ITEM 1. BUSINESS General Business Overview First Financial Service Corporation was incorporated in August 1989 under Kentucky law and became the holding company for First Federal Savings Bank of Elizabethtown (the “Bank”), effective on June 1, 1990. Since that date, we have engaged in no significant activity other than holding the stock of the Bank and directing, planning and coordinating its business activities. Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly owned subsidiary, the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries. In 2004 we amended our articles of incorporation to change our name from First Federal Financial Corporation of Kentucky to First Financial Service Corporation.
We are headquartered in Elizabethtown, Kentucky and were originally founded in 1923 as a state-chartered institution and became federally chartered in 1940. In 1987, we converted to a federally chartered savings bank and converted from mutual to stock form. We are a member of the Federal Home Loan Bank (“FHLB”) of Cincinnati and, since converting to a state charter in 2003, have been subject to regulation, examination and supervision by the FDIC and the KDFI. Our deposits are insured by the Deposit Insurance Fund and administered by the FDIC.
We serve the needs and cater to the economic strengths of the local communities in which we operate, and we strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.
Our full complement of lending services includes:
• a broad array of residential mortgage products, both fixed and adjustable rate;
• consumer loans, including home equity lines of credit, auto loans, recreational vehicle, and other secured and unsecured loans;
• specialized financing programs to support community development;
• mortgages for multi-family real estate;
• commercial real estate loans;
• commercial loans to businesses, including revolving lines of credit and term loans;
• real estate development;
• construction lending; and
• agricultural lending.
We also provide a broad selection of deposit instruments. These include:
• multiple checking and NOW accounts for both personal and business accounts;
• various savings accounts, including those for minors;
• money market accounts;
• tax qualified deposit accounts such as Health Savings Accounts and Individual Retirement Accounts; and
• a broad array of certificate of deposit products.
We also support our customers by providing services such as:
• providing access to merchant bankcard services;
• supplying various forms of electronic funds transfer;
• providing debit cards and credit cards; and
• providing telephone and Internet banking.
Through our personal investment financial counseling services, we offer a wide variety of mutual funds, equity investments, and fixed and variable annuities. We invest in the wholesale capital markets to manage a portfolio of securities and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, and collateralized mortgage obligations.
Our results of operations depend primarily on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Our operations are also affected by non-interest income, such as service charges, loan fees, gains and losses from the sale of mortgage loans and revenue earned from bank owned life insurance. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense, FDIC insurance premiums and provisions for loan losses.
Regulatory Matters & Recent Developments On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI. A copy of the Consent Order is set forth as Exhibit 10.1 of the Form 8-K filed with the SEC on January 27, 2011. Under the terms of the Consent Order, the Bank cannot declare dividends without the prior written approval of the FDIC and KDFI. Other material provisions of the Consent Order required the Bank to:
• obtain an independent assessment of executive management and senior commercial lending staff;
• increase the Bank’s capital ratios;
• develop and implement a plan to reduce the level of non-performing assets;
• develop and implement a plan to reduce concentrations of credit in commercial real estate loans;
• maintain adequate reserves for loan and lease losses;
• implement revised credit risk management practices and credit administration policies and procedures;
• implement procedures to ensure compliance with applicable laws, rules, regulations and policy statements;
• periodically evaluate the Bank’s strategic plan and budget;
• develop revisions to the Bank’s funding contingency plan, which identifies available sources of liquidity and plans for dealing with potential adverse economic and market conditions; and
• prepare and submit progress reports to the FDIC and KDFI.
The Consent Order requires the Bank to achieve the minimum capital ratios presented below by June 30, 2011:
On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve the minimum capital ratios set forth in the table above by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. The new Consent Order requires the Bank to continue to adhere to the plans implemented in response to the January 2011 Consent Order, and includes the substantive provisions of the January 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to this Annual Report on Form 10-K.
On April 20, 2011 the Corporation entered into a formal agreement 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.
The Consent Orders and formal agreement will remain in effect until modified or terminated by the FDIC, KDFI and Federal Reserve Bank of St. Louis.
As part of our ongoing capital initiatives, on February 9, 2012, we signed a definitive agreement to sell our four Indiana banking centers to First Savings Bank, F.S.B., the banking subsidiary of First Savings Financial Group, Inc. The purchase price will represent a 3.65% percent premium based on the actual level of consumer and commercial deposits at closing, which totaled $99.7 million at December 31, 2011. Under the agreement, First Savings Financial Group, Inc. will also acquire government, corporate, other financial institution deposits and municipal deposits, which were $17.5 million at December 31, 2011, at book value. A total of $35.4 million of performing loans will be purchased at a discount of 0.80% based on the actual level of loans at closing. The consummated transaction would result in a one-time gain of approximately $3.4 million based on information at December 31, 2011. We believe the transaction places us in a better position to meet the conditions of the regulatory consent order in a manner that is beneficial to our shareholders. This transaction is projected to increase our Tier I capital ratio from 5.86% to 6.74% and increase our total risk-based capital ratio from 10.18% to 11.32% based on information at December 31, 2011, and is expected to close early in the third quarter of 2012.
On February 10, 2012, we announced the following changes to our management and the board of directors.
• Senator Walter Dee Huddleston had stepped down as Chairman of the Board while continuing to serve as a director.
• J. Stephen Mouser, President of Mouser Custom Cabinetry, LLC, and a director since 1997, was appointed as the Board’s new Chairman.
• B. Keith Johnson, Chief Executive Officer of the Corporation and the Bank since 1997, had stepped down from those positions. Mr. Johnson assumed the position of the Board’s Vice Chairman, while continuing to work at the Bank in an advisory role.
• Gregory S. Schreacke, President of the Corporation and the Bank since 2008, assumed principal management responsibility for the Corporation and the Bank. Mr. Schreacke also joined the boards of directors of both the Corporation and the Bank.
• Dann Small was appointed as Chief Lending Officer of the Bank and will direct the Bank’s lending program and supervise all phases of the lending operation. Mr. Small has over 30 years of experience in finance, lending, credit underwriting and executive management.
• Robert L. Critchfield was appointed as Chief Credit Officer of the Bank, with responsibility for the overall management of its loan, credit and risk policies. Mr. Critchfield has over forty years of experience in the banking industry, including seventeen years as President and CEO of two commercial banks.
Market Area We operate 22 full-service banking centers and a commercial private banking center in eight contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area, including southern Indiana. Our markets range from Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown to Harrison County, Indiana approximately 60 miles northwest of our headquarters. Our markets are supported by a diversified industry base and have a regional population of over 1 million. We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky and in Harrison and Floyd counties in southern Indiana. We control in the aggregate 23% of the deposit market share in our central Kentucky markets outside of Louisville. After the sale of our four Indiana banking centers, we will exit the southern Indiana market.
The following table shows our market share and rank in terms of deposits as of June 30, 2011, in each Kentucky and Indiana county where we have offices. We have four offices in Jefferson County, which is Louisville, Kentucky. The Louisville metropolitan area has a population of more than one million.
Lending Activities Commercial Real Estate Lending. At December 31, 2011, we had $458.8 million outstanding in commercial real estate loans. We originate commercial loans that are primarily secured by real estate and primarily in our market area. In recent years, we have put greater emphasis on originating loans for small and medium-sized businesses from our various locations. We make commercial loans to a variety of industries. Substantially all of the commercial real estate loans we originate have adjustable interest rates with maturities of 25 years or less or are loans with fixed interest rates and maturities of five years or less. The security for commercial real estate loans includes retail businesses, warehouses, churches, apartment buildings and motels. In addition, the payment experience of loans secured by income producing properties typically depends on the success of the related real estate project and thus may be more vulnerable to adverse conditions in the real estate market or in the economy generally.
Loans secured by multi-family residential property, consisting of properties with more than four separate dwelling units, amounted to $26.1 million of the loan portfolio at December 31, 2011. These loans are included in the $458.8 million outstanding in commercial real estate loans discussed above. We generally do not lend above 75% of the appraised values of multi-family residences on first mortgage loans. The mortgage loans we currently offer on multi-family dwellings are generally one or five year ARMs with maturities of 25 years or less.
Commercial Business Lending. We make secured and unsecured loans for commercial, corporate, business, and agricultural purposes, including issuing letters of credit and engaging in inventory financing and commercial leasing activities. Commercial loans generally are made to small-to-medium size businesses located within our defined market area. Commercial loans generally carry a higher yield and are made for a shorter term than real estate loans. Commercial loans, however, involve a higher degree of risk than residential real estate loans due to potentially greater volatility in the value of the assigned collateral, the need for more technical analysis of the borrower’s financial position, the potentially greater impact that changing economic conditions may have on the borrower’s ability to retire debt, and the additional expertise required for commercial lending personnel. Commercial business loans outstanding at December 31, 2011, totaled $30.1 million.
Residential Real Estate. Residential mortgage loans are secured primarily by single-family homes. The majority of our mortgage loan portfolio is secured by real estate in our markets outside of Louisville and our residential mortgage loans do not have sub-prime characteristics. Fixed rate residential real estate loans we originate have terms ranging from ten to thirty years. Interest rates are competitively priced within the primary geographic lending market and vary according to the term for which they are fixed. At December 31, 2011, we had $151.9 million in residential mortgage loans outstanding.
We generally emphasize the origination of adjustable-rate mortgage loans (“ARMs”) when possible. We offer seven ARM products with an annual adjustment, which is tied to a national index with a maximum adjustment of 2% annually, and a lifetime maximum adjustment cap of 6%. As of December 31, 2011, approximately 32.6% of our residential real estate loans were adjustable rate loans with adjustment periods ranging from one to seven years and balloon loans of seven years or less. Originating these ARMs can be more difficult in a low interest rate environment where there is a significant demand for fixed rate mortgages. We limit the maximum loan-to-value ratio on one-to-four-family residential first mortgages to 90% of the appraised value and generally limit the loan-to-value ratio on second mortgages on one-to-four-family dwellings to 90%.
Construction Lending. Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value before the completion of construction. The uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies make it relatively difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. The analysis of prospective construction loan projects requires significantly different expertise from that required for permanent residential mortgage lending. At December 31, 2011, we had $3.9 million outstanding in construction loans.
Our underwriting criteria are designed to evaluate and minimize the risks of each construction loan. Among other things, we consider evidence of the availability of permanent financing or a takeout commitment to the borrower; the reputation of the borrower and his or her financial condition; the amount of the borrower’s equity in the project; independent appraisals and cost estimates; pre-construction sale and leasing information; and cash flow projections of the borrower.
Consumer Lending. Consumer loans include loans on automobiles, boats, recreational vehicles and other consumer goods, as well as loans secured by savings accounts, home improvement loans, and unsecured lines of credit. As of December 31, 2011, consumer loans outstanding were $91.9 million. These loans involve a higher risk of default than loans secured by one-to-four-family residential loans. We believe, however, that the shorter term and the normally higher interest rates available on various types of consumer loans help maintain a profitable spread between the average loan yield and cost of funds. Home equity lines of credit as of December 31, 2011, totaled $54.2 million.
Our underwriting standards reflect the greater risk in consumer lending than in residential real estate lending. Among other things, the capacity of individual borrowers to repay can change rapidly, particularly during an economic downturn, collection costs can be relatively higher for smaller loans, and the value of collateral may be more likely to depreciate. Our Consumer Lending Policy establishes the appropriate consumer lending authority for all loan officers based on experience, training, and past performance for approving high quality loans. Loans beyond the authority of individual officers must be approved by additional officers, the Executive Loan Committee or the Board of Directors, based on the size of the loan. We require detailed financial information and credit bureau reports for each consumer loan applicant to establish the applicant’s credit history, the adequacy of income for debt retirement, and job stability based on the applicant’s employment records. Co-signers are required for applicants who are determined marginal or who fail to qualify individually under these standards. Adequate collateral is required on the majority of consumer loans. The Executive Credit Committee monitors and evaluates unsecured lending activity by each loan officer.
The indirect consumer loan portfolio is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within the service area. Indirect consumer loans are considered to have greater risk of loan losses than direct consumer loans due to, among other things: borrowers may have no existing relationship with us; borrowers may not be residents of the lending area; less detailed financial statement information may be collected at application; collateral values can be more difficult to determine; and the condition of vehicles securing the loan can deteriorate rapidly. To address the additional risks associated with indirect consumer lending, the Executive Loan Committee continually evaluates data regarding the dealers enrolled in the program, including monitoring turn down and delinquency rates. All applications are approved by specific lending officers, selected based on experience in this field, who obtain credit bureau reports on each application to assist in the decision. Aggressive collection procedures encourage more timely recovery of late payments. At December 31, 2011, total loans under the indirect consumer loan program totaled $21.9 million.
Subsidiary Activities First Service Corporation of Elizabethtown (“First Service”), our licensed brokerage affiliate, provides investment services to our customers and offers tax-deferred annuities, government securities, mutual funds, and stocks and bonds. First Service employs four full-time employees. The net income of First Service was $73,000 for the year ended December 31, 2011.
First Federal Office Park, LLC, holds commercial lots adjacent to our home office on Ring Road in Elizabethtown that are available for sale. Currently, one of the original nine lots held for sale remains unsold.
We provide title insurance coverage for mortgage borrowers through two subsidiaries: First Heartland Title, LLC, and First Federal Title Services, LLC. First Heartland Title is a joint venture with a title insurance company in Hardin County and First Federal Title Services is a joint venture with a title insurance company in Louisville. We hold a 48% interest in First Heartland Title and a 49% interest in First Federal Title Services. The subsidiaries generated $144,000 in income for the year ended December 31, 2011, of which our portion was $69,000.
Heritage Properties, LLC, holds real estate acquired through foreclosure which is available for sale. Currently, sixty-two properties valued at $29.1 million are held for sale.
Competition We face substantial competition both in attracting and retaining deposits and in lending. Direct competition for deposits comes from commercial banks, savings institutions, and credit unions located in north-central Kentucky and southern Indiana, and less directly from money market mutual funds and from sellers of corporate and government debt securities.
The primary competitive factors in lending are interest rates, loan origination fees and the range of services offered by the various financial institutions. Competition for origination of real estate loans normally comes from commercial banks, savings institutions, mortgage bankers, mortgage brokers, and insurance companies. Retail establishments effectively compete for loans by offering credit cards and retail installment contracts for the purchase of goods, merchandise and services (for example, Home Depot, Lowe’s, etc.). We believe that we have been able to compete effectively in our primary market area.
We have offices in nine cities in six central Kentucky counties and offices in four cities in two southern Indiana counties. In addition to the financial institutions with offices in these counties, we compete with several commercial banks and savings institutions in surrounding counties, many of which have assets substantially greater than we have. These competitors attempt to gain market share through their financial product mix, pricing strategies, internet banking and banking center locations. In addition, Kentucky’s interstate banking statute, which permits banks in all states to enter the Kentucky market if they have reciprocal interstate banking statutes, has further increased competition for us. We believe that competition from both bank and non-bank entities will continue to remain strong in the near future.
Employees As of December 31, 2011, we employed 325 employees, of which 307 were full-time and 18 part-time. None of our employees are subject to a collective bargaining agreement, and we believe that we enjoy good relations with our personnel.
Regulation General Regulatory Matters. The Bank is a Kentucky chartered commercial bank and is subject to supervision and regulation, which involves regular bank examinations, by both the FDIC and the KDFI. Our deposits are insured by the FDIC. Kentucky’s banking statutes contain a “super-parity” provision that permits certain well-rated Kentucky banks to engage in any banking activity in which a national bank operating in any state, a state bank, thrift or savings bank operating in any other state, or a federally chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.
In connection with our conversion, we registered to become a bank holding company under the Bank Holding Company Act of 1956, and are subject to supervision and regulation by the Federal Reserve Board. As a bank holding company, we are required to file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to its operational guidelines. We are subject to the Bank Holding Company Act and other federal laws and regulations regarding the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.
Regulators have broad enforcement powers over bank holding companies and banks, including, but not limited to, the power to mandate or restrict particular actions, activities, or divestitures, impose monetary fines and other penalties for violations of laws and regulations, issue cease and desist or removal orders, seek injunctions, publicly disclose such actions and prohibit unsafe or unsound practices. This authority includes both informal actions and formal actions to effect corrective actions or sanctions.
Certain regulatory requirements applicable to the Corporation and the Bank are referred to below or elsewhere in this filing. The description of statutory provisions and regulations applicable to banks and their holding companies set forth in this filing does not purport to be a complete description of such statutes and regulations and their effect on the Corporation or the Bank and is qualified in its entirety by reference to the actual laws and regulations.
We are required by regulation to maintain adequate levels of capital to support our operations. 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 agreed to achieve and maintain a Tier 1 leverage ratio of at least 9.0% by June 30, 2011. At December 31, 2011, we were not in compliance with the Tier 1 capital requirement. On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve and maintain a Tier 1 leverage ratio of at least 9.0% by June 30, 2012. We expect the regulatory agencies to reevaluate our progress toward the higher Tier 1 capital ratio at June 30, 2012. On April 20, 2011 the Corporation entered into a formal agreement 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.
Acquisitions, Change in Control and Branching. As a bank holding company, we must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock of a bank, and before engaging in, or acquiring a company that is not a bank but is engaged in certain non-banking activities. In approving these acquisitions, the Federal Reserve Board considers a number of factors, and weighs the expected benefits to the public such as greater convenience, increased competition and gains in efficiency, against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board also considers the financial and managerial resources of the bank holding company, its subsidiaries and any company to be acquired, and the effect of the proposed transaction on these resources. It also evaluates compliance by the holding company’s financial institution subsidiaries and the target institution with the Community Reinvestment Act. The Community Reinvestment Act generally requires each financial institution to take affirmative steps to ascertain and meet the credit needs of its entire community, including low and moderate income neighborhoods.
Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance and then only if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company, in the absence of a larger shareholder, would constitute an acquisition of control of the bank holding company. In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.
Kentucky law generally permits a Kentucky chartered bank to establish a branch office in any county in Kentucky. A Kentucky bank may also, subject to regulatory approval and certain restrictions, establish a branch office outside of Kentucky. Well-capitalized Kentucky banks that have been in operation at least three years and that satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a branch in Kentucky without the approval of the Executive Director of the KDFI, upon notice to the KDFI and any other state bank with its main office located in the county where the new branch will be located. Branching by all other banks requires the approval of the Executive Director of the KDFI, who must ascertain and determine that the public convenience and advantage will be served and promoted and that there is a reasonable probability of the successful operation of the branch. In any case, the transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.
Section 613 of the Dodd-Frank Act effectively eliminated the interstate branching restrictions set forth in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Banks located in any state may now de novo branch in any other state, including Kentucky. Such unlimited branching power will likely increase competition within the markets in which the Corporation and the Bank operate.
Other Financial Activities. The Gramm-Leach-Bliley Act of 1999 permits a bank holding company to elect to become a financial holding company, which permits the holding company to conduct activities that are “financial in nature.” To become and maintain its status as a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well managed, and have at least a satisfactory Community Reinvestment Act rating. We have not filed an election to become a financial holding company and are ineligible to do so due to the Bank’s “troubled institution” designation and entering into the Consent Order.
Subject to certain exceptions, insured state banks are permitted to control or hold an interest in a financial subsidiary that engages in a broader range of activities than are permissible for national banks to engage in directly, subject to any restrictions imposed on a bank under the laws of the state under which it is organized. Conducting financial activities through a bank subsidiary can impact capital adequacy and regulatory restrictions may apply to affiliate transactions between the bank and its financial subsidiaries.
Other Holding Company Regulations. Federal law substantially restricts transactions between financial institutions and their affiliates. As a result, a bank is limited in extending credit to its holding company (or any non-bank subsidiary), in investing in the stock or other securities of the bank holding company or its non-bank subsidiaries, and/or in taking such stock or securities as collateral for loans to any borrower. Moreover, transactions between a bank and a bank holding company (or any non-bank subsidiary) for loans to any borrower must generally be on terms and under circumstances at least as favorable to the bank as those prevailing in comparable transactions with independent third parties or, in the absence of comparable transactions, on terms and under circumstances that in good faith would be available to nonaffiliated companies.
Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and to commit resources for their support. Such support may restrict the Corporation’s ability to pay dividends, and may be required at times when, absent this Federal Reserve Board policy, a holding company may not be inclined to provide it. A bank holding company may also be required to guarantee the capital restoration plan of an undercapitalized banking subsidiary. In addition, any capital loans by the Corporation to the Bank are subordinate in right of payment to deposits and to certain other indebtedness of the Bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Dodd-Frank Act codifies the Federal Reserve Board’s existing “source of strength” policy that holding companies act as a source of strength to their insured institution subsidiaries by providing capital, liquidity and other support in times of distress.
Regulatory Capital Requirements. The Federal Reserve Board and the FDIC have substantially similar risk-based and leverage capital guidelines applicable to the banking organizations they supervise. Under the risk-based capital requirements, we are generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital (4%) must be composed of common equity, retained earnings and qualifying perpetual preferred stock and certain hybrid capital instruments, less certain intangibles (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital” which, together with Tier 1 capital, composes “total capital”). To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total risk-weighted capital ratio of at least 10% and a Tier 1 risk-weighted ratio of 6% or greater.
The Federal Deposit Insurance Corporation Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Due to the losses we have incurred in recent quarters, our elevated levels of non-performing loans and other real estate, and the ongoing economic stress in Jefferson and Oldham Counties, Kentucky, the FDIC, KDFI and the Bank entered into the Consent Order referred to above under the section “Regulatory Matters & Recent Developments.” The Consent Order resulted in the Bank being categorized as a “troubled institution” by bank regulators, which by definition does not permit the Bank to be considered “well-capitalized”. The “troubled institution” designation also prohibits the Bank from accepting, renewing or rolling over brokered deposits and restricts the amount of interest the Bank may pay on deposits. Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates within .75% of the average rates computed by the FDIC. The Bank must apply annually to be granted this waiver, which it has done and was granted for 2011.
FDICIA also requires the bank regulatory agencies to implement systems for “prompt corrective action” for institutions that fail to meet minimum capital requirements within these five categories, with progressively more severe restrictions on operations, management and capital distributions according to the category in which an institution is placed. Failure to meet capital requirements can also cause an institution to be directed to raise additional capital. FDICIA also mandates that the agencies adopt safety and soundness standards relating generally to operations and management, asset quality and executive compensation, and authorizes administrative action against an institution that fails to meet such standards.
In addition, the Federal Reserve Board and the FDIC have each adopted risk-based capital standards that explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by each agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy. In addition to the “prompt corrective action” directives, failure to meet capital guidelines can subject a banking organization to a variety of other enforcement remedies, including additional substantial restrictions on its operations and activities, termination of deposit insurance by the FDIC, and under some conditions the appointment of a conservator or receiver.
Dividends. The Corporation is a legal entity separate and distinct from the Bank. The majority of our revenue is from dividends we receive from the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and a hearing, that the institution cease and desist from such practice. The federal banking agencies have indicated that paying dividends that deplete an institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under FDICIA, an insured institution may not pay a dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve Board and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings.
Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank’s capital surplus equals the amount of its stated capital attributable to its common stock. Moreover, the KDFI Commissioner must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank’s total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or if becoming unable to pay debts as they come due. According to the terms of the Consent Order referred to above under the section “Regulatory Matters & Recent Developments,” the Bank cannot pay any dividends or distributions without prior regulatory approval. The Corporation has also agreed with the Federal Reserve Bank of St. Louis to not pay any dividends or distributions without prior regulatory approval.
Consumer Protection Laws. We are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.
Home Mortgage Disclosure Act (“HMDA”). The HMDA has grown out of public concern over credit shortages in certain urban neighborhoods. One purpose of HMDA is to provide public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics, as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes. The HMDA requires institutions to report data regarding applications for loans for the purchase or improvement of single family and multi-family dwellings, as well as information concerning originations and purchases of such loans. Federal bank regulators rely, in part, upon data provided under HMDA to determine whether depository institutions engage in discriminatory lending practices. The appropriate federal banking agency, or in some cases the Department of Housing and Urban Development, enforces compliance with HMDA and implements its regulations. Administrative sanctions, including civil money penalties, may be imposed by supervisory agencies for violations of the HMDA.
Equal Credit Opportunity Act (“ECOA”). The ECOA prohibits discrimination against an applicant in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs or good faith exercise of any rights under the Consumer Credit Protection Act. Under the Fair Housing Act, it is unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. Among other things, these laws prohibit a lender from denying or discouraging credit on a discriminatory basis, making excessively low appraisals of property based on racial considerations, or charging excessive rates or imposing more stringent loan terms or conditions on a discriminatory basis. In addition to private actions by aggrieved borrowers or applicants for actual and punitive damages, the U.S. Department of Justice and other regulatory agencies can take enforcement action seeking injunctive and other equitable relief or sanctions for alleged violations.
Truth in Lending Act (“TILA”). The TILA is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As result of the TILA, all creditors must use the same credit terminology and expressions of rates, and disclose the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule for each proposed loan. Violations of the TILA may result in regulatory sanctions and in the imposition of both civil and, in the case of willful violations, criminal penalties. Under certain circumstances, the TILA also provides a consumer with a right of rescission, which if exercised within three business days would require the creditor to reimburse any amount paid by the consumer to the creditor or to a third party in connection with the loan, including finance charges, application fees, commitment fees, title search fees and appraisal fees. Consumers may also seek actual and punitive damages for violations of the TILA.
Real Estate Settlement Procedures Act (“RESPA”). The RESPA requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. The RESPA also prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Violations of the RESPA may result in imposition of penalties, including: (1) civil liability equal to three times the amount of any charge paid for the settlement services or civil liability of up to $1,000 per claimant, depending on the violation; (2) awards of court costs and attorneys’ fees; and (3) fines of not more than $10,000 or imprisonment for not more than one year, or both.
Fair Credit Reporting Act (“FACT”). The FCRA requires the Bank to adopt and implement a written identity theft prevention program, paying particular attention to several identified “red flag” events. The program must assess the validity of address change requests for card issuers and for users of consumer reports to verify the subject of a consumer report in the event of notice of an address discrepancy. The FCRA gives consumers the ability to challenge banks with respect to credit reporting information provided by the bank. The FCRA also prohibits banks from using certain information it may acquire from an affiliate to solicit the consumer for marketing purposes unless the consumer has been given notice and an opportunity to opt out of such solicitation for a period of five years.
Loans to One Borrower. Under current limits, loans and extensions of credit outstanding at one time to a single borrower and not fully secured generally may not exceed 15% of an institution’s unimpaired capital and unimpaired surplus. Loans and extensions of credit fully secured by certain readily marketable collateral may represent an additional 10% of unimpaired capital and unimpaired surplus.
Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.
The Community Reinvestment Act (“CRA”) requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC’s assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board’s consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new branch office or to relocate an office. The Federal Reserve Board will also assess the CRA record of the subsidiary banks of a bank holding company in its consideration of any application to acquire a bank or other bank holding company, which may be the basis for denying the application.
Bank Secrecy Act. The Bank Secrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities.
In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.
USA Patriot Act. The USA PATRIOT Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. The Patriot Act also grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.
The Corporation and the Bank, like all U.S. companies and individuals, are prohibited from transacting business with certain individuals and entities named on the Office of Foreign Asset Control’s (“OFAC”) list of Specially Designated Nationals and Blocked Persons. Failure to comply may result in fines and other penalties. The OFAC issued guidance for financial institutions in which it asserted that it may, in its discretion, examine institutions determined to be high risk or to be lacking in their efforts to comply with these prohibitions.
Federal Deposit Insurance Assessments. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund, or the DIF, of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating.
Effective January 1, 2007, the FDIC imposed deposit assessment rates based on the risk category of insured banks. Risk Category I is the lowest risk category while Risk Category IV is the highest risk category. Because of favorable loss experience and a healthy reserve ratio in the Bank Insurance Fund, or the BIF, of the FDIC at that time, well-capitalized and well-managed banks, have in recent years paid minimal premiums for FDIC insurance.
On October 16, 2008, the FDIC published a restoration plan designed to replenish the Deposit Insurance Fund over a period of five years and to increase the deposit insurance reserve ratio, which decreased to 1.01% of insured deposits on June 30, 2008, to the statutory minimum of 1.15% of insured deposits by December 31, 2013. In order to implement the restoration plan, the FDIC proposed to change both its risk-based assessment system and its base assessment rates. For the first quarter of 2009 only, the FDIC increased all FDIC deposit assessment rates by 7 basis points. These new rates range from 12 to 14 basis points for Risk Category I institutions to 50 basis points for Risk Category IV institutions.
Under the FDIC’s restoration plan, the FDIC proposed to establish new initial base assessment rates that will be subject to adjustment as described below. Beginning April 1, 2009, the base assessment rates would range from 12 to 16 basis points for Risk Category I institutions to 45 basis points for Risk Category IV institutions.
Changes to the risk-based assessment system include increasing premiums for institutions that rely on excessive amounts of brokered deposits, increasing premiums for excessive use of secured liabilities (including Federal Home Loan Bank advances), lowering premiums for smaller institutions with very high capital levels, and adding financial ratios and debt issuer ratings to the premium calculations for banks with over $10 billion in assets, while providing a reduction for their unsecured debt.
Either an increase in the Risk Category of the Company’s bank subsidiary or adjustments to the base assessment rates could result in a material increase in our expense for federal deposit insurance. Because the Bank entered into the Consent Order and is designated a “troubled institution” it is in a higher risk category and now pays one of the highest deposit assessment rates.
In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation (FICO), a mixed-ownership government corporation established to recapitalize a predecessor to the Deposit Insurance Fund. The current annualized assessment rate is 1.14 basis points, or approximately .285 basis points per quarter. These assessments will continue until the Financing Corporation bonds mature in 2019.
The FDIC implemented a five basis point emergency special assessment on insured depository institutions as of June 30, 2009. The special assessment was paid on September 30, 2009. This assessment resulted in a cost of $477,000 and is reflected in our income statement for 2009. The interim rule also authorizes the FDIC to impose an additional emergency assessment of up to 10 basis points in respect to deposits for quarters ended after June 30, 2009 if necessary to maintain public confidence in federal deposit insurance. In addition, during the fourth quarter of 2009, the FDIC approved that all banks prepay three and a quarter years worth of FDIC assessments on December 31, 2009. The prepayment is based on average third quarter deposits. The prepaid amount will be amortized over the prepayment period. Our prepayment was $7.5 million of which $3.2 million was reflected in our 2011 income statement.
On February 7, 2011, the FDIC Board of Directors adopted a final rule (with changes that went into effect beginning with the second quarter 2011), which redefined the deposit insurance assessment base as required by the Dodd-Frank Act; made changes to assessment rates; implemented Dodd-Frank’s DIF dividend provisions; and revised the risk-based assessment system for all large insured depository institutions (“IDIs”), generally, those institutions with at least $10 billion in total assets. Nearly all of the 7,600-plus institutions with assets less than $10 billion paid smaller assessments as a result of this final rule. The final rule:
• Redefined the deposit insurance assessment base as average consolidated total assets minus average tangible equity (defined as Tier I Capital);
• Made generally conforming changes to the unsecured debt and brokered deposit adjustments to assessment rates;
• Created a depository institution debt adjustment;
• Eliminated the secured liability adjustment; and
• Adopted a new assessment rate schedule effective April 1, 2011, and, in lieu of dividends, other rate schedules when the reserve ratio reaches certain levels.
The FDIC is authorized to set the reserve ratio for the DIF annually at between 1.15% and 1.50% of estimated insured deposits. The Dodd-Frank Act mandates that the statutory minimum reserve ratio of the DIF increase from 1.15% to 1.35% of insured deposits by September 30, 2020. Banks with assets of less than $10 billion are exempt from any additional assessments necessary to increase the reserve fund above 1.15%.
The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which would result in termination of the Bank’s deposit insurance.
Emergency Economic Stabilization Act. In October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. The EESA authorizes the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (“TARP”). The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department has allocated $250 billion towards the TARP Capital Purchase Program (“CPP”). Under the CPP, Treasury has purchased debt or equity securities from participating institutions, including us.
The TARP also includes direct purchases or guarantees of troubled assets of financial institutions. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. For details regarding our sale of $20 million of preferred stock to the Treasury Department through the CPP, see “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation - Capital and Note 12 of the Notes to Consolidated Financial Statements.”
EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase was in place until December 31, 2013, and has since been made permanent by the Dodd-Frank Act.
Temporary Liquidity Guarantee Program. The FDIC established a Temporary Liquidity Guarantee Program (“TLGP”) on October 14, 2008. The TLGP includes the Transaction Account Guarantee Program (“TAGP”), which provides unlimited deposit insurance coverage through December 31, 2012 for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts. Institutions participating in the TAGP pay a 10 basis points fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place. The TLGP also includes the Debt Guarantee Program (“DGP”), under which the FDIC guarantees certain senior unsecured debt of FDIC-insured institutions and their holding companies. The unsecured debt must be issued on or after October 14, 2008 and not later than October 31, 2009, and the guarantee is effective through the earlier of the maturity date or June 30, 2012. The DGP coverage limit is generally 125% of the eligible entity’s eligible debt outstanding on September 30, 2008 and scheduled to mature on or before June 30, 2009 or, for certain insured institutions, 2% of their liabilities as of September 30, 2008. Depending on the term of the debt maturity, the nonrefundable DGP fee ranges from 50 to 100 basis points (annualized) for covered debt outstanding until the earlier of maturity or June 30, 2012. The TAGP and DGP are in effect for all eligible entities, unless the entity opted out on or before December 5, 2008. First Financial Service Corporation’s bank subsidiary elected to participate in the TAGP and both the bank subsidiary and the holding company are eligible to participate in DGP.
Certificate of Deposit Account Registry Service. To mitigate the risks associated with carrying balances in excess of federally insured limits, we are participating in the Certificate of Deposit Account Registry Service (“CDARS”). CDARS is a system that allows certificates of deposit that would be in excess of FDIC coverage in a single financial institution to be redistributed to other financial institutions within the CDARS network in increments under the current FDIC coverage limit. Consequently, the full amount of the certificates of deposit becomes eligible for FDIC protection. Even though we have deposits that will remain in the CDARS network, those deposits are considered brokered deposits and the Bank’s “troubled institution” designation prevents us from accepting, renewing or rolling over brokered deposits. Therefore, as long as the Consent Order remains in effect, we will be able to retain only our deposits within the CDARS network that do not come up for renewal or roll over.
American Recovery and Reinvestment Act. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law by President Obama. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future CPP recipients, including the Corporation, until the institution has repaid the Treasury. ARRA also permits CPP participants to redeem the preferred shares held by the Treasury Department without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency. We have not redeemed any of the preferred shares we issued to the Treasury.
Dodd-Frank Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) was signed into law on July 21, 2010. The Dodd-Frank Act is intended to affect a fundamental restructuring of federal banking regulation. Among other things, the Dodd-Frank Act creates a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. The Dodd-Frank Act additionally creates a new independent federal regulator to administer federal consumer protection laws.
It is difficult to predict at this time what impact the new legislation and implementing regulations will have on community banks like the Bank, including the lending and credit practices of such banks. Moreover, many of the provisions of the Dodd-Frank Act will not take effect for several months, and the legislation requires various federal agencies to promulgate numerous and extensive implementing regulations over the next several years. Although the substance and scope of these regulations cannot be determined at this time, it is expected that the legislation and implementing regulations, particularly those provisions relating to the new Consumer Financial Protection Bureau will increase our operating and compliance costs and restrict our ability to pay dividends.
The Dodd-Frank Act is expected to have a significant impact on the Corporation’s business operations as its provisions take effect. Among the provisions that affect the Corporation are the following:
Corporate Governance. The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation at their first annual meeting taking place six months after the date of enactment and at least every three years thereafter and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions. The new legislation also authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company’s proxy materials. Additionally, the Dodd-Frank Act directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1 billion, regardless of whether the company is publicly traded or not. The Dodd-Frank Act gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.
Transactions with Affiliates and Insiders. The Dodd-Frank Act applies Section 23A and Section 22(h) of the Federal Reserve Act (governing transactions with insiders) to derivative transactions, repurchase agreements and securities lending and borrowing transactions that create credit exposure to an affiliate or an insider. Any such transactions with affiliates must be fully secured. The current exemption from Section 23A for transactions with financial subsidiaries is eliminated. The Dodd-Frank Act additionally prohibits an insured depository institution from purchasing an asset from or selling an asset to an insider unless the transaction is on market terms and, if representing more than 10% of capital, is approved in advance by the disinterested directors.
Consumer Financial Protection Bureau. The Dodd-Frank Act creates a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the ECOA, TILA, RESPA, FCRA, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach Bliley Act (“GLBA”) and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB, but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive acts or practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations. Federal preemption of state consumer protection law requirements, traditionally an attribute of the federal savings association charter, has also been modified by the Dodd-Frank Act and now requires a case-by-case determination of preemption by the Office of the Comptroller of the Currency (“OCC”) and eliminates preemption for subsidiaries of a bank. Depending on the implementation of this revised federal preemption standard, the operations of the Bank could become subject to additional compliance burdens in the states in which it operates.
Deposit Insurance. The Dodd-Frank Act permanently increases the maximum deposit insurance amount for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2009, and extends unlimited deposit insurance to non interest-bearing transaction accounts through December 1, 2012. The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution. The Dodd-Frank Act requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. The Dodd-Frank Act also eliminates the federal statutory prohibition against the payment of interest on business checking accounts.
Capital. Under the Dodd-Frank Act, the proceeds of trust preferred securities are excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by bank or savings and loan holding companies with less than $15 billion of assets. The legislation also establishes a floor for capital of insured depository institutions that cannot be lower than the standards in effect today, and directs the federal banking regulators to implement new leverage and capital requirements within 18 months that take into account off-balance sheet activities and other risks, including risks relating to securitized products and derivatives.
Uncertainty remains as to ultimate impact of the Dodd-Frank Act, but the Board and management anticipates that the provisions summarized above, as well as others set forth in the Dodd-Frank Act, could have an adverse impact on the financial services industry as a whole and our business, results of operations and financial condition.
Available Information Our internet website address is http://www.ffsbky.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available or may be accessed free of charge through the Investor Relations section of our internet website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission, or SEC.
ITEM 1A.
ITEM 1A. RISK FACTORS The risks identified below, as well as in the other cautionary statements made throughout this report, identify factors that could materially and adversely affect our business, financial condition, and/or operating results.
If we continue to incur significant losses, it may be difficult to continue to operate. We recorded a net loss to common shareholders of $24.2 million in 2011, a net loss to common shareholders of $10.5 million in 2010 and a net loss to common shareholders of $7.7 million in 2009, for a three year total of $42.4 million. The net loss for 2011 was due in part to provision for loan losses of $21.2 million and write downs on other real estate owned of $9.3 million. The net loss for 2010 was due in part to a $4.8 million deferred tax valuation allowance and the net loss for 2009 was due in part to an $11.9 million non-cash pre-tax goodwill impairment charge.
During 2011, 2010 and 2009, we recorded total provisions for loan losses of $47.6 million, total write downs on other real estate owned of $12.2 million and other than temporary impairment losses on investments of $2.1 million. While our losses also included a charge off of goodwill of $11.9 million, and a charge to establish an allowance against the realization of our deferred tax asset of $4.8 million, these latter charges were largely influenced by the losses on loans and investments.
We could be required to make additional provisions for loan losses and impairments to investments if asset values continue to decline in the current economic climate. This in turn may require the Corporation to raise additional capital to fund the Bank’s operations so that the Bank can sustain such losses and attain compliance with the minimum capital levels set forth in the Consent Order. See Part I, Item 1 - Business - Regulatory Matters & Recent Developments, for a description of the Bank’s capital requirements set forth in the Consent Order.
