General

First Defiance Financial Corp. ("First Defiance" or "the Company") is a unitary thrift holding company that 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 ASC Topic 320.

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 $1,697,000 at September 30, 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 $127.0 million at September 30, 2009. The available-for-sale portfolio consists of obligations of U.S. Government corporations and agencies ($13.4 million), certain municipal obligations ($45.1 million), CMOs and REMICs ($34.5 million), mortgage backed securities ($32.0 million) and trust preferred stock ($2.0 million).

In accordance with ASC Topic 320, 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.

In order to properly assess the collateral dependent loans included in its loan portfolio, the Company has established policies regarding the monitoring of the collateral underlying such loans. The Company requires an appraisal that is less than one year old for all new collateral dependent real estate loans, and all renewed collateral dependent real estate loans where new money is extended. The appraisal process is handled by the Credit Department, which selects the appraiser and orders the appraisal. First Defiance's loan policy prohibits the account officer from talking or communicating with the appraiser to insure that the appraiser is not influenced by the account officer in any way in making their determination of value.

First Federal generally does not require updated appraisals for performing loans unless new money is requested by the borrower.

When a collateral dependent loan is downgraded to classified status, First Federal reviews the most current appraisal on file and if necessary, based on First Federal's assessment of the appraisal, such as age, market, etc, First Federal will discount this amount to a more appropriate current value based on inputs from lenders and realtors. This amount may then be discounted further by First Federal's estimation of the carrying and selling costs. Finally, First Federal assesses whether there is any collateral short fall, considering guarantor support, and determines if a reserve is necessary.

When a collateral dependent loan moves to non-performing status, First Federal generally gets a new third party appraisal and adjusts the reserve as necessary based upon the new appraisal and an estimate of costs to liquidate the collateral. All properties that are moved into the Other Real Estate Owned "OREO") category are supported by current appraisals, and the OREO is carried at the appraised value less First Federal's estimate of the liquidation costs.

First Federal does not adjust any appraisals upward without written documentation of this valuation change from the appraiser. When setting reserves on classified loans, appraisal values may be discounted downward based upon First Federal's experience with liquidating similar properties.

All collateral dependent loans over 90 days past due and or on non-accrual as well as all Troubled Debt Restructured collateral dependent loans are classified as non-performing loans. Non-performing status automatically occurs in the month in which the 90 day delinquency occurs. For Troubled Debt Restructured collateral dependent loans, the loans are put into non-performing status in the month in which the restructure occurs.

As stated above, once a collateral dependent loan is identified as non-performing, First Federal generally gets an appraisal. Troubled Debt Restructure collateral dependent loans receive an appraisal as part of the restructure credit decision.

Appraisals are received within approximately 60 days after they are requested. The First Federal Loan Loss Reserve Committee reviews each new appraisal and makes any necessary adjustment to the reserve at its meeting prior to the end of each quarter.

Any partially charged-off collateral dependent loans are considered non-performing, and as such, would need to show an extended period of time with satisfactory payment performance as well as cash flow coverage capability supported by current financial statements before First Federal will consider an upgrade to performing status. If the loan maintains a rate at restructuring that is lower than the market rate for similar credits, the loan will remain classified as a Troubled Debt Restructuring until such time as it is paid off or restructured at prevailing rates and terms. First Federal may consider moving the loan to an accruing status after six months of satisfactory payment performance.

For loans where First Federal determines that an updated appraisal is not necessary, other means are used to verify the value of the real state, such as recent sales of similar properties on which First Federal had loans as well as calls to appraisers, brokers, realtors, and investors. First Federal monitors and tracks its reserves quarterly to determine accuracy. Based on these results, changes may occur in the processes used. The recent analysis indicates that First Federal is within its target range of the ultimate losses on liquidated loans being on average within 10% of the specific reserves established for these loans.

