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FFKY > SEC Filings for FFKY > Form 10-Q on 13-Nov-2012All Recent SEC Filings

Show all filings for FIRST FINANCIAL SERVICE CORP

Form 10-Q for FIRST FINANCIAL SERVICE CORP


13-Nov-2012

Quarterly Report


MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

GENERAL

We operate 17 full-service banking centers in six contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area. 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. 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. In aggregate, our deposit market share is 23% in our central Kentucky markets outside of Louisville.

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.

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, costs associated with other real estate and provisions for loan losses.

The discussion and analysis section covers material changes in the financial condition since December 31, 2011 and material changes in the results of operations for the three and nine month periods ending September 30, 2012 as compared to 2011. It should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our Annual Report on Form 10-K for the period ended December 31, 2011.

OVERVIEW

Our performance for the first nine months of 2012 continued to be impacted by the unfavorable economic conditions that have persisted since 2007. A new management team is in place with the objective of restoring the institution to soundness and profitability. We have adjusted our policies, procedures and allocated additional resources to address credit quality and facilitate the structure and processes to diversify and strengthen our lending function. 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. Credit quality impacted our results during 2012 in the areas of write downs in asset values, resources allocated to the disposition of assets and loan workout activities, lost productivity, net interest income and reversals of tax benefits. We anticipate modest improvement in the net interest margin over the next several quarters once the branch sale is consummated and we continue to restructure the composition of the balance sheet. The increased level of liquidity is anticipated to remain elevated in the near term as loan balances continue to decline.

Our net loss attributable to common shareholders for the quarter ended September 30, 2012 was $1.0 million or $0.21 per diluted common share compared to net loss attributable to common shareholders of $7.7 million or $1.62 per diluted common share for the same period in 2011. Our net loss attributable to common shareholders for the nine month period ended September 30, 2012 was $6.0 million or $1.25 per diluted common share compared to a net loss of $22.2 million or $4.68 per diluted common share for the same period a year ago. The nine month 2012 results include a $14.5 million decrease in provision for loan losses, a gain of $3.1 million on the sale of our four Indiana banking centers, write downs and losses on other real estate owned of $5.2 million, $1.5 million in FHLB advance prepayment penalties, a $1.5 million termination fee paid that was related to the termination of a property investment and management agreement on a residential development, a net gain of $2.7 million on the sale of available for sale securities, gains of $1.2 million on the sale of real estate acquired through foreclosure, a gain of $175,000 on the sale of a lot held for development and a decrease of $795,000 in FDIC insurance premiums. The sale of securities is mainly a result of a combination of increasing our cash position as we prepare for the sale of the Louisville branches as well as our focus to restructure the composition of the balance sheet.

Although our level of non-performing assets remains elevated, we experienced our lowest level of non-performing assets since the second quarter of 2010. Compared to June 30, 2012, we saw a decline in non-performing loans of 17%, a decline in non-performing assets of 19% and a decline in classified and criticized assets of 5%. Compared to September 30, 2011, we saw a decline in non-performing loans of 38%, a decline in non-performing assets of 25% and a decline in classified and criticized assets of 23%. We sold forty other real estate owned properties totaling $11.0 million during the 2012 period. The net proceeds received from the sale of the majority of these properties exceeded the carrying value we had on the books, indicating an appropriate market value for these other real estate owned properties.

Our non-performing assets are largely comprised of residential housing development assets, building lots, an office building and strip centers most of which are located in Jefferson and Oldham Counties. Non-performing assets were $60.4 million or 5.92% of total assets at September 30, 2012 compared to $68.9 million or 5.61% of total assets at December 31, 2011. The decrease in non-performing assets is mainly attributable to a decrease in non-accrual loans of $6.1 million and a decrease in restructured non-accruing mortgage, commercial and commercial real estate loans of $1.9 million.

We believe that our level of real estate acquired through foreclosure has stabilized and we anticipate decreased levels over the next several quarters as we continue to sell these properties and the inflow has slowed down substantially when compared to 2010 and 2011. During 2011, we had substantially all of our non-performing assets appraised or reappraised, including our high end residential development loans and related other real estate owned and recorded substantial valuation adjustment and charge offs based on those appraisals. The lower values on the appraisals and reviews of properties appraised within the first nine months of 2012 resulted in $4.9 million in write downs on other real estate owned compared to $7.9 million in total write downs recorded during the first nine months of 2011. We believe that we have written down other real estate values to levels that will facilitate their liquidation as indicated by recent sales. We also believe we have appropriately addressed and risk-weighted real estate loans in our portfolio.