We are subject to a consent order with the FDIC and KDFI and a formal agreement with the Federal Reserve that restrict the conduct of our operations and may have a material adverse effect on our business. Our good standing with bank regulatory agencies is of fundamental importance to the continuation of our businesses. In January 2011, the Bank agreed to a consent order by the FDIC and KDFI by which the Bank agreed to develop and implement actions to reduce the amount of classified assets and improve earnings. The Bank agreed to a new consent order with the FDIC and the KDFI on March 9, 2012. Any material failures to comply with the consent order would likely result in more stringent enforcement actions by the FDIC and KDFI, which could damage the reputation of the Bank and have a material adverse effect on our business. The provisions of each of the consent orders are outlined above in the “Regulatory Matters & Recent Developments” section. Compliance with the consent order will increase our operating expense, which could adversely affect our financial performance.
Current federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized banks. Under this system, the FDIC has established three undercapitalized categories (“undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized”), and it is required to take certain mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in one of the three undercapitalized categories. The severity of any actions taken will depend upon the capital category in which a bank is placed. Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is “critically undercapitalized”. A bank that has a tangible equity capital to average total assets ratio equal to or less than 2% is deemed to be “critically undercapitalized.” The Bank’s actual tangible equity capital to average total assets ratio at December 31, 2011 is 5.86%.
In April 2011, the Corporation entered into a formal agreement 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. Any material failures to comply with the formal agreement would likely result in more stringent enforcement actions by the Federal Reserve which could damage our reputation and have a material adverse effect on our business.
Our ability to pay cash dividends on our common and preferred stock and pay interest on the junior subordinated debentures that relate to our trust preferred securities is currently restricted. Our inability to resume paying dividends and distributions on these securities may adversely affect our common shareholders. We historically paid quarterly cash dividends on our common stock until we suspended dividend payments in December 2009. During the third quarter of 2010, we also suspended cash dividends on the Treasury Preferred Stock and have begun deferring interest payments on the junior subordinated notes relating to our trust preferred securities. Deferring interest payments on the junior subordinated notes will result in a deferral of distributions on our trust preferred securities. Future payment of cash dividends on our common stock and future payment on treasury preferred stock will be subject to the prior payment of all unpaid dividends on the Treasury Preferred Stock and all deferred distributions on our trust preferred securities. If we miss six quarterly dividend payments on the Treasury Preferred Stock, whether or not consecutive, the Treasury Department will have the right to appoint two directors to our board of directors until all accrued but unpaid dividends have been paid. Dividends on the Treasury Preferred Stock and deferred distributions on our trust preferred securities are cumulative and therefore unpaid dividends and distributions will accrue and compound on each subsequent payment date. If we become subject to any liquidation, dissolution or winding up of affairs, holders of the trust preferred securities and then holders of the preferred stock will be entitled to receive the liquidation amounts to which they are entitled including the amount of any accrued and unpaid distributions and dividends, before any distribution to the holders of common stock.
We need to raise additional capital in the future, but that capital may not be available when needed or at all. The Bank has agreed with the FDIC and the KDFI to develop a plan to increase its tier one leverage ratio to 9.00% and its total capital as a percentage of risk weighted assets to 12.00%. We are evaluating various specific initiatives to increase our regulatory capital and to reduce our total assets. Strategic alternatives include divesting of branch offices, selling loans and raising capital by selling stock.
As part of our ongoing capital initiatives, on February 9, 2012, we signed a definitive agreement to sell our four Indiana banking centers to First Savings Bank, F.S.B., the banking subsidiary of First Savings Financial Group, Inc. This transaction is projected to increase our Tier I capital ratio from 5.86% to 6.74% and increase our total risk-based capital ratio from 10.18% to 11.32% based on information at December 31, 2011, and is expected to close early in the third quarter of 2012.
Our ability to raise additional capital will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. We may not have access to capital on acceptable terms or at all. Our inability to raise additional capital on acceptable terms when needed could have a material adverse effect on our businesses, financial condition and results of operations.
Future sales of our common stock or other securities will dilute the ownership interests of our existing shareholders and could depress the market price of our common stock. We are currently evaluating strategies to meet our capital needs and regulatory requirements. These strategies may result in the issuance of additional common shares. We can issue common shares without shareholder approval, up to the number of authorized shares set forth in our articles of incorporation. Our Board of Directors may determine to seek additional capital through the issuance and sale of common shares, preferred shares or other securities convertible into or exercisable for our common shares, subject to limitations imposed by the NASDAQ Stock Market and the Federal Reserve. We may not be able to issue common shares at prices or on terms better than or equal to the prices and terms on which our current shareholders acquired their shares. Our future issuance of any additional common shares or other securities may have the effect of reducing the book value or market price of then-outstanding common shares. Our issuance of additional common or securities convertible into or exercisable for common shares will reduce the proportionate ownership and voting power of our existing shareholders.
In addition, if our shareholders sell a substantial number of our common shares or securities convertible into or exercisable for our common shares in the public market, or if there is a perception that such sales are likely to occur, it could cause the market price of our common shares to continue declining. We cannot predict the effect, if any, that either future sales of a substantial volume of our common shares in the market, or the
potential for large volumes of sales in the market, would have on the market price of our common shares. However, if the market price of our common shares declines, it could impair our ability to raise capital through sales of stock.
We cannot guarantee whether such financing will be available to us on acceptable terms or at all. If we are unable to obtain future financing, we may not have the capital and financial resources needed to operate our business or to meet regulatory requirements.
Ongoing market developments may continue to adversely affect our industry, businesses and results of operations. Since mid-2007, the financial services industry as a whole has been materially and adversely affected by very significant declines in the values of nearly all asset classes and by a very serious lack of liquidity. Financial institutions in particular have been subject to increased volatility and an overall loss in investor confidence. Concerns about the stability of the financial markets generally and the strength of counterparties have caused many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers including financial institutions.
The lack of available credit, loss of confidence in the financial sector, increased volatility in the financial markets and reduced business activity have materially and adversely affected our business, financial condition and results of operations. Further negative market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provisions for credit losses. A worsening of these conditions would likely exacerbate the adverse effects that these difficult market conditions have had on us and others in the financial services industry.
Sustained weakness or weakening in business and economic conditions generally or specifically in our markets has had and could continue to have the following adverse effects on our business:
• A decrease in the demand for loans and other products and services that we offer;
• A decrease in the value of our loans held for sale or other assets secured by consumer or commercial real estate;
• An impairment of certain intangible assets;
• An increase in the number of clients who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us.
Higher numbers of delinquencies, bankruptcies or defaults have resulted in a higher level of nonperforming assets, net charge-offs, and provision for loan losses.
Overall, the general business environment has had an adverse effect on our business in recent years, and there can be no assurance that the environment will improve in the near term. Until conditions improve, we expect our businesses, financial condition and results of operations will continue to be adversely affected.
If we cannot borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Corporation. Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies don’t work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers. Our Asset Liability Committee follows established board-approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and medium and long-term debt, which includes Federal Home Loan Bank advances that are collateralized with mortgage-related assets.
As long as the Consent Order remains in effect, the Bank will not be able to rely on brokered deposits (including deposits through the CDARs program) for its liquidity needs. The designation of the Bank as a “troubled institution” in connection with the issuance of the Consent Order prohibits the Bank from accepting new brokered deposits or renewing or rolling over any existing brokered deposits at the Bank. The Bank is
also restricted in the amount of interest it may pay on core deposits. See Part I, Item I - Business - Regulation - Regulatory Capital Requirements for a description of the Bank’s interest rate restrictions. The Bank’s designation as a “troubled institution” may also limit the amount of additional advances available from the FHLB. The Bank currently has sufficient collateral to borrow, approximately, an additional $15.4 million in advances from the FHLB.
The Corporation is a separate and distinct legal entity from the Bank. Historically, the Corporation has received substantially all of its revenue in the form of dividends from the Bank. Regulations limit the amount of dividends that the Bank may pay to us. Recent losses have had the consequence of not allowing the Bank to pay any dividends to the Corporation without prior regulatory approval. The Corporation has no other sources of revenue. At December 31, 2011 the Corporation had liquidity in the form of cash of $554,000.
We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including the sale or securitization of loans, the ability to acquire additional non-core brokered deposits, additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions. If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital. For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations. We maintain an allowance for loan losses at a level we believe is adequate to absorb any probable incurred losses in our loan portfolio based on historical loan loss experience, specific problem loans, value of underlying collateral and other relevant factors.
If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual loan losses, which would require us to increase our provision for loan losses and adversely affect our operating results. Our estimates are subjective and their accuracy depends on the outcome of future events. Changes in economic, operating and other conditions that are generally beyond our control could cause the financial condition of our borrowers to deteriorate and our actual loan losses to increase significantly. Bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies have required us to increase our provision for loan losses or to recognize further loan charge-offs when their judgment has differed from ours, and they may do so in the future, which could have a material negative impact on our operating results.
Our loan portfolio possesses increased risk due to our relatively high concentration of loans collateralized by real estate. Approximately 91% of our loan portfolio as of December 31, 2011 was comprised of loans collateralized by real estate. An adverse change in the economy that depresses values of real estate generally or in our primary markets such as we have recently experienced could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. When real estate values decline, it becomes more likely that we would be required to increase our allowance for loan losses as we did in 2011, 2010 and 2009. If during a period of reduced real estate values we are required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.
Declines in asset values may result in impairment charges and adversely affect the value of our investments, financial performance and capital. Under U.S. generally accepted accounting principles, we are required to review our investment portfolio periodically for the presence of other-than-temporary impairment of our securities, taking into consideration current market conditions, the extent and nature of change in fair value, issuer rating changes and trends,
volatility of earnings, current analysts’ evaluations, our ability and intent to hold investments until a recovery of fair value, as well as other factors. Adverse developments with respect to one or more of the foregoing factors may require us to deem particular securities to be other-than-temporarily impaired, with the reduction in the value recognized as a charge to earnings. Recent market volatility has made it extremely difficult to value certain securities. Subsequent valuations, in light of factors prevailing at that time, may result in significant changes in the values of these securities in future periods. Any of these factors could require us to recognize further impairments in the value of our securities portfolio, which may have an adverse effect on our results of operations in future periods.
Our profitability depends significantly on local economic conditions. Because most of our business activities are conducted in central Kentucky and adjacent counties of Indiana, and most of our credit exposure is in that region, we are at risk from adverse economic or business developments affecting this area, including declining regional and local business activity, a downturn in real estate values and agricultural activities and natural disasters. To the extent the central Kentucky economy further declines, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio would likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by economic downturn or a localized natural disaster. An economic downturn or other events that affect our markets could, therefore, result in losses that may materially and adversely affect our business, financial condition, results of operations and future prospects.
Our small to medium-sized business target market may have fewer resources to weather the downturn in the economy. Our strategy includes lending to small and medium-sized businesses and other commercial enterprises. Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. Economic downturns and other events could have a more pronounced negative impact on our target market, which could cause us to incur substantial credit losses that could materially harm our operating results.
Our profitability is vulnerable to fluctuations in interest rates. Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Factors beyond our control, such as inflation, recession, unemployment, and money supply may also affect interest rates. If our interest-earning assets mature or re-price more quickly than our interest-bearing liabilities in a given period, as a result of decreasing interest rates, our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or re-price more quickly than interest-earning assets in a given period as a result of increasing interest rates.
Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to re-pricing before assets become subject to re-pricing. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates. In the current low interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.
We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition. We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds and other mutual funds. Competition in making loans in the Louisville metropolitan area has increased in recent years after changes in banking law allowed several banks to enter the market by establishing new branches. Likewise, competition is increasing in our other markets, which may adversely affect our ability to maintain our market share.
Competition in the banking industry may also limit our ability to attract and retain banking clients. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete. Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:
• offer higher interest rates on deposits and lower interest rates on loans than we can;
• offer a broader range of services than we do;
• maintain numerous branch locations; and
• mount extensive promotional and advertising campaigns.
In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking clients may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.
We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect our financial performance and our ability to implement our growth and operating strategies. We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, which is described under “Item 1 Business - Regulation.” Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance funds, and the banking system as a whole, not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably.
Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations and policies or to maintain our capital requirements affects our ability to pay dividends on common stock, our ability to grow through the development of new offices and our ability to make acquisitions. We currently may not pay a dividend from the Bank to the Corporation without the prior written consent of our primary banking regulators, which limits our ability to pay dividends on our common stock. These limitations may also prevent us from successfully implementing our growth and operating strategies.
In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans. Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board, the Consumer Financial Protection Bureau and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.
Recent financial reform legislation could have a material effect on our future operations. The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act institutes a wide range of reforms that will have an impact on all financial institutions. The Dodd-Frank Act changes the deposit insurance and financial regulatory systems, enhances bank capital requirements and requires new regulations to protect consumers in financial transactions, among other things. Many of these provisions require rule-making and studies that will be conducted in the future. For these reasons, we cannot assess the impact the Dodd-Frank Act may have on us at the present time.
Our issuance of securities to the US Department of the Treasury may limit our ability to return capital to our shareholders and is dilutive to our common shares. In addition, the dividend rate increases substantially after five years if we cannot redeem the shares by that time. On January 9, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury under the Emergency Economic Stabilization Act of 2008 (“EESA”), we sold $20 million of senior preferred stock to the Department of the Treasury. We also issued to the Department of the Treasury a warrant to purchase approximately 216,000 shares of our common stock at $13.89 per share. The terms of the transaction with the Department of the Treasury limit our ability to pay dividends and repurchase our shares. For three years after issuance or until the Department of the Treasury no longer holds any preferred shares, we will not be able to increase our dividends above the most recent level before October 14, 2008 ($.19 per common share on a quarterly basis) nor repurchase any of our shares without the Department of the Treasury’s approval with limited exceptions, most significantly purchases in connection with benefit plans. Also, we will not be able to pay any dividends at all unless we are current on our dividend payments on the preferred shares. These restrictions, as well as the dilutive impact of the warrant, may have an adverse effect on the market price of our common stock.
Unless we are able to redeem the preferred stock during the first five years, the dividends on this capital will increase substantially at that point, from 5% (approximately $1 million annually) to 9% (approximately $1.8 million annually). Depending on market conditions and our financial performance at the time, this increase in dividends could significantly impact our capital and liquidity.
The US Department of the Treasury has the unilateral ability to change some of the restrictions imposed on us by virtue of our sale of securities to it. Our agreement with the US Department of the Treasury under which it purchased our securities imposes restrictions on our conduct of our business, including restrictions related to our payment of dividends and repurchase of our stock and related to our executive compensation and governance. The US Department of the Treasury has the right under this agreement to unilaterally amend it to the extent required to comply with any future changes in federal statutes. The American Recovery and Reinvestment Act of 2009 amended provisions of EESA relating to compensation and governance as they affect companies that have sold securities to the US Department of the Treasury. These amendments could have an adverse impact on the conduct of our business, as could additional amendments in the future that impose further requirements or amend existing requirements.
The Federal Reserve Bank’s (FRB’s) rule to repeal the prohibition against payment of interest on demand deposits may increase competition for such deposits and ultimately increase interest expense. On July 21, 2011, the FRB’s rule to repeal of Regulation Q, which prohibited the payment of interest on demand deposits by institutions that are member banks of the Federal Reserve System, went into effect. The rule implements Section 627 of the Reform Act, which repeals Section 19(i) of the Federal Reserve Act in its entirety. As a result, banks and thrifts are now permitted to offer interest-bearing demand deposit accounts to commercial customers, which were previously forbidden under Regulation Q. The repeal of Regulation Q may cause increased competition from other financial institutions for these deposits. If the Bank decides to pay interest on demand accounts, it would expect interest expense to increase.
Downgrades of the current “AA” credit rating assigned to U.S. Government could adversely affect the Bank. On August 5, 2011, Standard & Poor’s lowered the long-term sovereign credit rating assigned to the United States from “AAA” to “AA+” with a negative outlook, indicating a further rating downgrade is possible in the future. On August 2, 2011, Moody’s Investors Service confirmed its “Aaa” rating for the
United States with a negative outlook. Fitch Ratings has announced that it expects to complete a review of its “AAA” rating for the United States by the end of August and has not ruled out assigning the rating a negative outlook.
On August 5, 2011, the FDIC, Federal Reserve, OCC and National Credit Union Administration issued a joint press release stating that for risk-based capital purposes, the risk weights assigned to securities issued or guaranteed by the U.S. Government, its agencies and U.S. Government-sponsored entities will not change. However, a downgrade of the U.S. Government’s sovereign credit rating below “AA” could cause a higher risk weight to be assigned to securities issued or guaranteed by the U.S Government or its agencies that we hold in our portfolio and increase our risk-based capital requirements. In addition, a ratings downgrade of securities issued or guaranteed by the U.S. Government or its agencies held in our portfolio could adversely affect the carrying value of such securities. At this time, we cannot assess the likelihood or severity of such a downgrade or the potential consequences it may have on either the capital position or investment portfolio of the Bank and Corporation.
While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer losses from operational risk in the future. Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions. However, there can be no assurance that we will be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.
We process large volumes of transactions on a daily basis and are exposed to numerous types of operation risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.
We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments We have no unresolved SEC staff comments.
ITEM 2.
ITEM 2. PROPERTIES Our executive offices and principal support are located at 2323 Ring Road in Elizabethtown, Kentucky. Our operational functions are located at 2323 Ring Road and 101 Financial Place in Elizabethtown, Kentucky. All of our banking centers are located in Kentucky and Southern Indiana. The location of our 22 full-service banking centers, an operations building and a commercial private banking center, whether owned or leased, and their respective approximate square footage are described in the following table. As discussed in the section, “Regulatory Matters and Recent Developments,” we have signed a definitive agreement to sell our four Indiana banking centers. The transaction is expected to close early in the third quarter of 2012.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS Although, from time to time, we are involved in various legal proceedings in the normal course of business, we believe that after consultation with legal counsel that at December 31, 2011 there were no material pending legal proceedings to which we are a party, or to which any of our property is subject.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
(a) Market Information Our common stock is traded on the Nasdaq Global Market (“NASDAQ”) under the symbol “FFKY”. The following table shows the high and low closing prices of our Common Stock and the dividends paid.
(b) Holders At December 31, 2011, the number of shareholders was approximately 1,338.
(c) Dividends Historically, the Corporation has depended upon dividends it received from the Bank to pay cash dividends to its shareholders. Currently, the Bank cannot pay such dividends without prior approval of the FDIC and KDFI. For additional discussion regarding dividends, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity.”
(d) Securities Authorized for Issuance Under Equity Compensation Plans The following table summarizes the securities authorized for issuance under our equity compensation plans as of December 31, 2011. We have no equity compensation plans that have not been approved by our shareholders.
See Note 16 of the Notes to Consolidated Financial Statements for additional information required by this item.
(e) Issuer Purchases of Equity Securities We did not repurchase any shares of our common stock during the quarter ended December 31, 2011.
(f) Performance Graph The graph below compares the cumulative total return on the common stock of the Corporation between December 31, 2006 through December 31, 2011 with the cumulative total return of the NASDAQ Composite Index and a peer group index over the same period. Dividend reinvestment has been assumed. The graph was prepared assuming that $100 was invested on December 31, 2006 in the common stock of the Corporation and in the indexes. The stock price performance shown on the graph below is not necessarily indicative of future stock performance.
First Financial Service Corporation
* FFKY Peer Group 2010 index consists of BB&T Corp. (BBT), Fifth Third Bancorp (FITB), First Horizon National Corp. (FHN), Huntington BancsharesInc. (HBAN), KeyCorp (KEY), M&T Bank Corp. (MTB), Marshall & Ilsley Corp. (MI - Now Historical), PNC Financial Services Group (PNC), RegionsFinancial Corp. (RF), SunTrust Banks Inc. (STI), Synovus Financial Corp. (SNV), Zions Bancorp. (ZION)
* FFKY Peer Group 2011 index consists of BB&T Corp. (BBT), Fifth Third Bancorp (FITB), First Horizon National Corp. (FHN), Huntington BancsharesInc. (HBAN), KeyCorp (KEY), M&T Bank Corp. (MTB), PNC Financial Services Group (PNC), RegionsFinancial Corp. (RF), SunTrust Banks Inc. (STI), Synovus Financial Corp. (SNV), Zions Bancorp. (ZION)
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
(1) Includes loans held for sale in probable branch divestiture and probable loan sale for 2011
(2) Includes allowance allocated to loans held for sale in probable branch divestiture for 2011
(3) Excludes goodwill impairment in 2009
ITEM 7.
