Summary of FIRST DEFIANCE FINANCIAL CORP

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

General

First Defiance Financial Corp. ("First Defiance" or "the Company") is a unitary thrift holding company which conducts business through its two wholly owned subsidiaries, First Federal Bank of the Midwest ("First Federal") and First Insurance and Investments, Inc. ("First Insurance"). First Federal is a federally chartered savings bank that provides financial services through 35 full-service branches in communities based in northwest Ohio, northeast Indiana, and southeastern Michigan. On March 14, 2008, First Defiance completed the acquisition of Pavilion Bancorp, Inc. ("Pavilion"), which added eight banking centers in southeast Michigan, expanding the Company's reach to markets adjacent to its existing branch network. First Federal provides a broad range of financial services including checking accounts, savings accounts, certificates of deposit, real estate mortgage loans, commercial loans, consumer loans, home equity loans and trust services. First Insurance sells a variety of property and casualty, group health and life, and individual health and life insurance products and investment and annuity products. Insurance products are sold through First Insurance's offices in Defiance and Bowling Green, Ohio while investment and annuity products are sold through registered investment representatives located at certain First Federal banking center locations.

First Defiance invests in U.S. Treasury and federal government agency obligations, obligations of municipal and other political subdivisions, mortgage-backed securities which are issued by federal agencies, corporate bonds, and collateralized mortgage obligations ("CMOs") and real estate mortgage investment conduits ("REMICs"). Management determines the appropriate classification of all such securities at the time of purchase in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.

Securities are classified as held-to-maturity when First Defiance has the positive intent and ability to hold the security to maturity. Held-to-maturity securities are stated at amortized cost and had a recorded value of $853,000 at March 31, 2009. Securities not classified as held-to-maturity are classified as available-for-sale, which are stated at fair value and had a recorded value of $122.6 million at March 31, 2009. The available-for-sale portfolio consists of obligations of U.S. Government corporations and agencies ($18.6 million), certain municipal obligations ($42.0 million), CMOs and REMICs ($25.9 million), mortgage backed securities ($33.7 million) and preferred stock ($2.4 million).

In accordance with FSP SFAS 115-2 and SFAS 124-2, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income.

The profitability of First Defiance is primarily dependent on its net interest income and non-interest income. Net interest income is the difference between interest income on interest-earning assets, principally loans and securities, and interest expense on interest-bearing deposits, Federal Home Loan Bank advances, and other borrowings. The Company's non-interest income is mainly derived from service fees and other charges, mortgage banking income, and insurance commissions. First Defiance's earnings also depend on the provision

for loan losses and non-interest expenses, such as employee compensation and benefits, occupancy and equipment expense, deposit insurance premiums, and miscellaneous other expenses, as well as federal income tax expense.

Participation in the U.S. Treasury Capital Purchase Program

On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 ("EESA"), which creates the Troubled Asset Relief Program ("TARP") and provides the U.S. Secretary of the Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets. The Capital Purchase Program ("CPP") was announced by the U.S. Treasury on October 14, 2008 as part of TARP. Pursuant to the CPP, the U.S. Treasury will purchase up to $250 billion of senior preferred shares on standardized terms from qualifying financial institutions. The purpose of the CPP is to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy.

The CPP is voluntary and 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 $0.26 per share in the case of First Defiance. This dividend limitation will remain in effect until such time that the preferred shares are no longer outstanding.

Eligible financial institutions could generally apply to issue senior preferred shares to the U.S. Treasury in aggregate amounts between 1% to 3% of the institution's risk-weighted assets. In the case of First Defiance, an application was approved by the U.S. Treasury and on December 5, 2008, First Defiance issued $37.0 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share ("Senior Preferred Shares"). The Senior Preferred Shares constitute Tier 1 capital and rank senior to First Defiance's 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.

As part of its participation in the CPP, First Defiance also issued a warrant to the U.S. Treasury to purchase 550,595 common shares having an exercise price of $10.08 per share. The initial exercise price for the warrant and the market price for determining the number of common shares subject to the warrant was determined by reference to the market price of the common shares on the date of the investment by the U.S. treasury in the Senior Preferred Shares (calculated on a 20-day trailing average). The warrant has a term of 10 years.