Loan modifications constitute a Troubled Debt Restructuring if First Federal for economic or legal reasons related to the borrower's financial difficulties grants a concession to the borrower that it would not otherwise consider. For loans that are considered Troubled Debt Restructurings, First Federal either computes the present value of expected future cash flows discounted at the original loan's effective interest rate or, as a practical expedient, we may measure impairment based on the observable market price of the loan or the fair value of the collateral even though Troubled Debt Restructurings are not expected to be deemed collateral dependent. The difference between the carrying value and fair value of the loan is recorded as a valuation allowance.

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, FHLB 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 September 30, 2009, First Defiance's total assets, deposits and stockholders' equity amounted to $2.02 billion, $1.54 billion and $234.5 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) remained flat at $1.59 billion at September 30, 2009 compared to December 31, 2008. The variances in loans receivable between December 31, 2008 and September 30, 2009 included decreases in residential real estate loans (down $17.8 million), home equity and improvement loans (down $10.7 million), construction loans (down $19.3 million), and consumer loans (down $4.6 million) while commercial loans increased $15.3 million and commercial real estate loans increased $46.7 million.

The investment securities portfolio increased $10.2 million to $128.7 million at September 30, 2009 from $118.5 million at December 31, 2008. The increase is the result of $33.0 million of securities being purchased during the first nine months of 2009 partially offset by $5.9 million of securities being matured or called in the period, principal pay downs of $12.2 million in CMOs and mortgage-backed securities, and $6.1 million of securities being sold. There was an unrealized gain in the investment portfolio of $1.9 million at September 30, 2009 compared to an unrealized loss of $1.7 million at December 31, 2008.

Deposits increased from $1.47 billion at December 31, 2008 to $1.54 billion as of September 30, 2009. Of the $73.2 million increase, interest-bearing demand deposits and money market accounts increased $103.1 million to $477.6 million and broker/national certificates of deposit increased $8.8 million to $47.3 million. These increases were slightly offset by a decline in retail time deposits of $37.0 million to $711.7 million and non-interest-bearing demand deposits decreased $1.9 million to $174.1 million. Savings accounts remained relatively flat at $132.3 million as of September 30, 2009 when compared to December 31, 2008.

FHLB advances decreased $9.1 million to $146.9 million at September 30, 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 part from the growth in deposits.

Stockholders' equity increased from $229.2 million at December 31, 2008 to $234.5 million at September 30, 2009. The increase is primarily the result of recording net income of $6.6 million and a $2.3 million unrealized gain on available-for-sale securities partially offset by $2.4 million of cash dividends declared on common stock and $1.4 million 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 investment on a tax-equivalent basis. All average balances are based upon daily balances.

                                                                 Three Months Ended September 30,
                                                         2009                                       2008
                                           Average                     Yield/         Average                     Yield/
                                           Balance      Interest(1)    Rate(2)        Balance      Interest(1)    Rate(2)
Interest-earning assets:
Loans receivable                         $ 1,613,529   $      23,812      5.85 %    $ 1,585,489   $      24,934      6.26 %
Securities                                   130,673           1,685      5.08          118,502           1,636      5.31
Interest-earning deposits                     60,822              41      0.27            2,231               5      0.89
FHLB stock and other                          21,376             258      4.79           21,121             301      5.67

Total interest-earning assets              1,826,400          25,796      5.60        1,727,343          26,876      6.18
Non-interest-earning assets                  203,570                                    201,644

Total assets                             $ 2,029,970                                $ 1,928,987


Interest-bearing liabilities:
Deposits                                 $ 1,374,441   $       6,163      1.78 %    $ 1,268,016   $       7,658      2.40 %
FHLB advances and other                      146,941           1,267      3.42          174,343           1,603      3.66
Subordinated debentures                       36,228             344      3.77           36,228             461      5.06
Notes payable                                 44,685             140      1.24           64,368             555      3.43

Total interest-bearing liabilities         1,602,295           7,914      1.96        1,542,955          10,277      2.65
Non-interest bearing deposits                175,928              -                     169,257              -

Total including non-interest bearing
demand deposits                            1,778,223           7,914      1.77        1,712,212          10,277      2.39
Other non-interest-bearing liabilities        17,506                                     22,323

Total liabilities                          1,795,729                                  1,734,535
Stockholders' equity                         234,241                                    194,452

Total liabilities and stock- holders'
equity                                   $ 2,029,970                                $ 1,928,987

Net interest income; interest rate
spread                                                 $      17,882      3.64 %                  $      16,599      3.53 %

Net interest margin (3)                                                   3.88 %                                     3.81 %

Average interest-earning assets to
average interest-bearing liabilities                                       114 %                                      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.