ITEM 7. MANAGEMENTS’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of our balance sheets and statements of operations. This section should be read in conjunction with our Consolidated Financial Statements and accompanying Notes and other detailed information.
OVERVIEW The unfavorable economic conditions that have persisted since 2007 continued to impact the banking industry and our performance during 2011. We have adjusted our policies, procedures and allocated additional resources to address credit quality. Our loan policy has been revised to support our focus on reducing our concentration in real estate and our focus to diversify lending. We established a board loan committee to meet weekly to address loan approvals and renewals, loan workout situations and the disposal of large other real estate owned assets. We also added personnel to concentrate on working with struggling borrowers, work on more efficient asset resolutions, and strengthen the management of other real estate owned. A new appraisal policy was implemented regarding management procedures surrounding the appraisal process. In accordance with our credit management processes, we obtain new appraisals on properties securing our non-performing commercial real estate loans and use those appraisals to determine specific reserves within the allowance for loan losses. As we receive new appraisals on properties securing non-performing loans, we recognize charge-offs and adjust specific reserves as appropriate. Our decline in credit quality impacted our results during 2011 in the areas of net interest income, provision for loan losses, non-interest income, non-interest expense, and reversals of tax benefits.
Our net loss attributable to common shareholders for 2011 was $24.2 million or $5.11 per diluted common share compared to net loss attributable to common shareholders of $10.5 million or $2.21 per diluted common share for the same period in 2010. The 2011 results include provision for loans losses of $21.2 million, write downs and losses on other real estate owned of $9.6 million, an increase in FDIC insurance expense of $525,000, and other than temporary securities impairment of $168,000.
Our credit quality metrics are unfavorable due to the elevated level of non-performing assets on our balance sheet. We experienced improvement in our credit quality metrics during the fourth quarter of 2011 as well as indications that credit quality may be stabilizing. Compared to September 30, 2011, we saw a decline in non-performing loans of 23%, a decline in non-performing assets of 15% and a decline in classified assets of 19%. We also have sales contracts in place on eleven other real estate owned properties totaling $7.1 million set to close during the first quarter of 2012 indicating continued improvement in classified credits.
Our non-performing assets are largely comprised of residential housing development assets, building lots, an office building and strip centers primarily located in Jefferson and Oldham Counties. Non-performing assets were $68.9 million or 5.61% of total assets compared to $68.0 million or 5.15% of total assets at December 31, 2010. During 2011, we have had substantially all of our non-performing assets appraised or reappraised, including our high end residential development loans and related other real estate owned. The lower values on the appraisals and reviews of properties appraised within the past year contributed to $21.2 million in provision expense and $9.3 million in write downs on other real estate owned recorded for the year. We believe that we have written down other real estate values to levels that will facilitate their liquidation. We also believe we have appropriately addressed and risk-weighted real estate loans in our portfolio. While deterioration in the portfolio is expected to continue, we believe it will be at a slower pace than the accelerated pace from the past nine quarters.
The allowance to total loans (including loans held for sale and the related allowance allocated to those loans in a probable branch divestiture and probable loan sale) was 2.37% at December 31, 2011 while net charge-offs totaled 325 basis points for 2011, compared to 125 basis points for 2010. Non-performing loans were $39.8 million, or 5.39% of total loans (including loans held for sale in probable branch divestiture and probable loan sale) at December 31, 2011 compared to $42.2 million, or 4.77% of total loans for December 31, 2010. The allowance for loan losses to non-performing loans was 44% at December 31, 2011 compared to 54% at December 31, 2010. The decline in the coverage ratio was due to the charge-off of specific reserves of $10.2 million of which $8.9 million was previously reserved for at December 31, 2010, as well as the increase in restructured loans.
Net interest income was $32.8 million for 2011 compared to $36.1 million for 2010, while the net interest margin was 2.85% for 2011 compared to 3.05% in 2010. The net interest margin was negatively impacted by a higher level of non-performing assets, a decline in average loan balances outstanding, and our efforts to increase liquidity by placing assets into lower yielding investments other than loans. Non-interest income decreased $6.8 million for 2011, primarily driven by an increase of $7.2 million in the loss on sale and write downs on real estate acquired through foreclosure. Non-interest expense increased $4.1 million to $38.2 million for the 2011 period compared to 2010. Outside services expense increased due to expenses incurred in connection with loan workout activities and the addition of loan workout specialists to our staff. FDIC insurance premiums increased $525,000 due to the higher FDIC insurance rate resulting from the Bank’s regulatory rating. Expense related to real estate acquired through foreclosure increased $201,000 due to the higher level of properties in this portfolio at December 31, 2011. Loan expense increased due to increases in loan portfolio management expenses such as the cost of obtaining new appraisals on real estate securing some of our commercial real estate loans. The increase in loan expense reflects our elevated level of non-performing loans. Other expense increased due to increases in interchange expense, examination and legal fees and losses on low income housing investments.
In its Consent Order with the FDIC and KDFI, the Bank agreed to 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 December 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 anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at June 30, 2012.
On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the January 2011 Consent Order by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. The new Consent Order requires the Bank to continue to adhere to the plans implemented in response to the January 2011 Consent Order, and includes the substantive provisions of the January 2011 Consent Order.
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 formal agreement 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.
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 action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business
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 strategic opportunities available to us. We continue reducing our costs where possible while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen executive management compensation the past three years and into 2012, frozen officer compensation for the past year and into 2012, eliminated board of director fees, reduced marketing expenses, reduced community donation expense, reduced compensation expense through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 were $1.1 million. Additional cost reductions for 2012 are projected to be in excess of $1.3 million. We are also evaluating remaining terms on existing contracts and identifying expenses we cannot reduce currently, but expect to be able to in 2012 and 2013, such as examination fees and loan workout and other real estate owned expenses. These efforts will remain ongoing.
As part of our ongoing capital initiatives, on February 9, 2012, we signed a definitive agreement to sell our four Indiana banking centers to First Savings Bank, F.S.B., the banking subsidiary of First Savings Financial Group, Inc. The purchase price will represent a 3.65% percent premium based on the actual level of consumer and commercial deposits at closing, which totaled $99.7 million at December 31, 2011. Under the agreement, First Savings Financial Group, Inc. will also acquire government, corporate, other financial institution deposits and municipal deposits, which were $17.5 million at December 31, 2011, at book value. A total of $35.4 million of performing loans will be purchased at a discount of 0.80% based on the actual level of loans at closing. The consummated transaction would result in a one-time gain of approximately $3.4 million based on information at December 31, 2011. We believe the transaction places us in a better position to meet the conditions of the regulatory consent order in a manner that is beneficial to our shareholders. This transaction is projected to increase our Tier I capital ratio from 5.86% to 6.74% and increase our total risk-based capital ratio from 10.18% to 11.32% based on information at December 31, 2011, and is expected to close early in the third quarter of 2012.
Our plans for 2012 include the following:
• Continue to pursue all available strategies to recapitalize the Bank. We are evaluating various specific initiatives to increase our regulatory capital and to reduce our total assets. Strategic alternatives include divesting of branch offices, selling loans and raising capital by selling stock.
• Continue to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise. The strength of this franchise contributes to earnings to help withstand our credit quality issues. In addition, the inherent value of the retail franchise will provide value to the Bank to accomplish the various capital initiatives.
• Continue to reduce our lending concentration in commercial real estate by obtaining pay downs and payoffs. In addition to allowing loans in these concentrations to roll off, we have started initiatives to diversify the Bank’s lending portfolio and change our lending culture. The mortgage and consumer lending operations have maintained strong credit quality metrics through this recession. These areas are being restructured to allow for additional emphasis on retail lending going forward. We will also emphasize small business lending and will seek resources to add expertise in this area. Our efforts will focus on back to basic community banking and servicing the entire relationship of the customer. These loans will be used to diversify the loan portfolio of the Bank as well as provide for profitability as the Bank works through our credit quality issues.
While our concerns about economic conditions in our market continue, we are working towards our long-range financial objectives, including building additional core customer relationships, maintaining sufficient liquidity and capital levels, improving shareholder value, remediating our problem assets and building upon the sustained success of our retail franchise.
CRITICAL ACCOUNTING POLICIES Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could change as our estimates, assumptions, and judgments change. Certain policies inherently rely more heavily on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. We consider our critical accounting policies to include the following:
Allowance for Loan Losses - We maintain an allowance we believe to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Our Allowance for Loan Loss Review Committee, which is comprised of senior officers and certain accounting associates, evaluate the allowance for loan losses on a monthly basis. We estimate the amount of the allowance using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the
underlying collateral, and current economic conditions. While we estimate the allowance for loan losses based in part on historical losses within each loan category, estimates for losses within the commercial real estate portfolio depend more on credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. Allowance estimates are developed with actual loss experience adjusted for current economic conditions. Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.
Based on our calculation, an allowance of $17.5 million or 2.37% of total loans was our estimate of probable incurred losses within the loan portfolio as of December 31, 2011. This estimate required us to record a provision for loan losses on the income statement of $21.2 million for the 2011 period. If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could materially increase.
Impairment of Investment Securities - We review all unrealized losses on our investment securities to determine whether the losses are other-than-temporary. We evaluate our investment securities on at least a quarterly basis, and more frequently when economic or market conditions warrant, to determine whether a decline in their value below amortized cost is other-than-temporary. We evaluate a number of factors including, but not limited to: valuation estimates provided by investment brokers; how much fair value has declined below amortized cost; how long the decline in fair value has existed; the financial condition of the issuer; significant rating agency changes on the issuer; and management’s assessment that we do not intend to sell or will not be required to sell the security for a period of time sufficient to allow for any anticipated recovery in fair value.
The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the possibility for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the cost basis of the security is written down to fair value and a charge to earnings is recognized for the credit component and the non-credit component is recorded to other comprehensive income.
Real Estate Owned - The estimation of fair value is significant to real estate owned-acquired through foreclosure. These assets are recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets when available. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Appraisals are performed at least annually, if not more frequently. Typically, appraised values are discounted for the projected sale below appraised value in addition to the selling cost. With certain appraised values where management believes a solid liquidation value has been established, the appraisal has been discounted by the selling cost. We have dedicated a team of associates and management to the resolution and work out of other real estate owned as it has become a larger portion of our assets and a larger area of our risk. Appropriate policies, committees and procedures have been put in place to ensure the proper accounting treatment and risk management of this area.
Income Taxes - The provision for income taxes is based on income/(loss) as reported in the financial statements. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future. The deferred tax assets and liabilities are computed based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. An assessment is made as to whether it is more likely than not that deferred tax assets will be realized. Valuation allowances are established when necessary to reduce deferred tax assets to an amount expected to be realized. Income tax expense is the tax
payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. Tax credits are recorded as a reduction to tax provision in the period for which the credits may be utilized.
In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2011 and 2010. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at December 31, 2011 and December 31, 2010.
RESULTS OF OPERATIONS Net loss attributable to common shareholders for the period ended December 31, 2011 was $24.2 million or $5.11 per diluted common share compared to net loss attributable to common shareholders of $10.5 million or $2.21 per diluted common share for the same period in 2010. Contributing to the net loss for 2011 was a decrease in our net interest margin, an increase of $4.3 million in provision for loan losses, a valuation allowance against deferred tax assets of $11.4 million write downs taken on real estate acquired through foreclosure, higher FDIC insurance premiums, and a higher level of other non-interest expense. Net loss attributable to common shareholders was also impacted by dividends accrued on preferred shares. Our book value per common share decreased from $10.89 at December 31, 2010 to $7.07 at December 31, 2011.
Net loss attributable to common shareholders for the period ended December 31, 2010 was $10.5 million or $2.21 per diluted common share compared to net loss attributable to common shareholders of $7.7 million or $1.65 per diluted common share for the same period in 2009. Contributing to the net loss for 2010 was a decrease in our net interest margin, an increase of $7.4 million in provision for loan losses, a valuation allowance against deferred tax assets of $4.8 million, write downs taken on investment securities that were other-than-temporarily impaired, write downs taken on real estate acquired through foreclosure, and higher FDIC insurance premiums. Net loss attributable to common shareholders was also impacted by dividends paid on preferred shares. Our book value per common share decreased from $13.87 at December 31, 2009 to $10.89 at December 31, 2010.
Net Interest Income - The principal source of our revenue is net interest income. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities and the interest expense on liabilities used to fund those assets, such as interest-bearing deposits and borrowings. Net interest income is affected by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities as well as changes in market interest rates.
The decline in the volume of interest earning assets and the change in the mix of interest earning assets caused a negative impact on net interest income, which decreased $3.3 million for 2011 compared to a year ago. Average interest earning assets decreased $28.1 million for 2011 compared to 2010 due to a decrease in average loans and our efforts to increase liquidity by increasing lower yielding investments. The decrease in average loans was due to loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to other real estate owned properties. The average loan yield was 5.63% for 2011 compared to an average loan yield of 5.76% for 2010.
The shift in the mix of assets resulting from the addition of lower yielding assets and the increase in the amount of non-performing assets also negatively impacted our net interest margin. The yield on earning assets averaged 4.61% for 2011 compared to an average yield on earning assets of 5.00% for 2010. This decrease was offset somewhat by a decrease in our cost of funds. Net interest margin as a percent of average earning assets decreased 20 basis points to 2.85% for 2011 compared to 3.05% for 2010.
Our cost of funds averaged 1.87% for 2011 compared to an average cost of funds of 2.13% for 2010. Going forward, we expect market short-term interest rates to remain low for an extended period of time. Continued re-pricing of variable rate loans and our efforts to increase liquidity by increasing lower yielding investments other than loans is likely to further compress our net interest margin in future quarters.
Comparative information regarding net interest income follows:
bp = basis point = 1/100th of a percent
AVERAGE BALANCE SHEETS The following table provides information relating to our average balance sheet and reflects the average yield on assets and average cost of liabilities for the indicated periods. Yields and costs for the periods presented are derived by dividing income or expense by the average balances of assets or liabilities, respectively.
(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.
(2) Includes loan fees, immaterial in amount in both interest income and the calculation of yield on loans.
(3) Calculations include non-accruing loans in the average loan amounts outstanding.
(4) Includes loans held for sale
RATE/VOLUME ANALYSIS The table below shows changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (change in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.
Non-Interest Income and Non-Interest Expense The following tables compare the components of non-interest income and expenses for the years ended December 31, 2011, 2010 and 2009. The tables show the dollar and percentage change from 2010 to 2011 and from 2009 to 2010. Below each table is a discussion of significant changes and trends.
Customer service fees on deposit accounts, our largest component of non-interest income, decreased for 2011 due to a decline in consumer overdraft activity. Contributing to the decline in consumer overdraft activity were the amended Regulation E guidelines, which took effect on August 15, 2010. The amended Reg. E guidelines prohibit financial institutions from charging consumers fees for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer affirmatively consents, or opts in, to the overdraft service for those types of transactions. We believe these guidelines had a negative impact on ur net income for 2011 and will have a negative impact in future quarters. We are evaluating all of the fees we charge for our deposit products to determine if and when we will revise fees in an effort to partially mitigate the anticipated loss of overdraft related income.
We originate qualified VA, KHC, RHC and conventional secondary market loans and sell them into the secondary market with servicing rights released. Gain on sale of mortgage loans decreased for 2011 due to a decrease in the volume of loans refinanced, originated and sold due to the stabilizing interest rate environment.
We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others. During 2011 we recorded a gain on the sale of investment securities of $995,000 and a loss on the sale of investment securities of $149,000. During 2010 we recorded a loss on the sale of an equity investment security of $23,000 and gains on the sale of equity investment securities of $60,000. Gains on investment securities are infrequent and are not a consistent recurring core source of income.
We recognized other-than-temporary impairment charges of $168,000 for the expected credit loss during the 2011 period on three of our trust preferred securities, compared to $1.0 million of impairment charges for 2010. Management believes this impairment was primarily attributable to the current economic environment which caused the financial conditions of some of the issuers to deteriorate.
Further reducing non-interest income for 2011 was an increase of $7.2 million in losses on the sale and write down of real estate owned properties due to the decline in market value of properties held in this portfolio. We believe that we have been aggressive in writing down other real estate owned values during 2011 to levels will facilitate their liquidation.
The decrease in other income for the 2011 period was the result of a reduction in loan fee income due to a decline in loan activity as well as an increase in refunded loan fees.
Outside services expense increased due to expenses incurred in connection with loan workout activities and the addition of loan workout specialists. Offsetting this increase was a decrease in marketing and advertising related expenses due to cost cutting initiatives.
The FDIC adopted a requirement that all banks prepay three and a quarter years worth of FDIC assessments on December 31, 2009. The prepaid amount will be amortized over the prepayment period. Our prepayment was $7.5 million of which $3.2 million was reflected in our 2011 income statement. Because the Bank entered into the Consent Order and is designated a “troubled institution” it is in a higher risk category and now pays a higher assessment rate.
The increase in real estate acquired through foreclosure expense was primarily due to increases in expense relating to repair, maintenance, insurance, attorney fees and taxes due to a higher volume of properties in this portfolio at December 31, 2011.
Loan expense increased due to increases in loan portfolio management expenses such as the cost of obtaining new appraisals on real estate securing some of our commercial real estate loans. The increase in loan expense reflects our elevated level of non-performing loans for 2011 compared to 2010.
Other expense increased primarily due to increases in interchange expense, examination and legal fees, and losses on low income housing investments.
Income Taxes The provision for income taxes includes federal and state income taxes and in 2011 and 2010 reflects a full valuation allowance against all of our deferred tax assets that are not currently recoverable through carryback. The effective tax rate for the year ended
December 31, 2011 was a benefit of 11% compared to a benefit of 15% for the year ended December 31, 2009. The effective tax rate for the year ended December 31, 2010 is not meaningful due to the size of our operating loss relative to income tax expense recorded resulting from a charge to establish a valuation allowance. Historically, the fluctuations in effective tax rates reflect the effect of the differences in the inclusion or deductibility of certain income and expenses, respectively, for income tax purposes.
A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 and 2011 primarily due to higher levels of provision for loan loss expense. These factors represent the most significant negative evidence that we considered in concluding that
a valuation allowance was necessary at December 31, 2011 and December 31, 2010. Our 2011 tax benefit is entirely due to gains in other comprehensive income that are presented in current operations in accordance with applicable accounting standards. Our future effective income tax rate will fluctuate based on the mix of taxable and tax free investments we make and, to a greater extent, the impact of changes in the required amount of valuation allowance recorded against our net deferred tax assets and our overall level of taxable income.
Recording a valuation allowance does not have any impact on our liquidity, nor does it preclude us from using the tax losses, tax credits or other timing differences in the future. To the extent that we generate taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense. Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once we can demonstrate a sustainable return to profitability and conclude that it is more likely than not the deferred tax asset will be utilized prior to expiration. See Note 13 of the Notes to Consolidated Financial Statements for additional discussion of our income taxes.
ANALYSIS OF FINANCIAL CONDITION Total assets at December 31, 2011 decreased to $1.2 billion compared to $1.3 billion at December 31, 2010. The decrease was primarily due to a decline in total loans, including loans held for sale in connection with a probable branch divestiture and probable loan sale, of $147.2 million, and a decrease in cash and cash equivalents of $73.9 million. This decrease was mainly offset by building our investment portfolio to $313.8 million, an increase of $117.6 million since December 31, 2010. This shift in the balance sheet reflects a conscious effort by management to increase on-balance sheet liquidity to better protect us against adverse changes to our current wholesale funding position.
Loans Total loans, including loans held for sale in connection with a probable branch divesture and probable loan sale, decreased $147.2 million to $737.4 million at December 31, 2011 compared to $884.5 million at December 31, 2010. Our commercial real estate and commercial portfolios decreased $113.3 million to $488.6 million at December 31, 2011. Our residential mortgage loan, real estate construction, consumer and home equity and indirect consumer portfolios all decreased for the 2011 period. The decline in our commercial real estate and commercial loan portfolios is a result of pay-offs, charge-offs on large commercial real estate loans, and commercial loans being transferred to real estate acquired through foreclosure. Charge-offs made up $27.0 million or 18.3% of this decrease. The loan portfolio also declined due to our aggressive efforts to resolve problem loans. During 2011 and 2010, we took deeds in lieu of foreclosure on several large commercial real estate properties, moving them to our other real estate owned portfolio.