Forward-Looking Information

Certain statements contained in this quarterly report are not historical facts, including but not limited to statements that can be identified by the use of forward-looking terminology such as "may", "will", "expect", "anticipate", or "continue" or the negative thereof or other variations thereon or comparable terminology are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21B of the Securities Act of 1934, as amended. Actual results could differ materially from those indicated in such statements due to risks, uncertainties and changes with respect to a variety of market and other factors.

Changes in Financial Condition

At March 31, 2009, First Defiance's total assets, deposits and stockholders' equity amounted to $2.01 billion, $1.54 billion and $230.6 million, respectively, compared to $1.96 billion, $1.47 billion and $229.2 million, respectively, at December 31, 2008.

Net loans receivable (excluding loans held for sale) decreased $32.4 million to $1.56 billion at March 31, 2009 compared to $1.59 billion at December 31, 2008. The decrease in loans receivable between December 31, 2008 and March 31, 2009 included decreases in commercial loans (down $6.5 million), one-to-four family residential real estate loans (down $10.7 million), home equity and improvement loans (down $4.4 million), construction loans (down $22.4 million), and consumer loans (down $2.3 million) while non-residential and multi-family loans increased $9.1 million.

The investment securities portfolio increased $5.0 million to $123.5 million at March 31, 2009 from $118.5 million at December 31, 2008. The increase is the result of $9.3 million of securities being purchased during the first three months of 2009 mostly offset by $350,000 of securities being matured or called in the period and principal pay downs of $3.0 million in CMOs and mortgage-backed securities. The unrealized loss in the investment portfolio increased $276,000 to $2.0 million at March 31, 2009 from $1.7 million at December 31, 2008.

Deposits increased from $1.47 billion at December 31, 2008 to $1.54 billion as of March 31, 2009. Of the $70.3 million increase, interest-bearing demand deposits and money market accounts increased $38.6 million to $413.1 million, retail time deposits increased $31.7 million to $780.4 million, savings accounts increased $444,000 to $132.6 million, and broker/national certificates of deposit increased $11.8 million to $50.3 million. These increases were slightly offset by a decline in non-interest bearing checking accounts of $12.2 million to $163.9 million.

The FHLB advances decreased $9.1 million to $147.0 million at March 31, 2009 from $156.1 million at December 31, 2008. The decrease is attributable to a $9.1 million decrease in overnight advances due in large from the growth in deposits.

Stockholders' equity increased from $229.2 million at December 31, 2008 to $230.6 million at March 31, 2009. The increase is primarily the result of recording net income of $3.4 million partially offset by $2.1 million of cash dividends declared on common stock and $463,000 of accrued dividends on preferred stock.

Average Balances, Net Interest Income and Yields Earned and Rates Paid

The following table presents for the periods indicated the total dollar amount of interest from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in thousands of dollars and rates, and the net interest margin. The table reports interest income from tax-exempt loans and investments on a tax-equivalent basis. All average balances are based upon daily balances.

                                                                 Three Months Ended March 31,
                                                        2009                                      2008
                                          Average                     Yield/        Average                     Yield/
                                          Balance      Interest(1)    Rate(2)       Balance      Interest(1)    Rate(2)
Interest-earning assets:
Loans receivable                        $ 1,596,592   $      23,405      5.95 %   $ 1,326,468   $      22,826      6.92 %
Securities                                  119,314           1,721      5.78         116,717           1,675      5.77
Interest-earning deposits                    44,737              14      0.13          14,087              99      2.83
FHLB stock and other                         21,376             239      4.53          18,610             243      5.25

Total interest-earning assets             1,782,019          25,379      5.77       1,475,882          24,843      6.77
Non-interest-earning assets                 202,966                                   169,554

Total assets                            $ 1,984,985                               $ 1,645,436


