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FFKY > SEC Filings for FFKY > Form 10-K on 27-Mar-2013All Recent SEC Filings

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Form 10-K for FIRST FINANCIAL SERVICE CORP


27-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'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

From 2008 to 2011, economic conditions deteriorated in the markets we serve, which has had a significant adverse impact on our business. As a result, our earnings declined due to higher levels of non-performing assets and loan losses, impairment charges on goodwill and real estate we acquired through foreclosure, and a charge to establish a valuation allowance against our deferred tax asset. As economic conditions improved and collateral values stabilized in 2012, our provision for loan losses for the year was much lower than in 2011. However, the effects of the economic downturn continue to impact us due to elevated non-performing assets and reduced net interest income in a continuing low interest rate environment. Low interest rates, coupled with a competitive lending environment, have proven challenging to our efforts to return to profitability. We expect that these challenges will continue until interest rates rise.

Net loss attributable to common shareholders for the period ended December 31, 2012 was $9.4 million or $1.98 per diluted common share compared to net loss attributable to common shareholders of $24.2 million or $5.11 per diluted common share for the same period in 2011. Factors contributing to the net loss for 2012 included the following:

declining net interest income driven by a decline in earning assets and interest bearing liabilities and impacted by the continuing low interest rate environment,

a $14.4 million decrease in provision for loans losses,

write downs and losses on other real estate owned ("OREO") totaling $6.1 million,

a gain of $3.1 million on the sale of our four Indiana banking centers,

a net gain of $2.3 million on the sale of securities available for sale, as we increased our cash position to prepare for the branch sale and restructured our balance sheet,

gains of $1.3 million on the sale of real estate acquired through foreclosure,

$1.5 million in penalties for prepaying advances from the Federal Home Loan Bank of Cincinnati (FHLB), which prepayment decreased our cost of funds and improved net interest income,

a $1.5 million fee paid to terminate a property investment and management agreement on a residential development held as OREO,

a decrease of $991,000 in FDIC insurance premiums, and

a gain of $175,000 on the sale of our last lot held for development.

While still elevated, our level of non-performing assets is now the lowest it has been since the second quarter of 2010. Compared to December 31, 2011, we saw a decline in non-performing loans of 46%, a decline in non-performing assets of 36% and a decline in classified and criticized assets of 33%. Compared to September 30, 2012, we saw a decline in non-performing loans of 32%, a decline in non-performing assets of 28% and a decline in classified and criticized assets of 17%. We sold fifty-two OREO properties totaling $16.0 million during the 2012 period. The net proceeds received from the sale of several of these properties exceeded the carrying value on our books, indicating they were appropriately valued.

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 $43.8 million or 4.35% of total assets at December 31, 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 $10.0 million decrease in non-accrual loans, an $8.3 million decrease in restructured non-accruing mortgage, commercial and commercial real estate loans, and a $6.8 million decrease in real estate acquired through foreclosure.

We believe that our level of real estate acquired through foreclosure has stabilized. We anticipate it will decrease over the next several quarters as we continue to sell these properties, while inflow has slowed down substantially 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 OREO, and recorded substantial valuation adjustments and charge offs based on those appraisals. The lower values on the appraisals and reviews of properties appraised within 2012 resulted in $5.1 million in write downs on OREO, including the $1.2 million bulk sale adjustment discussed below, compared to $9.3 million in total write downs recorded during 2011. We believe that we have written down OREO 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.

We have entered into a bulk sale contract to sell fourteen OREO properties with a carrying value of $12.0 million scheduled to close during the second quarter of 2013. The net proceeds after sales expenses will be $10.8 million, resulting in a $1.2 million charge against these properties of which $1.1 million 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 a property-by-property basis, it is unlikely that we would have accepted a discount this large. However, the proposed bulk sale presented an opportunity to reduce our OREO balance by 53% from $22.3 million recorded as of December 31, 2012. As with all sales contracts, completing the sale is subject to both parties meeting all of the contractual terms and conditions, and if closing conditions are not satisfied, the proposed sale could be terminated.