Loan Portfolio Composition. The following table presents a summary of the loan portfolio, net of deferred loan fees, by type. There are no foreign loans in our portfolio and other than the categories noted; there is no concentration of loans in any industry exceeding 10% of total loans.
Loan Maturity Schedule. The following table shows at December 31, 2011, the dollar amount of loans, net of deferred loan fees, maturing in the loan portfolio based on their contractual terms to maturity.
(1) Includes loans held for sale in probable branch divestiture and probable loan sale
The following table breaks down loans maturing after one year, by fixed and adjustable rates.
(1) Includes loans held for sale in probable branch divestiture and probable loan sale
Allowance and Provision for Loan Losses Our financial performance depends on the quality of the loans we originate and management’s ability to assess the degree of risk in existing loans when it determines the allowance for loan losses. An increase in loan charge-offs or non-performing loans or an inadequate allowance for loan losses could reduce net interest income, net income and capital, and limit the range of products and services we can offer.
The Allowance for Loan Loss Review Committee evaluates the allowance for loan losses monthly to maintain a level it believes to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Periodic provisions to the allowance are made as needed. The Committee determines the allowance by applying loss estimates to graded loans by categories, as described below. When appropriate, a specific reserve will be established for individual loans based upon the risk classification and the estimated potential for loss. In accordance with our credit management processes, we obtain new appraisals on properties securing our non-performing commercial real estate loans and use those appraisals to determine specific reserves within the allowance for loan losses. As we receive new appraisals on properties securing non-performing loans, we recognize charge-offs and adjust specific reserves as appropriate. In addition, the Committee analyzes such factors as changes in lending policies and procedures; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.
Further declines in collateral values, including commercial real estate, may impact our ability to collect on certain loans when borrowers are dependent on the values of the real estate as a source of cash flow. Beginning the second half of 2008 and continuing into 2011, we substantially increased our provision for loan losses for our general and specific reserves as we identified adverse conditions. The foreseeable future will continue to be a challenging time as we manage the overall level of our credit quality. It is likely that provision for loan losses will remain elevated in the near term.
As discussed in Note 2 to the consolidated financial statements, we entered into a Consent Order with bank regulatory agencies. In addition to increasing capital ratios, we agreed to maintain adequate reserves for loan losses, develop and implement a plan to reduce the level of non-performing assets through collection, disposition, charge-off or improvement in the credit quality of the loans, develop and implement a plan to reduce concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures and to report our progress to the regulators.
The following table analyzes loan loss experience for the periods indicated.
(1) Includes loans held for sale in probable branch divestiture and probable loan sale for 2011
(2) Includes allowance allocated to loans held for sale in probable branch divestiture for 2011
Provision for loan loss increased $4.3 million to $21.2 million for 2011 compared to 2010. The increase was primarily related to residential housing development and building lot loans in Jefferson and Oldham Counties and our continued efforts to ensure the adequacy of the allowance by adding specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. We require appraisals and perform evaluations on impaired assets upon initial identification. Thereafter, we obtain appraisals or perform market value evaluations on impaired assets at least annually. Recognizing the volatility of certain assets, we assess the transaction and market conditions to determine if updated appraisals are needed more frequently than annually. Additionally, we evaluate the collateral condition and value upon foreclosure. The higher provision was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the general credit quality trend and the higher level of charge-offs.
The allowance for loan losses decreased $5.2 million to $17.5 million from December 31, 2010 to December 31, 2011. The decrease was driven by net charge-offs of $26.4 million taken during the period, including specific reserves of $10.2 million on our collateral dependent loans of which $8.9 million was previously reserved for at December 31, 2010, in addition to taking other write downs on loans to reflect updated appraisal information obtained as part of our on-going monitoring of the loan portfolio. This was due to appraisal values declining significantly on one to four family residential developments during 2011 above declines experienced during 2010. We believe these values are at or near liquidation value at December 31, 2011. We also believe this concentration has been fully identified and properly risk rated. The pass loans in this concentration have been separately evaluated for general allowance allocations. The decline in the specific reserves from charge-offs resulted in a decline in the allowance as a percent of total loans and the allowance as a percent of non-performing loans. The allowance for loan losses as a percent of total loans was 2.37% for December 31, 2011 compared to 2.56% at December 31, 2010. Specific reserves as allocated to substandard loans made up 25% of the total allowance for loan loss at December 31, 2011. Net charge-offs for the 2011
period included $19.3 million in partial charge-offs compared to partial charge-offs of $2.0 million at December 31, 2010. Allowance for loan losses to total non-performing loans declined to 44% at December 31, 2011 from 54% at December 31, 2010. The decline in the coverage ratio was due to the charge-off of specific reserves for December 31, 2011 as well as the increase in restructured loans.
The provision for loan losses increased $7.4 million to $16.9 million in 2010 compared to 2009. The increase in provision for loan losses was primarily attributable to residential housing development loans in Jefferson and Oldham Counties. During 2010, we continued our efforts to ensure the adequacy of the allowance by adding specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. The higher provision was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the increase in classified loans for the 2010 period. The allowance for loan losses increased $4.9 million to $22.7 million from December 31, 2009 to December 31, 2010. The increase was due to specific reserves placed on loans due to updated appraisal information obtained as part of our on-going monitoring of the loan portfolio, as well as the provision recorded to reflect an increase in classified loans for the 2010 period. Specific reserves as allocated to substandard loans made up 56% of the total allowance for loan loss at December 31, 2010. The increase in charge-offs for 2010 was primarily attributed to charging down previously recorded specific reserves on non-performing loans whose condition worsened during 2010.
The following table depicts management’s allocation of the allowance for loan losses by loan type. Allowance and allocation is based on management’s current evaluation of risk in each category, economic conditions, past loss experience, loan volume, past due history and other factors. Since these factors and management’s assumptions are subject to change, the allocation is not a prediction of future portfolio performance.
(1) Includes $283 allowance allocated to loans held for sale in probable branch divestiture for 2011
Federal regulations require banks to classify their own assets on a regular basis. The regulations provide for three categories of classified loans - substandard, doubtful and loss. In addition, we also classify loans as criticized. Loans classified as criticized have a potential weakness that deserves management’s close attention.
The following table provides information with respect to criticized and classified loans for the periods indicated:
Approximately $69.6 million or 86% of the total classified loans at December 31, 2011 were related to commercial real estate loans in our market area. Several of the non-performing loans that were added during the 2011 period were adequately collateralized and therefore did not require additional reserves. Classified consumer loans totaled $1.4 million, classified mortgage loans totaled $5.3 million and classified commercial loans totaled $4.4 million. The change in our level of allowance for loan losses is a result of a consistent allowance methodology that is driven by risk ratings. For more information on collection efforts, evaluation of collateral and how loss amounts are estimated, see “Non-Performing Assets,” below.
Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for active charge-offs. We develop our allowance estimates based on actual loss experience adjusted for current economic conditions. Allowance estimates represent a prudent measurement of the risk in the loan portfolio, which we apply to individual loans based on loan type. If economic conditions continue to put stress on our borrowers going forward, this may require higher provisions for loan losses in future periods. Credit quality will continue to be a primary focus during 2012 and going forward.
Non-Performing Assets Non-performing assets consist of certain non-accruing restructured loans for which the interest rate or other terms have been renegotiated, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets. We do not have any loans longer than 90 days past due still on accrual. Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection. Loans are considered impaired when we no longer anticipate full principal or interest payments in accordance with the contractual loan terms. If a loan is impaired, we allocate a portion of the allowance so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate, or at the fair value of collateral if repayment is expected solely from collateral.
Loans that have been restructured are generally placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which will require that the borrower demonstrate a period of performance in accordance to the restructured terms of six months or more.
We review our loans on a regular basis and implement normal collection procedures when a borrower fails to make a required payment on a loan. If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action. We generally charge off consumer loans when management deems a loan uncollectible and any available collateral has been liquidated. We handle commercial business and real estate loan delinquencies on an individual basis. These loans are placed on non-accrual status upon becoming contractually past due 90 days or more as to principal and interest or where substantial doubt about full repayment of principal and interest is evident.
We recognize interest income on loans on the accrual basis except for those loans in a non-accrual of income status. We discontinue accruing interest on impaired loans when management believes, after consideration of economic and business conditions and collection efforts, that the borrowers’ financial condition is such that collection of interest is doubtful, typically after the loan becomes 90 days delinquent. When we discontinue interest accrual, we reverse existing accrued interest and subsequently recognize interest income only to the extent we receive cash payments.
We classify real estate acquired as a result of foreclosure or by deed in lieu of foreclosure as real estate owned until such time as it is sold. We classify new and used automobile, motorcycle and all terrain vehicles acquired as a result of foreclosure as repossessed assets until they are sold. When such property is acquired we record it at the lower of the unpaid principal balance of the related loan or its fair value. We charge any write-down of the property at the time of acquisition to the allowance for loan losses. Subsequent gains and losses are included in non-interest income and non-interest expense.
Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. We monitor market information and the age of appraisals on existing real estate owned
properties and obtain new appraisals as circumstances warrant. Real estate acquired through foreclosure increased $3.3 million to $29.1 million at December 31, 2011. Real estate acquired through foreclosure includes $11.8 million in land development properties and building lots located primarily in our Jefferson County market. We anticipate that our level of real estate acquired through foreclosure will remain at elevated levels for some period of time as foreclosures reflecting both weak economic conditions and soft commercial real estate values continue. We also have sales contracts in place on eleven other real estate owned properties totaling $7.1 million set to close during the first quarter of 2012 indicating continued improvement in classified credits. All properties held in other real estate owned are listed for sale with various independent real estate agents.
A summary of the real estate acquired through foreclosure activity is as follows:
The following table provides information with respect to non-performing assets for the periods indicated.
Non-performing loans decreased $2.4 million to $39.8 million at December 31, 2011 compared to $42.2 million at December 31, 2010. The decrease for 2011 was the result of a decrease in non-accrual loans of $20.5 million offset by an increase in restructured non-accruing mortgage, commercial and commercial real estate loans of $18.0 million. Loans that have been restructured are generally placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which will require that the borrower demonstrates a period of performance in accordance to the restructured terms of six months or more. The change in non-accrual loans resulted from the addition of seventeen non-accrual relationships totaling $16.5 million. Offsetting this increase was a decrease in non-accrual loans due to write-downs of $25.0 million based upon updated appraisals and, transfers of six non-accrual relationships totaling $8.8 million to real estate acquired through foreclosure. A concentration in loans for residential subdivision
development in Jefferson and Oldham Counties contributed significantly to the increases in our non-performing loans for 2010 and 2009 and in our non-performing assets for 2011, 2010 and 2009. At December 31, 2011, substantially all of our residential housing development assets in these counties have been classified as impaired and written down to what we believe to be at or near liquidation value. The remaining residential development credits are smaller and have strong guarantors. All non-performing loans are considered impaired.
The following table provides information with respect to restructured loans for the periods indicated.
The increase in total restructured loans for 2011 resulted from short-term interest-only periods granted for three loan relationships totaling $12.7 million, the restructuring of a residential housing development loan for $1.6 million, the restructuring of three commercial properties including an office building for $10.0 million, a car wash for $1.2 million and a commercial real estate property for $1.5 million. Two of the newly restructured credits are strip centers that experienced vacancies. One strip center lost a big box retailer and is currently in discussions with another larger retailer to fill the vacancy. The interest only period is to allow for the borrower to secure the new tenant. The second strip center has partially replaced a vacancy with a new tenant and was granted an interest only period to fill the remaining space. The commercial office building is on accrual status at 12/31/2011. This property has experienced improvement with additional tenants and cash flows on a proper basis. The loans were evaluated as impaired loans and appropriately allocated specific reserve allowances.
The terms of our restructured loans have been renegotiated to reduce the rate of interest or extend the term, thus reducing the amount of cash flow required from the borrower to service the loans. The borrowers are currently meeting the terms of the restructured loans. We anticipate that our level of restructured loans will continue to increase as we identify borrowers in financial difficulty and work with them to modify to more affordable terms.
Investment Securities Interest on securities provides us our largest source of interest income after interest on loans, constituting 14.6% of the total interest income for the year ended December 31, 2011. The securities portfolio serves as a source of liquidity and earnings, and contributes to the management of interest rate risk. We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers’ acceptances, and federal funds. We may also invest a portion of our assets in certain commercial paper and corporate debt securities. We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The available-for-sale investment portfolio increased by $117.7 million due to the purchase of U.S. Government agency securities, government-sponsored mortgage-backed securities and obligations of states and political subdivisions. Recent purchases have been high cash flow instruments with short average lives in order to decrease the volatility of the investment portfolio as well as provide cash flow in order to limit interest rate risk.
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. We consider the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and whether management has the intent to sell the debt security or whether it is more likely than not that we will be required to sell the debt security before its anticipated recovery. In analyzing an issuer’s financial condition, we may consider whether the
securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
The unrealized losses on 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 have the ability and intent to hold these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2011.
We have evaluated the decline in the fair value of our trust preferred securities, which are directly related to the credit and liquidity crisis that the financial services industry has experienced in recent years. The trust preferred securities market is currently inactive making the valuation of trust preferred securities very difficult. We value trust preferred securities using unobservable inputs through a discounted cash flow analysis as permitted under current accounting guidance and using the expected cash flows appropriately discounted using present value techniques. Refer to Note 5 - Fair Value for more information.
We recognized other-than-temporary impairment charges of $168,000 for the expected credit loss during the 2011 period and $2.1 million during the time we have held these securities on five of our trust preferred securities with an original cost basis of $3.0 million. All of our trust preferred securities are currently rated below investment grade. One of our trust preferred securities continues to pay interest as scheduled through December 31, 2011, and is expected to continue paying interest as scheduled. The other four trust preferred securities are paying either partial or full interest in kind instead of full cash interest. See Note 3 - Securities for more information. Management will continue to evaluate these securities for impairment quarterly.
The following table provides the carrying value of our securities portfolio at the dates indicated.
The following table provides the scheduled maturities, amortized cost, fair value and weighted average yields for our securities at December 31, 2011.
* The weighted average yields are calculated on amortized cost.
Deposits We rely primarily on providing excellent customer service and fostering long-standing relationships with customers to attract and retain deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits. We attract both short-term and long-term deposits from the general public by offering a wide range of deposit accounts and interest rates. In recent years market conditions have caused us to rely increasingly on short-term certificate accounts and other deposit alternatives that are more responsive to market interest rates. We use forecasts based on interest rate risk simulations to assist management in monitoring our use of certificates of deposit and other deposit products as funding sources and the impact of the use of those products on interest income and net interest margin in various rate environments.
Total deposits decreased $51.1 million compared to December 31, 2010. Retail and commercial deposits decreased $44.5 million. Public funds increased $5.6 million. Brokered deposits and Certificate of Deposits Account Registry Service (“CDARS”) certificates decreased $12.2 million. The decline in money market balances was partially due to a decline in the balance of one of our commercial customers who used $10.0 million in money market funds to pay down a loan. Brokered deposits were $87.3 million at December 31, 2011 compared to $90.3 million at December 31, 2010. As a result of our Consent Order with bank regulatory agencies, we are no longer allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval.
We continue to offer attractive certificate rates for various terms to allow us to retain deposit customers and reduce interest rate risk during the current rate environment, while protecting the margin. However, the Consent Order resulted in the Bank being categorized as a “troubled institution” by bank regulators. The “troubled institution” designation restricts the amount of interest the Bank may pay on deposits. Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates within .75% of the average rates computed by the FDIC. The Bank must apply annually to be granted this waiver, which it has done and was granted for 2011.
We offer a broad selection of deposit instruments, including non-interest bearing checking, statement and passbook savings accounts, health savings accounts, NOW accounts, money market accounts and fixed and variable rate certificates with varying maturities. We also offer tax-deferred individual retirement accounts. The flow of deposits is influenced significantly by general economic conditions, changes in interest rates and competition. As of December 31, 2011, approximately 42% of our deposits consisted of various savings and demand deposit accounts from which customers can withdraw funds at any time without penalty. Management periodically adjusts interest rates paid on our deposit products, maturity terms, service fees and withdrawal penalties.
We also offer certificates of deposit with a variety of terms, interest rates and minimum deposit requirements. The variety of deposit accounts allows us to compete more effectively for funds and to respond with more
flexibility to the flow of funds away from depository institutions into direct investment vehicles such as government and corporate securities. However, market conditions and regulatory restrictions continue to significantly affect our ability to attract and maintain deposits and our cost of funds.
The following table breaks down our deposits.
Included in total non-interest bearing deposits for 2011 are non-interest bearing deposits held for sale of $5.0 million. NOW demand, savings, money market and certificate of deposit balances include $112.2 million in held for sale deposits for 2011. We have public funds deposits from school boards, water districts and municipalities within our markets. These deposits are larger than individual retail depositors. We do not have a deposit relationship that is significant enough to cause a negative impact on our liquidity position. We bid and won a three-year bid for our largest public funds depositor in Bullitt County and a smaller, but influential, public funds depositor in Hardin County during the third quarter of 2011.
As of December 31, 2011, certificates of deposits in amounts of $100,000 or more total $312.0 million, with $228.8 million held by persons residing within our service areas. An additional $81.5 million of certificates of deposits in amounts of $100,000 or more were obtained from deposit brokers and $1.7 million were obtained from our participation in the Certificate of Deposit Account Registry Service (“CDARS”) at December 31, 2011. CDARS is a system that allows certificates of deposit that would be in excess of FDIC coverage in a single financial institution to be redistributed to other financial institutions within the CDARS network in increments under the current FDIC coverage limit. Brokered deposits consist of certificates of deposit placed by deposit brokers for a fee and can be utilized to support our asset growth. However, due to our agreement with bank regulatory agencies, we are not allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval.
The following table shows at December 31, 2011 the amount of our certificates of deposit of $100,000 or more by time remaining until maturity.
Advances from Federal Home Loan Bank Deposits are the primary source of funds for our lending and investment activities and for our general business purposes. We can also use advances (borrowings) from the Federal Home Loan Bank of Cincinnati (FHLB) to compensate for reductions in deposits or deposit inflows at less than projected levels. At December 31, 2011 we had $27.7 million in advances outstanding from the FHLB. In January 2011, a $25 million convertible fixed rate advance with an interest rate of 5.05% matured and was paid in full. At December 31, 2011, we had sufficient collateral available to borrow, approximately, an additional $15.4 million in advances from the FHLB. Advances from the FHLB are secured by our stock in the FHLB, certain securities and substantially all of our first mortgage loans.
The FHLB of Cincinnati functions as a central reserve bank providing credit for savings banks and other member financial institutions. As a member, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our home mortgages, other real estate loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided that we meet certain creditworthiness standards. For further information, see Note 10 of the Notes to Consolidated Financial Statements in this Annual Report.
The following table provides information about our FHLB advances and short-term borrowings as of and for the periods ended.
Subordinated Debentures In 2008, an unconsolidated trust subsidiary of First Financial Service Corporation issued $8.0 million in trust preferred securities. The trust loaned the proceeds of the offering to us in exchange for junior subordinated deferrable interest debentures, which proceeds we used to finance the purchase of FSB Bancshares, Inc. The subordinated debentures, which mature on June 24, 2038, can be called at par in whole or in part on or after June 24, 2018. The subordinated debentures pay a fixed rate of 8% for thirty years. We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.
A different trust subsidiary issued 30 year cumulative trust preferred securities totaling $10 million at a 10 year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basis points. The subordinated debentures, which mature March 22, 2037, can be called at par in whole or in part on or after March 15, 2017. We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.
Our trust subsidiaries loaned the proceeds of their offerings of trust preferred securities to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts (variable interest entity), therefore the trusts are not consolidated in our financial statements, but rather the subordinated debentures are shown as a liability. Our investment in the common stock of the trusts was $310,000.
On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes, together having an outstanding principal amount of $18 million, relating to outstanding trust preferred securities. We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of December 31, 2011, these accrued but unpaid interest payments totaled $1.7 million.