Interest-bearing liabilities:
Deposits                                $ 1,348,178   $       7,183      2.16 %   $ 1,111,711   $       8,670      3.14 %
FHLB advances and other                     147,091           1,319      3.64         146,520           1,655      4.54
Notes payable                                39,532             157      1.61          25,958             194      3.01
Subordinated debentures                      36,251             426      4.77          36,281             529      5.86

Total interest-bearing liabilities        1,571,052           9,085      2.35       1,320,470          11,048      3.37
Non-interest bearing deposits               165,881              -                    124,643              -

Total including non-interest bearing
demand deposits                           1,736,933           9,085      2.12       1,445,113          11,048      3.07
Other non-interest-bearing
liabilities                                  17,953                                    28,630

Total liabilities                         1,754,886                                 1,473,743
Stockholders' equity                        230,099                                   171,693

Total liabilities and stock- holders'
equity                                  $ 1,984,985                               $ 1,645,436

Net interest income; interest rate
spread                                                $      16,294      3.42 %                 $      13,795      3.40 %

Net interest margin (3)                                                  3.71 %                                    3.76 %

Average interest-earning assets to
average interest-bearing liabilities                                      113 %                                     112 %

(1) Interest on certain tax-exempt loans and securities is not taxable for Federal income tax purposes. In order to compare the tax-exempt yields on these assets to taxable yields, the interest earned on these assets is adjusted to a pre-tax equivalent amount based on the marginal corporate federal income tax rate of 35%.

(2) Annualized

(3) Net interest margin is net interest income divided by average interest-earning assets.

Results of Operations

Three Months Ended March 31, 2009 and 2008

On a consolidated basis, First Defiance's net income for the quarter ended March 31, 2009 was $3.41 million compared to income of $3.42 million for the comparable period in 2008. Net income applicable to common shares was $2.91 million for the first quarter of 2009. On a per share basis, basic and diluted earnings per common share for the three months ended March 31, 2009 were both $0.36, compared to basic and diluted earnings per common share of $0.48 and $0.47, respectively, for the quarter ended March 31, 2008.

Net Interest Income.

The Company's net interest income is determined by its interest rate spread (i.e. the difference between the yields on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income is the Company's largest source of revenue, representing 70.2% of total revenue during the first quarter of 2009. Net interest margin is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.

The Federal Reserve Board influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The federal funds rate, which is the cost of immediately overnight funds and established by the Federal Reserve Board's Open Market Committee, began 2008 at 4.25% and decreased 200 basis points in the first quarter, 25 basis points in the second quarter and 175 basis points in the fourth quarter to end the year at 0.25%. During the first quarter of 2009, the federal funds rate did not change ending the quarter at 0.25%. The federal funds rate drives the Company's prime rate, which is used to price a substantial balance of loans in the commercial and home equity portfolios. The prime interest rate began 2008 at 7.25% and decreased 200 basis points in the first quarter, 25 basis points in the second quarter and 175 basis points in the fourth quarter to end the year at 3.25%. During the first quarter of 2009, the prime interest rate did not change ending the quarter at 3.25%. First Defiance effectively managed the impact of the change in the prime rate by reducing its deposit rates and by changing the mix of its interest-bearing liabilities.

Net interest income was $16.0 million for the first quarter of 2009 compared to $13.6 million in the first quarter of 2008. For the first quarter of 2009, total interest income was $25.1 million, a $483,000 increase over the first quarter of 2008. The 2008 results only included seventeen days of the Pavilion acquisition as this acquisition closed on March 14, 2008.

Interest expense was $9.1 million for the first quarter of 2009 compared to $11.0 million in the first quarter of 2008. The majority of the decrease in interest expense occurred in interest-bearing deposits, where despite average balances increasing $236.5 million to $1.35 billion for the first quarter of 2009, the cost of that funding decreased 0.98% between the 2008 and 2009 first quarters, to 2.16% from 3.14%. The decrease in interest expense was also impacted by the aforementioned closing of the Pavilion acquisition.

