must be presented on the face of the financial statements. ASU No. 2011-05 requires retrospective application, and it is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 (for us this will be our 2012 first quarter), with early adoption permitted. The new standard is not expected to have a material impact on our consolidated financial position or results of operations.

Reclassifications Some items in the prior year financial statements were classified to conform to the current presentation.

 
9

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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, and June 30, 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 September 30, 2011.

The Bank’s Consent Order with the FDIC and KDFI requires us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation. We are also no longer allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval.

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, we have engaged an investment banking firm with expertise in the financial services sector to assist with a review of all strategic opportunities available to us including the following:

 
·
Raising capital by selling capital stock through a public offering or private placement; and

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

Our plans for the third quarter of 2011 include the following:

 
·
Pursue all available strategies to recapitalize the Bank;

 
·
Continue to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner.

 
·
Continue to reduce our lending concentration in commercial real estate by obtaining paydowns and payoffs; and

 
·
Take significant operating expense reductions and other cost cutting measures aimed at lowering expenses.

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. Any of these alternatives could damage our reputation and have a material adverse effect on our business.

 
10

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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:
                       
June 30, 2011:
                       
U.S. Treasury and agencies
  $ 101,925     $ 107     $ (1,001 )   $ 101,031  
Government-sponsored mortgage-backed residential
    154,811       2,003       (276 )     156,538  
Equity
    299       -       (5 )     294  
State and municipal
    22,515       808       (1 )     23,322  
Trust preferred securities
    1,078       -       (701 )     377  
                                 
Total
  $ 280,628     $ 2,918     $ (1,984 )   $ 281,562  
                                 
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:
                       
June 30, 2011:
                       
Trust preferred securities
  $ 22     $ -     $ -     $ 22  
                                 
Total
  $ 22     $ -       -     $ 22  
                                 
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 June 30, 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     $ 115     $ -     $ -  
Due after one year through five years
    11,936       12,012       -       -  
Due after five years through ten years
    15,310       15,329       -       -  
Due after ten years
    98,157       97,274       22       22  
Government-sponsored mortgage-backed residential
    154,811       156,538       -       -  
Equity
    299       294       -       -  
    $ 280,628     $ 281,562     $ 22     $ 22  

For the June 30, 2011 six month period, proceeds from sales of available-for-sale and held-to-maturity debt securities were $88.3 million and for the 2010 period, proceeds from sales of available-for-sale equity securities were $500,000.  Gross realized gains recognized in income in 2011 were $231,000 and gross realized losses recognized were $38,000.  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 $67.4 million and fair value of $67.3 million at June 30, 2011 and a $66.8 million amortized cost and fair value of $65.1 million at December 31, 2010.

Securities with unrealized losses at June 30, 2011 and December 31, 2010 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

June 30, 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
  $ 73,988     $ (1,001 )   $ -     $ -     $ 73,988     $ (1,001 )
Government-sponsored mortgage-backed residential
    23,609       (276 )     -       -       23,609       (276 )
Equity
    -       -       3       (5 )     3       (5 )
State and municipal
    769       (1 )     -       -       769       (1 )
Trust preferred securities
    -       -       377       (701 )     377       (701 )
                                                 
Total temporarily impaired
  $ 98,366     $ (1,278 )   $ 380     $ (706 )   $ 98,746     $ (1,984 )

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 June 30, 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 June 30, 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 9 - Fair Value, the fair value of our portfolio of trust preferred securities, has decreased significantly.  There is limited trading 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 June 30, 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 other than temporary impairment 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 June 30, 2011 and the related credit losses recognized in earnings during the six months ended June 30, 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     $ 120     $ 18,000       27 %   $ 1  
Preferred Term Securities VI
 
Mezzanine
  A1  
Caa1
    259       22       22       30,000       74 %     79  
Preferred Term Securities XV B1
 
Mezzanine
  A2  
Ca
    1,004       425       184       211,700       35 %     -  
Preferred Term Securities XXI C2
 
Mezzanine
  A3  
Ca
    1,018       393       72       225,890       31 %     24  
Preferred Term Securities XXII C1
 
Mezzanine
  A3  
Ca
    503       80       1       428,500       33 %     -  
                                                             
Total
              $ 3,028     $ 1,100     $ 399                     $ 104  

The table below presents a roll-forward of the credit losses recognized in earnings for the periods ended June 30, 2011 and 2010:

(Dollars in thousands)
 
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Beginning balance
  $ 1,947     $ 1,034     $ 1,910     $ 862  
Increases to the amount related to the credit loss for which other-than-temporary impairment was previously recognized
    67       11       104       183  
Ending balance
  $ 2,014     $ 1,045     $ 2,014     $ 1,045  


 
14

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.
LOANS

Loans are summarized as follows:

   
June 30,
   
December 31,
 
(Dollars in thousands)
 
2011
   
2010
 
             
Commercial
  $ 31,433     $ 42,265  
Commercial Real Estate:
               
Land Development
    43,204       56,086  
Building Lots
    9,311       11,333  
Other
    450,785       490,345  
Real estate construction
    7,356       11,034  
Residential mortgage
    157,395       163,975  
Consumer and home equity
    74,525       77,781  
Indirect consumer
    25,739       29,588  
Loans held for sale
    5,708       6,388  
      805,456       888,795  
Less:
               
Net deferred loan origination fees
    (333 )     (473 )
Allowance for loan losses
    (17,708 )     (22,665 )
      (18,041 )     (23,138 )
                 
Net Loans
  $ 787,415     $ 865,657  

The following table presents the activity in the allowance for loan losses by portfolio segment for the three and six months ending June 30, 2011:

Three Months Ended
                                         
June 30, 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
  $ 1,679     $ 20,536     $ 104     $ 776     $ 742     $ 754     $ 24,591  
Provision for loan losses
    (225 )     9,655       -       131       (29 )     (15 )     9,517  
Charge-offs
    (100 )     (16,068 )     (9 )     (205 )     (38 )     (56 )     (16,476 )
Recoveries
    17       10       -       -       15       34       76  
Total ending allowance balance
  $ 1,371     $ 14,133     $ 95     $ 702     $ 690     $ 717     $ 17,708  
                                                         
Six Months Ended
                                                       
June 30, 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
    (203 )     13,006       -       174       55       (50 )     12,982  
Charge-offs
    (142 )     (17,684 )     (63 )     (224 )     (136 )     (87 )     (18,336 )
Recoveries
    59       216       -       1       63       58       397  
Total ending allowance balance
  $ 1,371     $ 14,133     $ 95     $ 702     $ 690     $ 717     $ 17,708  

The following table presents the activity in the allowance for loan losses for the three and six months ended June 30, 2010:

   
Three Months Ended
   
Six Months Ended
 
(Dollars in thousands)
 
June 30,
   
June 30,
 
   
2010
   
2010
 
             
Balance, beginning of period
  $ 18,810     $ 17,719  
Provision for loan losses
    3,274       5,026  
Charge-offs
    (1,193 )     (1,904 )
Recoveries
    62       112  
Balance, end of period
  $ 20,953     $ 20,953  
 
 
15

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.
LOANS – (Continued)

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

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 June 30, 2011 and December 31, 2010:

June 30, 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
  $ 566     $ 6,796       -     $ 220     $ 130