During the second quarter we entered into a bulk sale contract to sell fourteen other real estate owned properties with a carrying value of $16.1 million scheduled to close during the fourth quarter of 2012, indicating a continued interest in our other real estate owned properties. The net proceeds after sales expenses will be $15.0 million, resulting in a $1.1 million charge against these properties which was recorded in the quarter ended June 30, 2012. We incurred higher than usual commission and closing costs due to the size of the transaction. If sold on an individual basis, it is unlikely that we would have accepted a discount this large for these properties. However, if this transaction goes through under these terms, it would represent a 52% decrease to our other real estate owned properties balance of $28.6 million as of September 30, 2012. As with all sales contracts, completing the sale is subject to both parties meeting all of the terms and conditions of the contracts. In the event that the terms and conditions are not met, by either of the parties, it is possible that the contracts on these sales will be terminated.

The allowance to total loans (including loans held for sale and the related discounts allocated to those loans in a probable branch divestiture) was 3.19% at September 30, 2012 while net charge-offs totaled 71 basis points annualized for 2012, compared to 411 basis points for 2011. Excluding loans held for sale and related discounts, the allowance to total loans is approximately 3.38% at September 30, 2012. We attribute the decrease in net charge-offs for 2012 to our aggressive approach of charging off loans to their liquidation value in 2011 and the relative stabilization of collateral values in 2012 compared to 2011. Non-performing loans were $31.7 million or 5.53% of total loans (including loans held for sale in a probable branch divestiture) at September 30, 2012 compared to $39.8 million, or 5.39% of total loans for December 31, 2011. The allowance for loan losses to non-performing loans was 58% at September 30, 2012 compared to 28% at September 30, 2011. The increase in the coverage ratio for 2012 was due to an increase in the allowance for loan losses and a decrease in non-accrual loans and restructured loans on non-accrual for the period.

Net interest income was $20.2 million for the nine month 2012 period compared to $24.8 million for the same 2011 period, while the net interest margin was 2.53% for 2012 compared to 2.84% in 2011. The net interest margin continues to be compressed due to the level of non-performing assets, a decline in average loan balances outstanding, increased liquidity levels and assets being placed into lower yielding investments other than loans. We anticipate modest improvement to the net interest margin over the next several quarters as we will not need to carry high levels of liquidity after the impending branch sale and our focus on restructuring the balance sheet should result in a decrease to our cost of funds and an improvement to interest income. However, the levels of liquidity may be impacted by acceleration of loan repayments. As a result, we have hired a full time consultant to assist us in being proactive in our efforts to restructure the balance sheet.

Non-interest income increased $10.8 million for the nine months ended September 30, 2012, primarily driven by net gains on the sale of investments, a gain on the sale of our four Indiana branches, a decline in write-downs on other real estate owned properties and an increase in gains on the sale of other real estate owned properties. Non-interest expense increased $1.2 million for the 2012 nine month period compared to the 2011 nine month period. FDIC insurance premiums decreased $795,000 mainly due to the change in the FDIC's assessment base and rate structure that went into effect during the second quarter of 2011. The increase in real estate acquired through foreclosure expense was primarily due to a $1.5 million termination fee paid that was related to the termination of a property investment and management agreement on a residential development held in other real estate owned. We prepaid two convertible fixed rate advances during the 2012 third quarter which resulted in $1.5 million in FHLB advance prepayment penalties. We prepaid these advances to decrease our cost of funds and improve net interest income. Other expense increased due to legal and consulting fees arising from the branch sale completed during the third quarter of 2012 and the sale of our four Louisville banking centers.

In its 2012 Consent Order with the FDIC and KDFI, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. At September 30, 2012, 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 December 31, 2012.

The 2012 Consent Order requires that if the Bank should be unable to reach the required capital levels by June 30, 2012, and the Bank receives written directions from the FDIC and KDFI to do so, then the Bank would develop, adopt and implement within 30 days a written plan to sell or merge itself into another federally insured financial institution. The 2012 Consent Order requires the Bank to continue to adhere to the plans implemented in response to the 2011 Consent Order, and includes the substantive provisions of the 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

While the Bank still has not met the required capital ratios at September 30, 2012, we have not received any written communications from the FDIC or KDFI directing the Bank to develop, adopt and implement a written plan to sell or merge the Bank into another federally insured financial institution.

The Bank's Consent Orders with the FDIC and KDFI require 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 Bank is also no longer allowed to accept, renew or rollover brokered deposits, including deposits through the Certificate of Deposit Account Registry Service (CDARs) without first obtaining a written waiver from our regulators.

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 response to the 2011 Consent Order, we engaged an investment banking firm with expertise in the financial services sector to assist with a review of all of our strategic alternatives as we work to achieve the higher regulatory capital ratios.