Net interest margin for the quarter ended March 31, 2009 was 3.71%, a 0.05% decline from the 2008 first quarter margin of 3.76%. The Company's interest rate spread improved to 3.42% in the 2009 first quarter compared to 3.40% in the same 2008 quarterly period. The net interest spread, as well as the net interest margin, will be impacted by future changes in short-term and long-term interest rate levels, as well as the impact from the competitive environment.

Provision for Loan Losses.

The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management's best estimate, is necessary to absorb probable credit losses within the existing loan portfolio. The provision for loan losses was $2.7 million in the first quarter of 2009 compared to $1.1 million for the first quarter of 2008. The period over period increase was primarily due to the deterioration of a number of large credits in the commercial portfolio as well as increases in reserves on loans with existing reserves based on declining collateral values. Charge-offs for the first quarter of 2009 were $1.8 million and recoveries of previously charged off loans totaled $128,000 for net charge-offs of $1.6 million. By comparison, $620,000 of charge-offs were recorded in the 2008 first quarter and $129,000 of recoveries were realized for net charge-offs of $491,000. As a percentage of average loans, annualized net charge-offs were 0.41% for the first quarter of 2009 compared to 0.15% in the same period in 2008.

Non-performing assets, which include non-accrual loans, accruing restructured loans and real estate owned, increased to $44.5 million at March 31, 2009 from $17.7 million at March 31, 2008 and from $41.3 million at December 31, 2008. Non-performing assets and asset quality ratios for First Defiance were as follows at March 31, 2009 and December 31, 2008:

                                                           March 31,         December 31,
                                                             2009                2008
                                                                   (in thousands)
Non-accrual loans                                         $    29,473       $       28,017
Restructured loans, accruing                                    7,199                6,250

Total non-performing loans                                $    36,672       $       34,267
Real estate owned (REO)                                         7,839                7,000

Total non-performing assets                               $    44,511       $       41,267


Allowance for loans losses as a percentage of total
loans                                                            1.62 %               1.52 %
Allowance for loan losses as a percentage of
non-performing assets                                           57.73 %              59.59 %
Allowance for loan losses as a percentage of
non-performing loans                                            70.06 %              71.77 %
Total non-performing assets as a percentage of total
assets                                                           2.21 %               2.11 %
Total non-performing loans as a percentage of total
loans                                                            2.28 %               2.10 %

Of the $29.5 million in non-accrual loans, $6.3 million were 1-4 family residential loans, $22.5 million were commercial or commercial real estate loans and $0.7 million were home equity or consumer loans.

First Federal Bank's Asset Review Committee meets monthly to review the status of work-out strategies for all criticized relationships, which include all non-accrual loans. Based on such factors as anticipated collateral values in liquidation scenarios, cash flow projections, assessment of net worth of guarantors and all other factors which may mitigate risk of loss, the Asset Review Committee makes recommendations regarding required allowances and proposed charge-offs which are approved by the Senior Loan Committee (in the case of charge-offs) or the Loan Loss Reserve Committee (in the case of specific allowances). At March 31, 2009 the specific allowance for loan losses recorded against the $22.5 million of non-accrual commercial and commercial real estate loans totaled $5.54 million. In management's opinion, the allowance for loan losses is appropriate. The allowance for loan losses at March 31, 2009 was $25.7 million compared to $24.6 million at December 31, 2008.

Non-Interest Income.

Total non-interest income increased to $6.8 million in the first quarter of 2009, compared with $6.0 million in the same period in 2008. Non-interest income was impacted by the Pavilion results which were included in the last 17 of the 91 day quarter in 2008.

Service Fees. Service fees and other charges increased by $463,000 or 17.6% in the 2009 first quarter compared to the same period in 2008. The increase was primarily related to fees earned on debit cards and NSF's mainly due to the aforementioned Pavilion acquisition only impacting 17 days of the first quarter of 2008.