LIQUIDITY Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we can meet the cash flow requirements of depositors and borrowers, as well as our operating cash needs, at a reasonable cost, taking into account all on- and off-balance sheet funding demands. Our investment and funds management policy identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The Asset Liability Committee continually monitors our liquidity position.
Our banking centers provide access to retail deposit markets. If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources. In addition to maintaining a stable core deposit base, we maintain adequate liquidity primarily through the use of investment securities. Traditionally, we have also borrowed from the FHLB to supplement our funding requirements. At December 31, 2011, we had sufficient collateral available to borrow, approximately, an additional $15.4 million in advances from the FHLB. We believe that we have adequate funding sources through unpledged investment securities, loan principal repayments, and potential asset maturities and sales to meet our foreseeable liquidity requirements.
At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the Corporation include dividends from the Bank, borrowings and access to the capital markets.
The primary source of funding for the Corporation has been dividends and returns of investment from the Bank. Kentucky banking laws limit the amount of dividends that may be paid to the Corporation by the Bank without prior approval of the KDFI. Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods. 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. The Corporation has also entered into a formal agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends. We may not redeem shares or obtain additional borrowings without prior approval. Because of these limitations, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to the Corporation. During 2011, the Bank did not declare or pay any dividends to the Corporation. Cash held by the Corporation at December 31, 2011 was $554,000 compared to cash of $237,000 at December 31, 2010.
CAPITAL Stockholders’ equity decreased $17.8 million during 2011, primarily due to a net loss recorded during the period. Offsetting this decrease was a decrease in unrealized losses on securities available-for-sale. Our average stockholders’ equity to average assets ratio decreased to 5.19% at December 31, 2011 compared to 6.77% at the end of 2010.
On January 9, 2009, we sold $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the U.S. Treasury under the terms of its Capital Purchase Program. The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares pay cumulative dividends at a rate of 5% per year for the first five years and will reset to a rate of 9% per year after five years.
Under the terms of our CPP stock purchase agreement, we also issued the U.S. Treasury a warrant to purchase an amount of our common stock equal to 15% of the aggregate amount of the Senior Preferred Shares, or $3 million. The warrant entitles the U.S. Treasury to purchase 215,983 common shares at a purchase price of $13.89 per share. The initial exercise price for the warrant and the number of shares subject to the warrant were determined by reference to the market price of our common stock calculated on a 20-day trailing average as of December 8, 2008, the date the U.S. Treasury approved our application. The warrant has a term of 10 years and is potentially dilutive to earnings per share.
On October 29, 2010, we gave written notice to the U.S. Treasury that effective with the fourth quarter of 2010, we were suspending the payment of regular quarterly cash dividends on our Senior Preferred Shares. The dividends are cumulative and failure to pay dividends for six quarters would trigger the rights of the holder of our Senior Preferred Shares to appoint representatives to our Board of Directors. The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes.
In addition to our agreement with the Federal Reserve that requires prior written consent to repurchase common shares, the terms of our Senior Preferred Shares do not allow us to repurchase shares of our common stock without the consent of the holder until the Senior Preferred Shares are redeemed. During 2011, we did not purchase any shares of our common stock.
Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.
In its Consent Order with the FDIC and KDFI, the Bank has agreed to 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 December 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 anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at June 30, 2012.
On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the January 2011 Consent Order by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. The new Consent Order requires the Bank to continue to adhere to the plans implemented in response to the January 2011 Consent Order, and includes the substantive provisions of the January 2011 Consent Order. We are working on various specific initiatives to increase our regulatory capital and to reduce our total assets such as the sale of branch offices and raising common stock.
As part of our ongoing capital initiatives, on February 9, 2012, we signed a definitive agreement to sell our four Indiana banking centers to First Savings Bank, F.S.B. The transaction is projected to increase our Tier I capital ratio from 5.86% to 6.74% and increase our total risk-based capital ratio from 10.18% to 11.32% based on information at December 31, 2011, and is expected to close early in the third quarter of 2012.
The following table shows the ratios of Tier 1 capital, total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of December 31, 2011.
The Consent Order requires the Bank to achieve the minimum capital ratios presented below by June 30 2011:
The new Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the table above by June 30, 2012.
OFF BALANCE SHEET ARRANGEMENTS Our off balance sheet arrangements consist of commitments to make loans, unused borrower lines of credit, and standby letters of credit, which are disclosed in Note 19 to the consolidated financial statements.
AGGREGATE CONTRACTUAL OBLIGATIONS
FHLB borrowings represent the amounts that are due to the FHLB of Cincinnati. These amounts have fixed maturity dates. Three of these borrowings, although fixed, are subject to conversion provisions at the option of the FHLB. The FHLB has the right to convert these advances to a variable rate or we can prepay the advances at no penalty. There is a substantial penalty if we prepay the advances before the FHLB exercises its right. We do not believe the convertible fixed rate advances will be converted in the near term.
The subordinated debentures, which mature June 24, 2038 and March 22, 2037, are redeemable before the maturity date at our option on or after June 24, 2018 and March 15, 2017 at their principal amount plus accrued interest. The subordinated debentures are also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The interest rate on the subordinated debentures is at a 30 year fixed rate of 8.00% and a 10 year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 1.60%.
On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes, together having an outstanding principal amount of $18 million, relating to outstanding trust preferred securities. We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the respective statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation, that were formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.
Lease commitments represent the total future minimum lease payments under non-cancelable operating leases.
IMPACT OF INFLATION & CHANGING PRICES The consolidated financial statements and related financial data presented in this filing have been prepared in accordance with U.S. generally accepted accounting principles, which require the measurement of financial position and operating results in historical dollars without considering changes in the relative purchasing power of money over time due to inflation.
The primary impact of inflation on our operations is reflected in increasing operating costs. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates have a more significant impact on our performance than the effects of general levels of inflation and changes in prices. Periods of high inflation are often accompanied by relatively higher interest rates, and periods of low inflation are accompanied by relatively lower interest rates. As market interest rates rise or fall in relation to the rates earned on our loans and investments, the value of these assets decreases or increases respectively.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Asset /Liability Management and Market Risk To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”). Comprised of senior management representatives, the ALCO has the responsibility for approving and ensuring compliance with asset/liability management policies. Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates. The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies. Management considers interest rate risk to be our most significant market risk.
We utilize an earnings simulation model to analyze net interest income sensitivity. We then evaluate potential changes in market interest rates and their subsequent effects on net interest income. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. We also incorporate assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.
Our interest sensitivity profile was asset sensitive at December 31, 2011 and December 31, 2010. Given a sustained 100 basis point decrease in rates, our base net interest income would decrease by an estimated 2.39% at December 31, 2011 compared to a decrease of .84% at December 31, 2010. Given a sustained 100 basis point increase in interest rates, our base net interest income would increase by an estimated .60% at December 31, 2011 compared to an increase of 2.69% at December 31, 2010.
Our interest sensitivity at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities, their relative pricing schedules, market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.
We use various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking. As demonstrated by the December 31, 2011 and December 31, 2010 sensitivity tables, our balance sheet has an asset sensitive position. This means that our earning assets, which consist of loans and investment securities, will change in price at a faster rate than our deposits and borrowings. Therefore, if short term interest rates increase, our net interest income will increase. Likewise, if short term interest rates decrease, our net interest income will decrease.
Our sensitivity to interest rate changes is presented based on data as of December 31, 2011 and 2010.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FIRST FINANCIAL SERVICE CORPORATION
Management’s Report on Internal Control Over Financial Reporting First Financial Service Corporation is responsible for the preparation, integrity, and fair presentation of the consolidated financial statements included in this annual report. We, as management of First Financial Service Corporation, are responsible for establishing and maintaining effective internal control over financial reporting that is designed to produce reliable financial statements in conformity with U. S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the system of internal control over financial reporting as of December 31, 2011, in relation to criteria for effective internal control over financial reporting as described in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management concludes that, as of December 31, 2011, its system of internal control over financial reporting was not effective. See “Item 9A. Controls and Procedures” for further discussion of the material weakness related to controls over the allowance review process. This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.
Date: March 30, 2012
By:
Gregory S. Schreacke
President
Principal Executive Officer
Principal Financial Officer &
Principal Accounting Officer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders
First Financial Service Corporation
Elizabethtown, Kentucky
We have audited the accompanying consolidated balance sheets of First Financial Service Corporation as of December 31, 2011 and 2010, and the related consolidated statements of operations, comprehensive income (loss), changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company has recently incurred substantial losses, largely as a result of elevated provisions for loan losses and other credit related costs. In addition, both the Company and its bank subsidiary, First Federal Savings Bank, are under regulatory enforcement orders issued by their primary regulators. First Federal Savings Bank is not in compliance with its regulatory enforcement order which requires, among other things, increased minimum regulatory capital ratios. First Federal Savings Bank’s continued non-compliance with its regulatory enforcement order may result in additional adverse regulatory action. Management’s plans with regard to these matters are also discussed in Note 2 to the consolidated financial statements.
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Balance Sheets
See notes to the consolidated financial statements.
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Operations
See notes to the consolidated financial statements.
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Comprehensive Income/(Loss)
The following is a summary of the accumulated other comprehensive income balances, net of tax:
See notes to the consolidated financial statements.
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Changes in Stockholders' Equity
Years Ending December 31, 2011, 2010 and 2009
(Dollars In Thousands, Except Per Share Amounts)
See notes to the consolidated financial statements.
FIRST FINANCIAL SERVICE CORPORATION
Consolidated Statements of Cash Flows
See notes to the consolidated financial statements.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The following is a description of the significant accounting policies First Financial Service Corporation follows in preparing and presenting its consolidated financial statements:
Principles of Consolidation and Business - The 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 wholly-owned subsidiary. All significant intercompany transactions and balances have been eliminated in consolidation.
Our business consists primarily of attracting deposits from the general public and origination of mortgage loans on commercial property, single-family residences and multi-family housing. We also make home improvement loans, consumer loans and commercial business loans. Our primary lending area is a region within North Central Kentucky. The economy within this region is diversified with a variety of medical service, manufacturing, and agricultural industries, and Fort Knox, a military installation.
The principal sources of funds for our lending and investment activities are deposits, repayment of loans, Federal Home Loan Bank advances and other borrowings. Our principal source of income is interest on loans. In addition, other income is derived from loan origination fees, service charges, returns on investment securities, gains on sale of mortgage loans, and brokerage and insurance commissions.
Our subsidiary First Service Corporation is a licensed broker providing investment services and offering tax-deferred annuities, government securities and stocks and bonds to our customers. Heritage Properties, LLC holds real estate acquired through foreclosure which is available for sale. First Federal Office Park, LLC, another subsidiary, holds a commercial lot adjacent to our home office on Ring Road in Elizabethtown, which is available for sale.
Estimates and Assumptions - The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of the amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The allowance for loan losses, fair value of financial instruments, other real estate owned and deferred tax asset realization are particularly subject to change.
Cash Flows - For purposes of the statement of cash flows, we consider all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and certain interest bearing deposits. Net cash flows are reported for interest-bearing deposits, loans, short-term borrowings and deposits.
Securities - We classify investments into held-to-maturity and available-for-sale. Debt securities in which management has a positive intent and ability to hold are classified as held-to-maturity and are carried at cost adjusted for the amortization of premiums and discounts using the interest method over the terms of the securities. Debt and equity securities, which do not fall into this category, are classified as available-for-sale. Unrealized holding gains and losses, net of tax, on available-for-sale securities are reported as a component of accumulated other comprehensive income.
Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued) financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) other-than-temporary impairment (OTTI) related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
Loans - Loans are stated at unpaid principal balances, less undistributed construction loans, and net deferred loan origination fees. We defer loan origination fees and discounts net of certain direct origination costs. These net deferred fees are amortized using the level yield method on a loan-by-loan basis over the lives of the underlying loans. Under applicable accounting guidance, for reporting purposes, the loan portfolio is categorized by portfolio segment and, within each portfolio segment, by class of financing receivables. The following classes of financing receivables have been identified: commercial, commercial real estate including land development and building lot loans, construction real estate, residential mortgage, consumer and home equity, and indirect consumer.
Interest income on commercial, commercial real estate, construction real estate and residential mortgage loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer and home equity and indirect consumer loans are typically charged off no later than 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. A loan is moved to non-accrual status in accordance with our policy, typically after 90 days of non-payment.
All interest accrued but not received for a loan placed on non-accrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses - The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when we believe the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Our periodic evaluation of the allowance is based on our past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and current economic conditions. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history we have experienced over the most recent three years with additional weight given to more recent losses. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued) staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following portfolio segments have been identified: commercial, commercial real estate, construction real estate, residential mortgage, consumer and home equity, and indirect consumer.
Commercial loans generally are made to small-to-medium size businesses located within our defined market area. Commercial loans generally carry a higher yield and are made for a shorter term than real estate loans. Commercial loans, however, involve a higher degree of risk than residential real estate loans due to potentially greater volatility in the value of the assigned collateral, the need for more technical analysis of the borrower’s financial position, the potentially greater impact that changing economic conditions may have on the borrower’s ability to retire debt, and the additional expertise required for commercial lending personnel.
Commercial loans that are primarily secured by real estate are made to a variety of industries and primarily in our market area. Substantially all of the commercial real estate loans we originate have adjustable interest rates with maturities of 25 years or less or are loans with fixed interest rates and maturities of five years or less. The security for commercial real estate loans includes retail businesses, warehouses, churches, apartment buildings and motels. In addition, the payment experience of loans secured by income producing properties typically depends on the success of the related real estate project and thus may be more vulnerable to adverse conditions in the real estate market or in the economy generally.
Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value before the completion of construction. The uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies make it relatively difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. The analysis of prospective construction loan projects requires significantly different expertise from that required for permanent residential mortgage lending. Our underwriting criteria are designed to evaluate and minimize the risks of each construction loan. Among other things, we consider evidence of the availability of permanent financing or a takeout commitment to the borrower; the reputation of the borrower and his or her financial condition; the amount of the borrower’s equity in the project; independent appraisals and cost estimates; pre-construction sale and leasing information; and cash flow projections of the borrower.
Residential mortgage loans are secured primarily by single-family homes. The majority of our mortgage loan portfolio is secured by real estate in our markets outside of Louisville and our residential mortgage loans do not have sub-prime characteristics. Appraisals are obtained to support the loan amount. We generally emphasize the origination of adjustable-rate mortgage loans (“ARMs”) when possible. Originating these ARMs can be more difficult in a low interest rate environment where there is a significant demand for fixed rate mortgages. We limit the maximum loan-to-value ratio on one-to-four-family residential first mortgages to 90% of the appraised value.
Consumer loans include loans on automobiles, boats, recreational vehicles and other consumer goods, as well as loans secured by savings accounts, home improvement loans, and unsecured lines of credit. These loans involve a higher risk of default than loans secured by one-to-four-family residential loans. Our underwriting standards reflect the greater risk in consumer lending than in residential real estate lending. Among other things, the capacity of individual borrowers to repay can change rapidly, particularly during an economic downturn, collection costs can be relatively higher for smaller loans, and the value of collateral may be more likely to depreciate. We require detailed financial information and credit bureau reports for each consumer loan applicant to establish the applicant’s credit history, the adequacy of income for debt retirement, and job stability based on the applicant’s employment records. Co-signers are required for applicants who are determined marginal or who fail to qualify individually under these standards. Adequate collateral is required on the majority of consumer loans.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued) The indirect consumer loan portfolio is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within the service area. Indirect consumer loans are considered to have greater risk of loan losses than direct consumer loans due to, among other things: borrowers may have no existing relationship with us; borrowers may not be residents of the lending area; less detailed financial statement information may be collected at application; collateral values can be more difficult to determine; and the condition of vehicles securing the loan can deteriorate rapidly. To address the additional risks associated with indirect consumer lending, the Executive Loan Committee continually evaluates data regarding the dealers enrolled in the program, including monitoring turn down and delinquency rates. All applications are approved by specific lending officers, selected based on experience in this field, who obtain credit bureau reports on each application to assist in the decision. Aggressive collection procedures encourage more timely recovery of late payments.
A loan is considered impaired when, based on current information and events, it is probable that full principal or interest payments are not anticipated in accordance with the contractual loan terms. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. We determine the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate, or at the fair value of collateral if repayment is expected solely from collateral. If these allocations cause the allowance for loan losses to require an increase, such increase is reported in the provision for loan losses. We classify all substandard, doubtful and loss classified loans as impaired.
Commercial, commercial real estate and construction real estate loans are individually evaluated for impairment. Individual residential mortgage, consumer and home equity and indirect consumer loans are evaluated for impairment based on the aging status of the loan and by payment activity and are separately identified for impairment disclosures. When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is on nonaccrual status, all payments are applied to principal under the cost recovery method. When the ultimate collectability of the total principal of an impaired loan is not in doubt and the loan is on nonaccrual status, contractual interest is credited to interest income when received under the cash basis method.
A troubled debt restructuring is where we have agreed to a loan modification in the form of a concession for a borrower who is experiencing financial difficulty. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, we determine the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
Held For Sale - Loans held for sale include mortgage loans held for sale of $10.2 million, loans held for sale in a probable branch divestiture of $35.1 million and loans held for sale in an additional probable loan sale of $10.7 million. Assets and liabilities classified as held for sale are carried at the lower of aggregate cost or market value. Premises and equipment held for sale, non-interest bearing deposits held for sale and interest-bearing deposits held for sale are reflective of the fixed assets and deposits which are held for probable branch sales.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued) Mortgage Banking Activities - Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market value. To deliver closed loans to the secondary market and to control its interest rate risk prior to sale, we enter into “best efforts” agreements to sell loans. The aggregate market value of mortgage loans held for sale considers the price of the sales contracts. The loans are sold with servicing released. Mortgage loans held for sale at December 31, 2011, totaled $10.2 million.
Loan commitments related to the origination of mortgage loans held for sale are accounted for as derivative instruments. Our commitments are for fixed rate mortgage loans, generally lasting 60 to 90 days and are at market rates when initiated. Considered derivatives, we had commitments to originate $1.5 million and $3.5 million in loans at December 31, 2011 and 2010, which we intend to sell after the loans are closed.
The fair value was not material. Substantially all of the gain on sale generated from mortgage banking activities continues to be recorded when closed loans are delivered into the sales contracts.
Federal Home Loan Bank Stock - The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. Investment in stock of Federal Home Loan Bank is carried at cost, and periodically evaluated for impairment. Both cash and stock dividends are reported as income.
Cash Surrender Value of Life Insurance - We have purchased life insurance policies on certain key executives. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Premises and Equipment - Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 40 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 15 years.
Real Estate Owned - Real estate properties acquired through foreclosure and in settlement of loans are stated at fair value less estimated selling costs at the date of foreclosure. The excess of cost over fair value less the estimated costs to sell at the time of foreclosure is charged to the allowance for loan losses. Costs relating to development and improvement of property are capitalized when such amounts do not exceed fair value. Costs relating to holding property are not capitalized and are charged against operations in the current period.
Real Estate Held for Development - Real estate properties held for development and sale are carried at the lower of cost, including cost of development and improvement subsequent to acquisition, or fair value less estimated selling costs. The portion of interest costs relating to the development of real estate is capitalized.
Other Repossessed Assets - Consumer assets acquired through repossession and in settlement of loans, typically automobiles, are carried at lower of cost or fair value at the date of repossession. The excess cost over fair value at time of repossession is charged to the allowance for loan losses.
Intangible Assets - Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank and branch acquisitions. They are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives, which range from 7 to 10 years. The remaining $1.0 million of other intangible assets will be fully amortized with the probable branch divestiture.
Long-Term Assets - Premises and equipment, core deposit and other intangible assets, and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued) Brokerage and Insurance Commissions - Brokerage commissions are recognized as income on settlement date. Insurance commissions on loan products (credit life, mortgage life, accidental death, and guaranteed auto protection) are recognized as income over the life of the loan.
Stock Based Compensation - Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of our common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
Income Taxes - Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. We recognize interest and penalties related to income tax matters in income tax expense.
Employee Stock Ownership Plan - Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings. Since the ESOP has not acquired shares in advance of allocation to participant accounts, the plan has no unallocated shares.