One of these strategic alternatives involved the sale of eight branches located outside of our core market. Effective after the close of business on July 6, 2012, we have successfully executed the sale of four banking centers located in Corydon, Elizabeth, Lanesville and Georgetown, Indiana to First Savings Bank, F.S.B. We received a 3.65% premium on the $102.3 million of consumer and commercial deposits at closing. They assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received zero premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. The consummated transaction resulted in a gain of $3.1 million.

We entered into a Branch Purchase Agreement with First Security Bank of Owensboro, Inc., the banking subsidiary of First Security, Inc. ("First Security"), headquartered in Owensboro, Kentucky on May 15, 2012. The Agreement provides for the sale of our four banking centers in Louisville, Kentucky to First Security. Under the terms of the Agreement, First Security will assume approximately $188.2 million of deposit liabilities. First Security will pay a deposit premium of approximately $2.9 million comprised of a premium of 2.00% on approximately $152.1 million of deposits and a premium ranging from 0% to 1.00% on approximately $36.1 million of other deposits. First Security will also assume performing loans related to the four branches at a 1.00% discount. The loans being assumed totaled approximately $46.9 million at September 30, 2012. The sale is subject to First Security raising additional capital, regulatory approval and other customary closing conditions. The Agreement provides that it may be terminated by either party after October 31, 2012, unless a closing occurs before that date or the Agreement is extended by the parties. On October 31, 2012, it was agreed by both parties to extend the termination date of the Branch Purchase Agreement to November 14, 2012.

The sale of our four Louisville banking centers, is projected to increase our Tier I capital ratio from 6.50% to over 8.00% and increase our total risk-based capital ratio from 11.88% to over 13.00% based on September 30, 2012 financial information.

Additionally, we continue reducing our non-interest costs where possible to offset the increased credit costs associated with other real estate and non-performing loans while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen most executive management compensation the past three years including 2012, frozen most officer compensation for the past year including 2012, eliminated board of director fees, reduced marketing expenses, community donation expenses, compensation expense through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 were $1.1 million and were approximately $1.0 million for the 2012 nine month period. We are also in the process of evaluating the remaining terms on existing contracts in an effort to identify expenses that can be eliminated in the near future. These efforts will remain ongoing.

On February 10, and May 15, 2012, we announced several changes to our management and the board of directors. In addition, on September 19, 2012 we announced the election of Gregory Schreacke to the board of directors of both the Corporation and the Bank. His term will expire at the 2013 annual meeting of the Corporation's shareholders. Mr. Schreacke has served as President of the Corporation and the Bank since January 2008. He assumed principal management responsibility for the Corporation and the Bank effective February 10, 2012. We also announced the retirement of Senator Walter Dee Huddleston as a director of the Corporation and the Bank. Senator Huddleston has served on the board of directors of the Bank since 1966, and the board of directors of the Corporation since its inception in 1987, serving as Chairman from 1997 through February 2012. Senator Huddleston has been appointed as a Director Emeritus of the Corporation and the Bank.

Our plans for 2012 include the following:

Continuing to research and evaluate all available strategic options to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank. Strategic alternatives include divesting of branch offices, as noted earlier we have already sold four banking centers in the Indiana market and have a Branch Purchase Agreement to sell four banking centers in the Louisville market. During 2012, we also sold commercial real estate loans totaling $10.7 million, at par, to First Capital Bank of Kentucky.

Continuing 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. As of June 30, 2012 data, we rank in the top three in four of the five counties that we serve. This excludes the Indiana market where we no longer have a presence and the Louisville market in anticipation of the pending sale of those branch centers. We rank first in Hardin County and Meade County with market share of approximately 23% and 49%, respectively.

Continuing to reduce our lending concentration in commercial real estate through natural roll off and loan diversification initiatives. The mortgage and consumer lending operations continue to maintain strong credit quality metrics throughout the economic downturn. The diversification of the loan portfolio includes an increased emphasis on retail lending, small business lending, and Small Business Administration ("SBA") lending which should provide a boost to non-interest fee income. We have already allocated and reallocated resources that should contribute to the successful execution of all of these efforts.

Enhancing our resources dedicated to special asset dispositions both on a permanent and temporary basis. This is a necessary step as we increase our ongoing efforts to speed up the disposal of our problem assets. This will significantly reduce the involvement of our commercial lenders in the special asset area allowing them to shift their focus to their existing loan customer base and to generate new business that will support our diversification efforts while stemming off some of the loan roll off. The new lenders that have been hired this year bring a significant amount of experience in real estate and commercial and industrial lending.

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. 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 $18.3 million or 3.19% of total loans was our estimate of probable incurred losses within the loan portfolio as ofSeptember 30, 2012. Approximately $468,000 of this allowance is allocated to the loans held for sale in our branch divestiture transaction and is based upon the discount agreed to in that transaction. This estimate required us to record a provision for loan losses on the income statement of $4.6 million for the 2012 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 or 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.

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