First Defiance's overdraft privilege program generally provides for the automatic payment of modest overdraft limits on all accounts deemed to be in good standing when the account is accessed using paper-based check processing, a teller withdrawal, a point-of-sale terminal, an ACH transaction, or an ATM. To be in good standing, an account must be brought to a positive balance within a 30-day period. Overdraft limits are established for all customers without discrimination using a risk assessment approach for each account classification. The approach includes a systematic review and evaluation of the normal deposit flows made to each account classification to establish reasonable and prudent negative balance limits that would be routinely repaid by normal, expected and reoccurring deposits. The risk assessment by portfolio approach assumes a minimal degree of undetermined credit risk associated with unidentified individual accounts that are overdrawn for 30 or more days. Accounts overdrawn for more than 60 days are automatically charged off. Fees are charged as a one-time fee per occurrence and the fee charged for an item that is paid is equal to the fee charged for a non-sufficient fund item that is returned.

Overdrawn balances, net of allowance for losses, are reflected as loans on First Defiance's balance sheet. The fees charged for this service are established based both on the return of processing costs plus a profit, and on the level of fees charged by competitors in the Company's market area for similar services. These fees are considered to be compensation for providing a service to the customer and therefore are deemed to be non-interest income rather than interest income. Fee income related to the overdraft privilege product, net of adjustments to the allowance for uncollectible overdrafts, was $1.9 million for the quarter ended March 31, 2009 compared to $1.7 million for the same period of 2008.

Mortgage Banking Activity. Total revenue from the sale and servicing of mortgage loans increased $1.6 million to $2.7 million for the first quarter of 2009 compared to $1.1 million for the same period of 2008. Gains realized from the sale of mortgage loans more than doubled in the first quarter of 2009 to $2.8 million from $1.1 million in the first quarter of 2008. Mortgage loan servicing revenue increased by $224,000 or 48.2% in the first quarter of 2009 compared to the first quarter of 2008. The increases in gains and servicing revenue were partially offset by increases of $605,000 for the amortization of mortgage servicing rights. The Company had a positive valuation adjustment of $169,000 in the first quarter of 2009 compared to a write-down of $142,000 in the first quarter of 2008. The mortgage servicing rights valuation is a reflection of the slight increase in the fair value of certain sectors of the Company's portfolio of mortgage servicing rights. The interest rate environment that gives rise to increased mortgage origination activity also typically causes increases in mortgage servicing rights amortization and impairment, creating a natural hedge in the mortgage banking line of business.

Loss on Sale or Write-Down of Securities. Non-interest income also includes investment securities gains or losses. In the first quarter of 2009, First Defiance recognized other-than-temporary impairment ("OTTI") charges of $672,000 for certain impaired investment securities, where in management's opinion, the value of the investment will not be recovered. The OTTI charge related to seven Trust Preferred Collateralized Debt Obligation ("CDOs") investments, including charges of $418,600 on three CDO investments which resulted in the total write-off of those investments that had an original cost of $2.0 million. The remaining OTTI charges of $253,400 were recorded on four CDOs with a remaining book value of $2.4 million. In the first quarter of 2008, management recorded a $100,000 OTTI charge on its investment in the equity notes of two CDOs that have since been were written off and $19,000 in gains from the calls of several securities in the first quarter of 2008. OTTI was determined as a result of additional defaults and deferrals during the period.

Insurance and Investment Sales Commission. Insurance and investment sales commission income decreased $413,000, to $1.5 million in the first quarter of 2009, from $1.9 million during the first quarter of 2008. First Insurance typically recognizes contingent revenues in the first quarter. These revenues are bonuses paid by insurance carriers when the Company achieves certain loss ratios and growth targets. In the first quarter of 2009, First Insurance earned $431,000 of contingent income compared to $784,000 in the same period of 2008.

Non-Interest Expense.

Non-interest expense increased to $15.0 million for the first quarter of 2009 compared to $13.5 million for the same period in 2008. The 2008 first quarter amount includes $750,000 of non-recurring acquisition related charges.

Compensation and Benefits. Compensation and benefits increased to $7.4 million for the quarter ended March 31, 2009 from $7.1 million for the same period in 2008. The increase is mainly attributable to having a full quarter of expenses . . .