The allowance for loan losses to total loans was 3.29% at December 31, 2012 while net charge-offs totaled 1.06% of average loans for 2012 compared to 3.25% for 2011. 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 $21.5 million or 4.09% of total loans at December 31, 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 80% at December 31, 2012 compared to 44% at December 31, 2011. The increase in the coverage ratio for 2012 was due to a decrease in non-accrual loans and restructured loans on non-accrual for the period.

Net interest income was $26.4 million for the 2012 period compared to $32.8 million for the 2011 period, while the net interest margin was 2.55% for 2012 compared to 2.85% 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 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 focus on restructuring the balance sheet to decrease our cost of funds and improve interest income. However, liquidity may be impacted by the acceleration of loan repayments. To be more proactive, we have hired an investment manager to assist us in our efforts to restructure the balance sheet.

Non-interest income increased $10.5 million for 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 OREO properties and an increase in gains on the sale of OREO properties. Non-interest expense increased $698,000 for 2012 compared to 2011. The increase in real estate acquired through foreclosure expense was primarily due to a $1.5 million fee paid to terminate a property investment and management agreement on a residential development held in OREO. We also prepaid two convertible fixed rate advances during the third quarter of 2012 to decrease our cost of funds and improve net interest income, which required payment of $1.5 million in penalties to the FHLB. The increase in other expense for the 2012 period also relates to increases in legal and consulting fees arising from the branch sale completed during the third quarter of 2012. FDIC insurance premiums decreased $991,000 mainly due to the change in the FDIC's assessment base and rate structure that went into effect during the second quarter of 2011.

In its 2012 Consent Order, 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. 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. To date the Bank has not received such a written direction. The 2012 Consent Order includes the substantive provisions of the 2011 Consent Order and requires the Bank to continue to adhere to the plans implemented in response to 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.

The 2012 Consent Order requires us to obtain the consent of the FDIC and the KDFI in order for the Bank to pay cash dividends to the Corporation. In addition, the "troubled institution" designation resulting from the Consent Order does not allow the Bank to accept, renew or rollover brokered deposits, restricts the amount of interest the Bank may pay on deposits, and increases its deposit insurance assessment.

At December 31, 2012, the Bank's Tier 1 capital ratio was 6.53% and the total risk-based capital ratio was 12.21%. We notified the bank regulatory agencies that one of the two capital ratios would not be achieved and are continuing our efforts to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank.

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 and to take steps to ensure the Bank complies with the Consent Order. 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 alternatives was to sell branches located outside of our core market. On July 6, 2012, we sold our four banking centers in Southern Indiana, receiving a 3.65% premium on the $102.3 million of consumer and commercial deposits at closing. The buyer 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 no premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. Other assets sold included vault cash of $367,000 and fixed assets of $887,000. The consummated transaction resulted in a gain of $3.1 million.

In addition to the sale of our Indiana branches, we also sold commercial real estate loans totaling $10.7 million at par during 2012.

On May 15, 2012, we entered into an agreement to sell our four banking centers in Louisville, Kentucky. The sale was subject to the buyer raising additional capital, regulatory approval and other customary closing conditions. On November 14, 2012, the buyer terminated the agreement due to its inability to raise sufficient capital to obtain governmental approval of the sale.

We continue to reduce non-interest costs where possible to offset the increased credit costs associated with OREO and non-performing loans, while maintaining the resources needed to execute our strategies. We have implemented various cost savings initiatives, including suspending the annual employee stock ownership contribution, freezing most executive management compensation for three years through 2012, freezing most officer compensation for the past year, eliminating cash compensation for the board of directors, reducing marketing and community donation expense, and reducing personnel. Expense reductions totaled $1.1 million for 2011 and $1.3 million for 2012. We are currently evaluating the remaining terms on existing contracts in an effort to identify expenses that can be eliminated in the near future. Our cost savings efforts will remain ongoing.