Earnings/(Loss) Per Common Share - Basic earnings (loss) per common share is net income attributable to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options and warrants. Earnings (loss) and dividends per share are restated for all stock dividends through the date of issuance of the financial statements.
Loss Contingencies - In the normal course of business, there are various outstanding legal proceedings and claims. In the opinion of management the disposition of such legal proceedings and claims will not materially affect our consolidated financial position, results of operations or liquidity.
Comprehensive Income/(Loss) - Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available-for-sale and the unrecognized loss on held-to-maturity securities for which an other-than-temporary charge has been recorded, which are also recognized as a separate component of equity, net of tax.
Loan Commitments and Related Financial Instruments - Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Dividend Restriction - Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company or by the holding company to shareholders. For additional information, see Note 14.
Fair Value of Financial Instruments - Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued) other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Operating Segments - Segments are parts of a company evaluated by management with separate financial information. Our internal financial information is primarily reported and evaluated in three lines of business, banking, mortgage banking, and brokerage. These segments are dominated by banking at a magnitude for which separate individual segment disclosures are not required.
Reclassifications - Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year operations or shareholder’s equity.
Adoption of New Accounting Standards - 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 new standard did not have a material impact on our consolidated financial position or results of operations.
In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this ASU generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs. The amendments in this ASU are to be applied prospectively and are effective for interim and annual periods beginning after December 31, 2011. The new standard did not 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. ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, which was issued on December 23, 2011, defers indefinitely the provision regarding the presentation of reclassification adjustments. ASU No. 2011-05 requires retrospective application of the other requirements, 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.
2. REGULATORY MATTERS AND RECENT DEVELOPMENTS In its Consent Order with the FDIC and KDFI, the Bank agreed to 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 December 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 anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at June 30, 2012.
On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the January 2011 Consent Order by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. REGULATORY MATTERS AND RECENT DEVELOPMENTS - (continued) implement a written plan to sell or merge itself into another federally insured financial institution. The new Consent Order requires the Bank to continue to adhere to the plans implemented in response to the January 2011 Consent Order, and includes the substantive provisions of the January 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to this Annual Report on Form 10-K.
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 formal agreement 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.
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 action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.
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 strategic opportunities available to us. We continue reducing our costs where possible while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen executive management compensation the past three years and into 2012, frozen officer compensation for the past year and into 2012, eliminated board of director fees, reduced marketing expenses, reduced community donation expense, reduced compensation expense through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 were $1.1 million. Additional cost reductions for 2012 are projected to be in excess of $1.3 million. We are also evaluating remaining terms on existing contracts and identifying expenses we cannot reduce currently, but expect to be able to in 2012 and 2013, such as examination fees and loan workout and other real estate owned expenses. These efforts will remain ongoing.
As part of our ongoing capital initiatives, on February 9, 2012, we signed a definitive agreement to sell our four Indiana banking centers to First Savings Bank, F.S.B., the banking subsidiary of First Savings Financial Group, Inc. The purchase price will represent a 3.65% percent premium based on the actual level of consumer and commercial deposits at closing, which totaled $99.7 million at December 31, 2011. Under the agreement, First Savings Financial Group, Inc. will also acquire government, corporate, other financial institution deposits and municipal deposits, which were $17.5 million at December 31, 2011, at book value. A total of $35.4 million of performing loans will be purchased at a discount of 0.80% based on the actual level of loans at closing. The consummated transaction would result in a one-time gain of approximately $3.4 million based on information at December 31, 2011. We believe the transaction places us in a better position to meet the conditions of the regulatory consent order in a manner that is beneficial to our shareholders. This transaction is projected to increase our Tier I capital ratio from 5.86% to 6.74% and increase our total risk-based capital ratio from 10.18% to 11.32% based on information at December 31, 2011, and is expected to close early in the third quarter of 2012.
On February 10, 2012, we announced the following changes to our management and the board of directors.
• Senator Walter Dee Huddleston had stepped down as Chairman of the Board while continuing to serve as a director.
• J. Stephen Mouser, President of Mouser Custom Cabinetry, LLC, and a director since 1997, was appointed as the Board’s new Chairman.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. REGULATORY MATTERS AND RECENT DEVELOPMENTS - (continued)
• B. Keith Johnson, Chief Executive Officer of the Corporation and the Bank since 1997, had stepped down from those positions. Mr. Johnson assumed the position of the Board’s Vice Chairman, while continuing to work at the Bank in an advisory role.
• Gregory S. Schreacke, President of the Corporation and the Bank since 2008, assumed principal management responsibility for the Corporation and the Bank. Mr. Schreacke also joined the boards of directors of both the Corporation and the Bank.
• Dann Small was appointed as Chief Lending Officer of the Bank and will direct the Bank’s lending program and supervise all phases of the lending operation. Mr. Small has over 30 years of experience in finance, lending, credit underwriting and executive management.
• Robert L. Critchfield was appointed as Chief Credit Officer of the Bank, with responsibility for the overall management of its loan, credit and risk policies. Mr. Critchfield has over forty years of experience in the banking industry, including seventeen years as President and CEO of two commercial banks.
Our plans for 2012 include the following:
• Continue to pursue all available strategies to recapitalize the Bank. We are evaluating various specific initiatives to increase our regulatory capital and to reduce our total assets. Strategic alternatives include divesting of branch offices, selling loans and raising capital by selling stock.
• Continue to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise. The strength of this franchise contributes to earnings to help withstand our credit quality issues. In addition, the inherent value of the retail franchise will provide value to the Bank to accomplish the various capital initiatives.
• Continue to reduce our lending concentration in commercial real estate by obtaining pay downs and payoffs. In addition to allowing loans in these concentrations to roll off, we have started initiatives to diversify the Bank’s lending portfolio and change our lending culture. The mortgage and consumer lending operations have maintained strong credit quality metrics through this recession. These areas are being restructured to allow for additional emphasis on retail lending going forward. We will also emphasize small business lending and will seek resources to add expertise in this area. Our efforts will focus on back to basic community banking and servicing the entire relationship of the customer. These loans will be used to diversify the loan portfolio of the Bank as well as provide for profitability as the Bank works through our credit quality issues.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. SECURITIES The amortized cost basis and fair values of securities are as follows:
The amortized cost and fair value of securities at December 31, 2011, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. SECURITIES - (continued) The following schedule shows the proceeds from sales of available-for-sale and held-to-maturity securities and the gross realized gains and losses on those sales:
Tax expense related to realized gains was $0, $20,000, and $0, respectively.
Investment securities pledged to secure public deposits and FHLB advances had an amortized cost of $119.1 million and fair value of $121.1 million at December 31, 2011 and a $66.8 million amortized cost and a $65.1 fair value at December 31, 2010.
Securities with unrealized losses at year end 2011 and 2010 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:
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 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
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. SECURITIES - (continued) 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 December 31, 2011.
As discussed in Note 6 - Fair Value, the fair value of our portfolio of trust preferred securities, is significantly below the amortized cost. 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 December 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 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 between 37.5 and 100 basis points.
• We assume a recovery rate of 40% on PreTSL IV and 15% on the remaining trust preferred securities on deferrals after two years.
• We assume 1% prepayments through the five year par call and then 1% per annum for the remaining life of PreTSL IV to account for the potential prepayments of large banks under the new Dodd Frank legislation.
• 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;
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. SECURITIES - (continued)
• 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 December 31, 2011 and the related credit losses recognized in earnings:
The table below presents a roll-forward of the credit losses recognized in earnings for the periods ended December 31, 2011 and 2010:
4. LOANS Loans are summarized as follows:
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued) We utilize eligible real estate loans to collateralize advances and letters of credit from the Federal Home Loan Bank. We had $117 million in residential mortgage loans pledged under this arrangement at December 31, 2011 and$217 million in residential mortgage and multi-family loans pledged at December 31, 2010.
The following table presents the activity in the allowance for loan losses by portfolio segment for the year ending December 31, 2011:
Activity in the allowance for loan losses was as follows:
We did not implement any changes to our allowance related 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 and based on the impairment method as of December 31, 2011 and 2010:
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued)
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2011 and 2010. The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits. The recorded investment and average recorded investment in loans excludes accrued interest receivable and loan origination fees.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued)
Impaired loans as of December 31, are summarized below.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued) The following table presents the recorded investment in restructured, nonaccrual and loans past due over 90 days still on accrual by class of loans as of December 31, 2011 and 2010.
The following table presents the aging of the unpaid principal in past due loans as of December 31, 2011 and 2010 by class of loans:
(1) Includes loans held for sale in probable branch divestiture and probable loan sale
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued)
Troubled Debt Restructurings: We have allocated $937,000 and $151,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2011 and December 31, 2010. We are not committed to lend additional funds to debtors whose loans have been modified in a troubled debt restructuring. Specific reserves are generally assessed prior to loans being modified as a TDR, as most of these loans migrate from our internal watch list and have been specifically reserved for as part of our normal reserving methodology.
During the period ending December 31, 2011, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.
Modifications involving a reduction of the stated interest rate of the loan were for periods ranging from six months to one year. Modifications involving an extension of the maturity date were for periods ranging from three to six months.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued) The following table presents loans by class modified as troubled debt restructurings that occurred during the year ending December 31, 2011:
The troubled debt restructurings described above increased the allowance for loan losses by $1.3 million and resulted in charge offs of $3.0 million during the year ending December 31, 2011.
The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the year ending December 31, 2011:
A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms. The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $12,000 and resulted in charge offs of $220,000 for the year ending December 31, 2011.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued) Credit Quality Indicators: We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk. This analysis includes commercial and commercial real estate loans. We also evaluate credit quality on residential mortgage, consumer and home equity and indirect consumer loans based on the aging status and payment activity of the loan. This analysis is performed on a monthly basis. We use the following definitions for risk ratings:
Criticized: Loans classified as criticized have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in our credit position at some future date.
Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loss: Loans classified as loss are considered non-collectible and their continuance as bankable assets is not warranted.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Loans listed as not rated are included in groups of homogeneous loans. For our residential mortgage, consumer and home equity, and indirect consumer homogeneous loans, we also evaluate credit quality based on the aging status of the loan, which was previously presented, and by payment activity.
As of December 31, 2011 and 2010, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
(1) Includes loans held for sale in probable branch divestiture and probable loan sale
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. LOANS - (continued)
The following table presents the unpaid principal balance in residential mortgage, consumer and home equity and indirect consumer loans based on payment activity as of December 31, 2011 and 2010:
5. REAL ESTATE ACQUIRED THROUGH FORECLOSURE A summary of the real estate acquired through foreclosure activity is as follows:
6. FAIR VALUE U.S. GAAP 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 at the measurement date and establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. FAIR VALUE - (continued) Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
We used the following methods and significant assumptions to estimate the fair value of available-for-sale-securities.
Securities: The fair values of some equity securities are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs). The fair values of most debt securities are determined by a matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. For trust preferred securities, discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations. For other equity securities, discounted cash flows are calculated with available market information through processes using benchmark yields, market spreads sourced from new issues, dealer quotes and trade prices among other sources. Equity securities are carried at cost which approximates fair value.
Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Other Real Estate Owned: The fair value of other real estate owned is generally based on recent real estate appraisals. These appraisals may use a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Loans Held For Sale: Loans held for sale associated with a probable branch divestiture and probable loan sale are presented at the purchase discount and are classified within Level 2 of the valuation hierarchy. Loans held for sale December 31, 2011 include $35.1 million of loans that we expect to sell in a branch divestiture transaction and $10.7 million of loans which we expect to sell during 2012.
Assets and Liabilities Measured at Fair Value on a Recurring Basis Assets measured at fair value on a recurring basis are summarized below: There were no significant transfers between Level 1 and Level 2 during the periods presented.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. FAIR VALUE - (continued)
Between June 2002 and July 2006, we invested in four available-for-sale and one held-to-maturity investment grade tranches of trust preferred collateralized debt obligation (“CDO”) securities. The securities were issued and are referred to as Preferred Term Securities Limited (“PreTSL”). The underlying collateral for the PreTSL is unguaranteed pooled trust preferred securities issued by banks, insurance companies and REITs geographically dispersed across the United States. We hold five PreTSL securities, none of which are currently investment grade. Prior to September 30, 2008, we determined the fair value of the trust preferred securities using a valuation technique based on Level 2 inputs. The Level 2 inputs included estimates of the market value for each security provided through our investment broker.
Since late 2007, the markets for collateralized debt obligations and trust preferred securities have become increasingly inactive. The inactivity began in late 2007 when new issues of similar securities were discounted in order to complete the offering. Beginning in the second quarter of 2008, the purchase and sale activity of these securities substantially decreased as investors elected to hold the securities instead of selling them at substantially depressed prices. Our brokers have indicated that little if any activity is occurring in this sector and that the PreTSL securities trades that are taking place are primarily distressed sales where the seller must liquidate as a result of insolvency, redemptions or closure of a fund holding the security, or other distressed conditions. As a result, the bid-ask spreads have widened significantly and the volume of trades decreased significantly compared to historical volumes.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. FAIR VALUE - (continued) During 2008, we concluded that the market for the trust preferred securities that we hold and for similar CDO securities (such as higher-rated tranches within the same CDO security) was also not active. That determination was made considering that there are few observable transactions for the trust preferred securities or similar CDO securities and the observable prices for those transactions have varied substantially over time. Consequently, we have considered those observable inputs and determined that our trust preferred securities are classified within Level 3 of the fair value hierarchy.
We have determined that an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs is equally or more representative of fair value than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.
We received valuation estimates on our trust preferred securities for December 31, 2011. Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market. In accordance with current accounting guidance, we determined that a risk-adjusted discount rate appropriately reflects the reporting entity’s estimate of the assumptions that market participants would use in an active market to estimate the selling price of the asset at the measurement date.
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes.
The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended December 31, 2011 and 2010:
The table below summarizes changes in unrealized gains and losses recorded in earnings for the year ended December 31 for Level 3 assets and liabilities that are still held at December 31.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. FAIR VALUE - (continued) Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis Assets measured at fair value on a nonrecurring basis are summarized below:
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. FAIR VALUE - (continued)
Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $49.0 million and $96.3 million, with a valuation allowance of $3.7 million and $13.3 million, resulting in an additional provision for loan losses of $14.1 million and $6.5 million for the 2011 and 2010 periods respectively. Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisals and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the estimated cost to replace the current property after considering adjustments for depreciation. Values of the market comparison approach evaluate the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investors required return. The final value is a reconciliation of these three approaches and takes into consideration any other factors management deems relevant to arrive at a representative fair value.
Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Fair value adjustments of $9.3 million and $2.3 million were made to real estate owned during the periods ended December 31, 2011 and 2010 respectively.
Trust preferred securities which are held-to-maturity are valued using an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The income approach is equally or more representative of fair value
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. FAIR VALUE - (continued) than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.
We received valuation estimates on our trust preferred security for December 31, 2011. Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.
Fair Value of Financial Instruments The estimated fair value of financial instruments not previously presented is as follows:
The methods and assumptions used in estimating fair value disclosures for financial instruments are presented below:
Carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, accrued interest receivable and payable, demand deposits, short-term debt and variable rate loans or deposits that re-price frequently and fully. Held-to-maturity securities fair values are based on market prices or dealer quotes and if no such information is available, on the rate and term of the security and information about the issuer. The value of mortgage loans held for sale is based on the underlying sale commitments. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life. Fair values of advances from Federal Home Loan Bank and subordinated debentures are based on current rates for similar financing. The fair value of off-balance-sheet items is based on the current fees or cost that would be charged to enter into or terminate such arrangements and is not material. It is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. PREMISES AND EQUIPMENT Premises and equipment consist of the following:
Certain premises are leased under various operating leases. Rental expense was $679,000, $669,000 and $751,000, for the years ended December 31, 2011, 2010 and 2009, respectively. Future minimum commitments under these leases are:
8. GOODWILL AND INTANGIBLE ASSETS The change in the balance of goodwill is as follows.
Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value, which is determined through a two-step impairment test. Step 1 includes the determination of the carrying value of our single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. We determined the fair value of our reporting unit and compared it to its carrying amount. If the carrying amount of a reporting unit exceeds its fair value, we are required to perform a second step to the impairment test.
Our annual impairment analysis as of December 31, 2009, indicated that the Step 2 analysis was necessary. Step 2 of the goodwill impairment test is performed to measure the impairment loss. Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. After performing Step 2 it was determined that the implied value of goodwill was less than the carrying costs, resulting in an impairment charge of $11.9 million.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. GOODWILL AND INTANGIBLE ASSETS - (continued) Acquired intangible assets were as follows at year end:
All of the acquired intangible assets listed above will be fully amortized with the probable branch divesture.
Aggregate amortization expense was $370,000, 396,000 and $510,000 for 2011, 2010 and 2009.
Estimated amortization expense for each of the next five years:
9. DEPOSITS Time Deposits of $100,000 or more were $312.0 million and $347.3 million at December 31, 2011 and 2010, respectively. At December 31, 2011, scheduled maturities of time deposits are as follows:
Brokered deposits totaled $87.3 million and $90.3 million at year end 2011 and 2010. Brokered deposits that are scheduled to mature within the next twelve months are $30.1 million. Due to our agreement with bank regulatory agencies, we are not allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. ADVANCES FROM FEDERAL HOME LOAN BANK Advances from the FHLB at year-end are as follows:
Our convertible fixed rate advances are fixed for periods ranging from one to three years. At the end of the fixed rate term and quarterly thereafter, the FHLB has the right to convert these advances to variable rate advances tied to the three-month LIBOR index. Upon conversion, we can prepay the advances at no penalty. In January 2011, a $25 million convertible fixed rate advance with an interest rate of 5.05% matured and was paid in full. Advances from the FHLB are secured by our stock in the FHLB, certain securities and substantially all of our first mortgage loans. At December 31, 2011, we had $117 million in loans pledged under this arrangement and sufficient collateral available to borrow, approximately, an additional $15.4 million in advances from the FHLB.
The aggregate minimum annual repayments of borrowings as of December 31, 2011 are as follows:
11. SUBORDINATED DEBENTURES In 2008, an unconsolidated trust subsidiary of First Financial Service Corporation issued $8.0 million in trust preferred securities. The trust loaned the proceeds of the offering to us in exchange for junior subordinated deferrable interest debentures, which proceeds we used to finance the purchase of FSB Bancshares, Inc. The subordinated debentures, which mature on June 24, 2038, can be called at par in whole or in part on or after June 24, 2018. The subordinated debentures pay a fixed rate of 8% for thirty years. We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.
A different trust subsidiary issued 30 year cumulative trust preferred securities totaling $10 million at a 10 year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basis points. The subordinated debentures, which mature March 22, 2037, can be called at par in whole or in part on or after March 15, 2017. We have the option to defer interest payments on the subordinated debt from time to time for a period
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. SUBORDINATED DEBENTURES - (continued) not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.
Our trust subsidiaries loaned the proceeds of their offerings of trust preferred securities to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts (variable interest entity), therefore the trusts are not consolidated in our financial statements, but rather the subordinated debentures are shown as a liability. Our investment in the common stock of the trusts was $310,000.
On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes, together having an outstanding principal amount of $18 million, relating to outstanding trust preferred securities. We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of December 31, 2011, these accrued but unpaid interest payments totaled $1.7 million.
12. PREFERRED STOCK On January 9, 2009, we issued $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the United States Treasury under its Capital Purchase Program (“CPP”). The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares pay cumulative dividends quarterly at a rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after five years. The Senior Preferred Shares may be redeemed at any time, subject to prior regulatory approval. We also have the ability to defer dividend payments at any time, at our option.
We also issued a warrant to purchase 215,983 common shares to the U.S. Treasury at a purchase price of $13.89 per share. The aggregate purchase price equals 15% of the aggregate amount of the Senior Preferred Shares purchased by the U.S. Treasury, which was $3 million. The initial purchase price per share for the warrant and the number of common shares subject to the warrant were determined by reference to the market price of the common shares (calculated on a 20-day trailing average) on December 8, 2008, the date the U.S. Treasury approved our TARP application. The warrant has a term of 10 years and is potentially dilutive to earnings per share.