                                                                 Nine Months Ended September 30,
                                                         2009                                       2008
                                           Average                     Yield/         Average                     Yield/
                                           Balance      Interest(1)    Rate(2)        Balance      Interest(1)    Rate(2)
Interest-earning assets:
Loans receivable                         $ 1,600,878   $      70,333      5.87 %    $ 1,485,455   $      72,297      6.50 %
Securities                                   126,883           5,145      5.36          118,908           4,959      5.50
Interest-earning deposits                     63,093              89      0.19            6,311             119      2.52
FHLB stock and other                          21,376             726      4.54           20,199             797      5.27

Total interest-earning assets              1,812,230          76,293      5.61        1,630,873          78,172      6.40
Non-interest-earning assets                  202,008                                    193,324

Total assets                             $ 2,014,238                                $ 1,824,197

Interest-bearing liabilities:
Deposits                                 $ 1,366,645   $      20,206      1.98 %    $ 1,210,631   $      23,851      2.63 %
FHLB advances and other                      146,994           3,865      3.52          161,891           4,803      3.96
Subordinated debentures                       36,241           1,139      4.19           36,245           1,445      5.33
Notes payable                                 42,446             433      1.36           48,018           1,217      3.39

Total interest-bearing liabilities         1,592,326          25,643      2.15        1,456,785          31,316      2.87
Non-interest bearing deposits                172,341              -                     155,000              -

Total including non-interest bearing
demand deposits                            1,764,667          25,643      1.94        1,611,785          31,316      2.60
Other non-interest-bearing liabilities        17,659                                     25,082

Total liabilities                          1,782,326                                  1,636,867
Stockholders' equity                         231,912                                    187,330

Total liabilities and stock-holders'
equity                                   $ 2,014,238                                $ 1,824,197

Net interest income; interest rate
spread                                                 $      50,650      3.46 %                  $      46,856      3.53 %

Net interest margin (3)                                                   3.73 %                                     3.83 %

Average interest-earning assets to
average interest-bearing liabilities                                       114 %                                      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 September 30, 2009 and 2008

On a consolidated basis, First Defiance's net income for the quarter ended September 30, 2009 was $329,000 compared to income of $322,000 for the comparable period in 2008. Net income applicable to common shares was a loss of $(184,000) for the third quarter of 2009. On a per share basis, basic and diluted earnings per common share for the three months ended September 30, 2009 were both $(0.02), compared to basic and diluted earnings per common share of $0.04 for the quarter ended September 30, 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 76.0% of total revenue during the third 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 third 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 third 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 $17.6 million for the third quarter of 2009 compared to $16.4 million in the third quarter of 2008. For the third quarter of 2009, total interest income was $25.5 million, a $1.2 million decrease from the third quarter of 2008. The decline in total interest income is the result of the decline in loan yields from period to period.

Interest expense was $7.9 million for the third quarter of 2009 compared to $10.3 million in the third quarter of 2008. The majority of the decrease in interest expense occurred in interest-bearing deposits, where despite average balances increasing $106.4 million to $1.37 billion for the third quarter of 2009, the cost of that funding decreased 0.62% between the 2008 and 2009 third quarters, to 1.78% from 2.40%.

Net interest margin for the quarter ended September 30, 2009 was 3.88%, a 0.07% increase from the 2008 third quarter margin of 3.81%. The Company's interest rate spread increased as well to 3.64% in the 2009 third quarter compared to 3.53% 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. In this low rate environment, management's attention will be to focus on a disciplined pricing strategy to strengthen the net interest margin for the remainder of 2009.

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 in the normal course of business. The allowance for loan loss is made up of two basic components. The first component is the specific allowance in which the company sets aside reserves based on the analysis of individual credits. The . . .