On October 29, 2010, we gave written notice to the U.S. Treasury that effective with the fourth quarter of 2010, we were suspending the payment of regular quarterly cash dividends on our Senior Preferred Shares. Under the CPP provisions, failure to pay dividends for six quarters would trigger the right of the holder of our Senior Preferred Shares to appoint representatives to our Board of Directors. The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes. As of December 31, 2011, these accrued but unpaid dividends totaled $1.4 million.
Participation in the CPP requires a participating institution to comply with a number of restrictions and provisions, including standards for executive compensation and corporate governance and limitations on share repurchases and the declaration and payment of dividends on common shares. The standard terms of the CPP require that a participating financial institution limit the payment of dividends to the most recent quarterly amount prior to October 14, 2008, which is $0.19 per share in our case. This dividend limitation will remain in effect until the earlier of three years or such time that the preferred shares are redeemed.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. PREFERRED STOCK - (continued) On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted. As required by ARRA, the U.S. Treasury has issued additional compensation standards on companies receiving financial assistance from the U.S. government. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on each CPP recipient, until the recipient has repaid the Treasury. ARRA also permits CPP participants to redeem the preferred shares held by the Treasury Department without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency.
13. INCOME TAXES We file a consolidated federal income tax return and income tax is apportioned among all companies based on their taxable income or loss. Provision for income taxes is as follows:
The provision for income taxes differs from the amount computed at the statutory rates as follows:
The calculation for the income tax provision or benefit generally does not consider the tax effects of changes in other comprehensive income, or OCI, which is a component of shareholders’ equity on the balance sheet. However, an exception is provided in certain circumstances, such as when there is a full valuation allowance against net deferred tax assets, there is a loss from continuing operations and income in other components of the financial statements. In such a case, pre-tax income from other categories, such as changes in OCI, must be considered in determining a tax benefit to be allocated to the loss from continuing operations. For the year ended December 31, 2011, this resulted in $3.1 million of income tax benefit allocated to continuing operations.
A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 13. INCOME TAXES - (continued) we did not meet our forecast levels in 2010 and 2011. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at December 31, 2011 and December 31, 2010.
Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant portions of deferred income taxes relate to the following:
At December 31, 2011, we had net operating carryforwards of $15 million which expire in 2031.
We file a consolidated U.S. federal income tax return and the Corporation files income tax returns in Kentucky, Indiana and Tennessee. The Bank is subject to federal income tax and state income tax in Indiana and Tennessee. These returns are subject to examination by taxing authorities for all years after 2007.
There were no unrecognized tax benefits at December 31, 2011 and we do not expect the total of unrecognized tax benefits to significantly increase in the next twelve months.
Federal income tax laws provided savings banks with additional bad debt deductions through 1987, totaling $9.3 million for us. Accounting standards do not require a deferred tax liability to be recorded on this amount, which would otherwise total $3.2 million at December 31, 2011 and 2010. If we were liquidated or otherwise ceased to be a bank or if tax laws were to change, the $3.2 million would be recorded as a liability with an offset to expense.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. STOCKHOLDERS’ EQUITY
(a) Regulatory Capital Requirements - The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.
Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined).
As part of an informal regulatory agreement with the FDIC and KDFI, the Bank was required to maintain a Tier 1 leverage ratio of 8%. At December 31, 2010, we were not in compliance with the Tier 1 capital requirement. Due to the losses we incurred in recent quarters, our elevated levels of non-performing loans and other real estate, and the ongoing economic stress in Jefferson and Oldham Counties, Kentucky, the FDIC, KDFI and the Bank entered into the Consent Order referred to in Note 2. The Consent Order resulted in the Bank being categorized as a “troubled institution” by bank regulators, which by definition does not permit the Bank to be considered “well-capitalized”.
On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the January 2011 Consent Order by June 30, 2012. See Note 2 for additional information.
Our actual and required capital amounts and ratios are presented below.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. STOCKHOLDERS’ EQUITY - (continued)
In its Consent Order the Bank agreed to achieve and maintain the capital ratios set forth in the following table by June 30, 2011. We were not in compliance with the Tier I and total risk-based capital requirements at December 31, 2011.
The new Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the table above by June 30, 2012.
We have signed a definitive agreement to sell our four Indiana banking centers to First Savings Bank, F.S.B. The transaction is expected to increase our Tier I capital ratio by approximately 88 basis points and increase our total risk-based capital ratio by approximately 114 basis points. The sale is expected to close early in the third quarter of 2012. See Note 2 for additional information.
(b) Dividend Restrictions - Our principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above. The Bank currently has a regulatory agreement with the FDIC and KDFI that 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. The Corporation has also entered into an agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends. We may not redeem shares or obtain additional borrowings without prior approval.
(c) Liquidation Account - In connection with our conversion from mutual to stock form of ownership during 1987, we established a “liquidation account”, currently in the amount of $566,000 for the purpose of granting to eligible deposit account holders a priority in the event of future liquidation. Only in such
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. STOCKHOLDERS’ EQUITY - (continued)
an event, an eligible account holder who continues to maintain a deposit account will be entitled to receive a distribution from the liquidation account. The total amount of the liquidation account decreases in an amount proportionately corresponding to decreases in the deposit account balances of the eligible account holders.
(d) Capital Purchase Program - On January 9, 2009, we sold $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the U.S. Treasury under the terms of its Capital Purchase Plan. The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares pay cumulative dividends at a rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after five years. The Senior Preferred Shares may be redeemed at any time, subject to prior regulatory approval. See Note 12 for additional information.
15. EARNINGS (LOSS) PER SHARE The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:
Stock options for 363,240, 296,521 and 279,706 shares of common stock were not included in the December 31, 2011, 2010 and 2009 computations of diluted earnings per share because their impact was anti-dilutive. The common stock warrant for 215,983 shares was not included in the 2011, 2010 and 2009 computations of diluted earnings per share because its impact was also anti-dilutive.
16. EMPLOYEE BENEFIT PLANS
(a) Pension Plan - We are a participant in the Pentegra Defined Benefit Plan for Financial Institutions (“The Pentegra DB Plan”), which is a tax-qualified, multi-employer defined benefit pension plan, covering employees hired before June 1, 2002. Because the plan was curtailed, employees hired on or after that date are not eligible for membership in the fund. Eligible employees are 100% vested at the completion of five years of participation in the plan. Our policy is to contribute annually the minimum funding amounts. The Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan Number is 333.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. EMPLOYEE BENEFIT PLANS - (continued) The Pentegra DB Plan is a single plan under Internal Revenue Code Section 413(c) and, as a result, all of the assets stand behind all of the liabilities. Accordingly, under the Pentegra DB Plan, contributions made by a participating employer may be used to provide benefits to participants of other participating employers. Total contributions received by the Pentegra DB Plan, as reported on Form 5500, for the plan years ending June 30, 2010 and 2009 totaled $203.6 million and $133.9 million, respectively.
Employer contributions and administrative expenses charged to operations for the years ended December 31, 2011, 2010 and 2009 totaled $404,000,$1,000, and $233,000, respectively. Accrued liabilities associated with the plan as of December 31, 2011 and 2010 were $221,000 and $324,000, respectively. Our contribution for 2011, 2010 and 2009 was not more than 5% of the total contributions made to the Pentegra DB Plan. There are no collective bargaining agreements in place that require contributions to the plan. The funded status of our plan as of July 1, 2011 and 2010 was 88% and 89% respectively.
(b) KSOP - We have a combined 401(k)/Employee Stock Ownership Plan. The plan is available to all employees meeting certain eligibility requirements. The plan allows employee contributions up to 50% of their compensation up to the annual dollar limit set by the IRS. The employer matches 100% of the employee contributions up to 4% of the employee’s compensation. Employees are 100% vested in matching contributions upon meeting the eligibility requirements of the plan. Shares of our common stock are acquired in non-leveraged transactions. At the time of purchase, the shares are released and allocated to eligible employees determined by a formula specified in the plan agreement. Accordingly, the plan has no unallocated shares. The number of shares to be purchased and allocated is at the Board of Directors discretion. In an effort to reduce costs, we have suspended the annual employee stock ownership contribution. Employer matching contributions and administrative expenses charged to operations for the plan for the years ended December 31, 2011, 2010 and 2009 were $513,000, $540,000, and $552,000, respectively.
Shares in the plan and the fair value of shares released during the year charged to compensation expense were as follows:
(c) Stock Based Compensation Plan - Our 2006 Stock Option and Incentive Compensation Plan, which is shareholder approved, succeeded our 1998 Stock Option and Incentive Compensation Plan. Under the 2006 Plan, we may grant restricted stock and incentive or non-qualified stock options to key employees and directors for a total of 647,350 shares of our common stock. Options available for future grant under the 1998 Plan totaled 38,500 shares and were rolled into the 2006 Plan. We believe that the ability to award stock options and other forms of stock-based incentive compensation can assist us in attracting and retaining key employees. Stock-based incentive compensation is also a means to align the interests of key employees with those of our shareholders by providing awards intended to reward recipients for our long-term growth. The option to purchase shares vest over periods of one to five years and expire ten years after the date of grant. We issue new shares of common stock upon the exercise of stock options. If options or awards granted under the 2006 Plan expire or terminate for any reason without having been exercised in full or released from restriction, the corresponding shares shall again be available for option or award for the purposes of the Plan. At December 31, 2011, options and restricted stock available for future grant under the 2006 Plan totaled 363,840.
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. EMPLOYEE BENEFIT PLANS - (continued) Compensation cost related to options and restricted stock granted under the 1998 and 2006 Plans that was charged against earnings for the years ended December 31, 2011, 2010 and 2009was $186,000, $100,000 and $103,000, respectively. As of December 31, 2011 there was $318,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 1998 and 2006 Plans. That cost is expected to be recognized over a weighted-average period of 2.9 years.
Stock Options - The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various weighted-average assumptions. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on the fluctuation in the price of a share of stock over the period for which the option is being valued and the expected life of the options granted represents the period of time the options are expected to be outstanding.
The weighted-average assumptions for options granted during the years ended December 31, 2011, 2010 and 2009 and the resulting estimated weighted average fair value per share is presented below.
A summary of option activity under the 1998 and 2006 Plans for the year ended December 31, 2011 is presented below:
The total intrinsic value of options exercised during the period ended December 31, 2009 was $119,000. There were no options exercised, modified or settled in cash during the 2011 and 2010 periods. There was no tax benefit recognized from the option exercises as they are considered incentive stock options. Management expects all outstanding unvested options will vest. Cash received from option exercises for the periods ended December 31, 2011, 2010 and 2009 was $0, $0 and $101,000 respectively.
Restricted Stock - In addition to stock options, on December 31, 2010, we granted 36,855 shares of restricted common stock at the weighted average current market price of $4.07. No restricted stock had been granted prior to December 31, 2010. Restricted stock provides the grantee with voting, dividend and anti-dilution rights equivalent to common shareholders. The restricted stock vests on December 31, 2012,
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. EMPLOYEE BENEFIT PLANS - (continued) provided that the recipient has continued to perform substantial services for the Company through that date. The restricted stock will become 100% vested before the vesting date upon the recipient’s death or disability or a change of control event as defined by federal regulations. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date of vesting. The recipient may not transfer, pledge or dispose of the restricted stock before the date of vesting, and thereafter only in proportion to percentage of the preferred shares originally issued to the U.S. Treasury that have been redeemed. As of December 31, 2011 there was $75,000 of total unrecognized compensation cost related to the restricted stock. That cost is expected to be recognized over the remaining vesting period of 1.0 years.
(d) Employee Stock Purchase Plan - We maintain an Employee Stock Purchase Plan whereby eligible employees have the option to purchase common stock of the Corporation through payroll deduction at a 10% discount. The purchase price of the shares under the plan will be 90% of the closing price of the common stock at the date of purchase. The plan provides for the purchase of up to 100,000 shares of common stock, which may be obtained by purchases issued from a reserve. Funding for the purchase of common stock is from employee contributions. Total compensation cost charged against earnings for the Plan for the periods ended December 31, 2011, 2010 and 2009 totaled $6,000, $9,000 and $12,000, respectively.
17. CASH FLOW ACTIVITIES The following information is presented as supplemental disclosures to the statement of cash flows.
(a) Cash Paid for:
(b) Supplemental disclosure of non-cash activities:
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 18. CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) The following condensed statements summarize the balance sheets, operating results and cash flows of First Financial Service Corporation (Parent Company only).
Condensed Balance Sheets
Condensed Statements of Income/(Loss)
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 18. CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY) - (continued) Condensed Statements of Cash Flows
19. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit, and lines and letters of credit, and involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of these instruments reflect the extent of our involvement in particular classes of financial instruments.
Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual notional amount of those instruments. Creditworthiness for all instruments is evaluated on a case-by-case basis in accordance with our credit policies. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Collateral from the customer may be required based on management’s credit
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 19. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK - (continued) evaluation of the customer and may include business assets of commercial customers as well as personal property and real estate of individual customers or guarantors.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The contractual amounts of financial instruments with off-balance-sheet risk at year end were as follows:
At December 31, 2011 and 2010, we had $121.9 million, and $100.7 million in letters of credit from the Federal Home Loan Bank issued to collateralize public deposits. These letters of credit are secured by a blanket pledge of eligible one-to-four family residential mortgage loans. (For additional information see Note 4 on Loans and Note 10 on Advances from the Federal Home Loan Bank.)
20. RELATED PARTY TRANSACTIONS Certain directors, executive officers and principal shareholders of the Company, including associates of such persons, are our loan and deposit customers. Related party deposits at December 31, 2011 and 2010 were $2.4 million and $3.3 million. A summary of the related party loan activity, for loans aggregating $60,000 or more to any one related party, is as follows:
FIRST FINANCIAL SERVICE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 21. SUMMARY OF QUARTERLY FINANCIAL DATA - (Unaudited)
Contributing to the increase in the net loss attributable to common shareholders for 2011 was a decrease in net interest income, an increase in provision for loan losses, increased write downs taken on real estate acquired through foreclosure, higher FDIC insurance premiums and a higher level of non-interest expense. The increase in the net loss attributable to common shareholders during the second and third quarters of 2011 was primarily due to the addition of specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. The higher provision was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the higher level of charge-offs and the general credit quality trend.
The net loss attributable to common shareholders for the fourth quarter of 2010 included a valuation allowance recorded against deferred tax assets of $4.8 million.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of December 31, 2011, an evaluation was performed under the supervision and with the participation of management, including the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, for the reasons described below, management and the Risk Management Committee of our Board of Directors determined that our internal controls were not effective.
Management is responsible for establishing and maintaining adequate internal controls over financial reporting that are designed to produce reliable financial statements in accordance with accounting principles generally accepted in the United States. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
We assessed our system of internal control over financial reporting as of December 31, 2011, in relation to criteria for effective internal control over financial reporting as described in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, we believe that, as of December 31, 2011, our system of internal control over financial reporting was not operating effectively. The Public Accounting Oversight Board’s Auditing Standard No. 5 has defined a material weakness as “a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.”
During our December 31, 2011 review of the allowance for loan loss the following controls were found to not be operating appropriately:
• Review over internal evaluations for impaired loans
• Review of the mathematical accuracy of impaired loan calculations
• Review of present value cash flow analysis performed on troubled debt restructuring calculations.
To remediate this material weakness described above and enhance our internal controls over financial reporting, management initiated the following significant changes during the first quarter of 2012:
The enhanced procedures included:
• An independent review was performed and documented by the Chief Credit Officer on all internal evaluations; and
• An independent review was performed and documented by the finance department to validate the accuracy of the calculation on all impaired loans and to validate the accuracy of all present value cash flow calculations performed on loans classified as troubled debt restructurings.
Notwithstanding the evaluation and initiation of these remediation actions, the identified material weakness in our internal controls over financial reporting will not be considered remediated until the new controls are fully implemented, in operation for a sufficient period of time, tested and concluded by management to be operating effectively.
In our December 31, 2010 financial statements, we noted a material weakness related to subsequent event reporting and the evaluation of subsequent events in our financial statements.
To remediate the material weakness described above and enhance our internal controls over financial reporting, management initiated the following changes during the second half of 2011:
• Reviewing on a weekly basis any classified and/or collateral dependent loans as well as other real estate owned properties for new and updated appraisals, changes in market conditions and the status of the borrowers and/or guarantors by the executive loan committee; and
• Establishing a tracking system to be shared with the finance department, loan officers and special assets officers showing property name, loan/asset number, and the date the appraisals were ordered, received and reviewed, and what, if any, change in valuation occurred.
During the second quarter, we took steps to resolve the material weakness by changing our procedures for handling appraisals, as discussed above. There were no other changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The new Consent Order requires the Bank to achieve the minimum capital ratios set forth in the table above by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. The new Consent Order requires the Bank to continue to adhere to the plans implemented in response to the January 2011 Consent Order, and includes the substantive provisions of the January 2011 Consent Order. See “Item 1 Business - Regulatory Matters and Recent Developments.” A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to this Annual Report on Form 10-K.
On March 13, 2012, we filed articles of amendment to the articles of incorporation of First Financial Service Corporation that increases the number of shares of common stock authorized for issuance from 10 million to 35 million shares. The amendment filing formally implements the proposal to increase the number of authorized shares that was approved at a special meeting of our shareholders on November 17, 2010, and described in our Current Report on Form 8-K filed on November 19, 2010.
PART III ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information contained under the sections captioned “Proposal I - Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive proxy statement for the 2012 Annual Meeting of Shareholders (the “Proxy Statement”) is incorporated herein by reference.
Code of Ethics
You may obtain copies of First Financial Service Corporation’s code of ethics free of charge by contacting Janelle Poppe, Corporate Secretary-Treasurer, First Federal Savings Bank, 2323 Ring Road, Elizabethtown, Kentucky 42701 (telephone) 270-765-2131.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION The information contained under the sections captioned “Executive Compensation” in the Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
(a) Security Ownership of Certain Beneficial Owners
Information required by this item is incorporated herein by reference to the section captioned “Voting Securities and Principal Holders Thereof” in the Proxy Statement.
(b) Security Ownership of Management
Information required by this item is incorporated herein by reference to the sections captioned “Proposal I - Election of Directors” and “Voting Securities and Principal Holders Thereof” in the Proxy Statement.
(c) Changes in Control
We know of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change of control of the Company.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated herein by reference to the section captioned “Transactions with the Corporation and the Bank” in the Proxy Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item is incorporated by reference to the section captioned “Independent Public Accountants” in the Proxy Statement.
PART IV ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
1. Financial Statements Filed
(a)(1) Report of Independent Registered Public Accounting Firm - Crowe Horwath, LLP
(b) Consolidated Statements of Operations for the years ended December 31, 2011 and 2010.
(c) Consolidated Statements of Operations for the years ended December 31, 2011, 2010 and 2009.
(d) Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2011, 2010 and 2009.
(e) Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2011, 2010 and 2009.
(f) Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010 and 2009.
(g) Notes to Consolidated Financial Statements.
2. Financial Statements Schedules
All financial statement schedules have been omitted, as the required information is either inapplicable or included in the financial statements or related notes.
3. Exhibits
* Incorporated by reference to Form 10-Q filed August 9, 2004.
** Incorporated by reference to Form 10-K dated March 15, 2005.
*** Incorporated by reference to Form 8-K dated April 15, 2003.
**** Incorporated by reference to Exhibit 10 to Form S-8 Registration Statement (No. 333-142415) filed April 27, 2007.
 Incorporated by reference to Form 8-K dated January 12, 2009
 Incorporated by reference to Form 8-K dated January 27, 2011
SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST FINANCIAL SERVICE CORPORATION
March 30, 2012
By:
/s/ Gregory S. Schreacke
Gregory S. Schreacke
President
Duly Authorized Representative
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated.
INDEX TO EXHIBITS
* Incorporated by reference to Form 10-Q filed August 9, 2004.
** Incorporated by reference to Form 10-K dated March 15, 2005.
*** Incorporated by reference to Form 8-K dated April 15, 2003.
**** Incorporated by reference to Exhibit 10 to Form S-8 Registration Statement (No. 333-142415) filed April 27, 2007.
 Incorporated by reference to Form 8-K dated January 12, 2009
 Incorporated by reference to Form 8-K dated January 27, 2011