Our plans for 2013 include the following:

Continuing to identify and evaluate available strategic options to meet regulatory capital levels and all other requirements of our Consent Order, such as further divestitures of branch offices.

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 as we work through 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 Louisville market and the Indiana market where we no longer have a presence. 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. We have implemented loan diversification initiatives in place that we believe should improve the loan portfolio. Increased emphasis on retail lending, small business lending and Small Business Administration ("SBA") lending are all expected to boost non-interest fee income. We have already reallocated resources that that we believe should contribute to the successful execution of all of these efforts. Our mortgage and consumer lending operations have maintained strong credit quality metrics throughout the economic downturn.

Enhancing our resources dedicated to special asset dispositions, both on a permanent and temporary basis, to accelerate our efforts to dispose of problem assets. Our objective is 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 generate new business that supports our diversification efforts while stemming some of the loan roll-off. We hired several new commercial loan officers this year who bring significant experience in real estate and commercial and industrial lending.

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, evaluates 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-impaired loans and is based on historical loss experience for certain categories 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 $17.3 million or 3.29% of total loans was our estimate of probable incurred losses within the loan portfolio as ofDecember 31, 2012. This estimate required us to record a provision for loan losses on the income statement of $6.8 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 only by the selling cost. We have dedicated a team of associates and management to the resolution and work out of OREO due to it having 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. A valuation allowance is 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 the 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 four year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels in 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at December 31, 2012 and December 31, 2011.

RESULTS OF OPERATIONS

Net loss attributable to common shareholders for the period ended December 31, 2012 was $9.4 million or $1.98 per diluted common share compared to net loss attributable to common shareholders of $24.2 million or $5.11 per diluted common share for the same period in 2011. Factors contributing to the net loss for 2012 included the following:

declining net interest income driven by a decline in earning assets and interest bearing liabilities and impacted by the continuing low interest rate environment,

a $16.0 million decrease in provision for loans losses,

write downs and losses on OREO totaling $6.1 million,

a gain of $3.1 million on the sale of our four Indiana banking centers,

a net gain of $2.3 million on the sale of securities available for sale, as we increased our cash position to prepare for the branch sale and restructured our balance sheet,

gains of $1.3 million on the sale of real estate acquired through foreclosure,

$1.5 million in penalties for prepaying FHLB advances, which prepayment decreased our cost of funds and improved net interest income,

a $1.5 million fee paid to terminate a property investment and management agreement on a residential development held as OREO,

a decrease of $991,000 in FDIC insurance premiums, and

a gain of $175,000 on the sale of our last lot held for development.

Net loss attributable to common shareholders was also increased by dividends accrued on preferred shares. Our book value per common share decreased from $7.07 at December 31, 2011 to $5.12 at December 31, 2012.

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 increases in 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 Interest Income - The largest component of our net income is our net interest income. Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

The majority of our assets are interest-earning and our liabilities are interest-bearing. Accordingly, changes in interest rates may impact our net interest margin. The Federal Open Markets Committee ("FOMC") uses the federal funds rate, which is the interest rate used by banks to lend to each other, to influence interest rates and the national economy. Changes in the federal funds rate have a direct correlation to changes in the prime rate, the underlying index for most of the variable-rate loans we issue. The FOMC has held the target federal funds rate at a range of 0-25 basis points since December 2008. As we are asset sensitive, continued low rates will negatively impact our earnings and net interest margin.

The large decline in the volume of interest earning assets and the change in the mix of interest earning assets reduced net interest income for 2012 by $6.5 million compared to the prior year. Average interest earning assets decreased $123.5 million for 2012 compared to 2011 driven by a decrease in average loans, partially offset by an increase in average securities. The decrease in average loans was due to loans included in the branch sale during the third quarter, loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to OREO properties. In addition, due to the higher regulatory capital ratios required by our consent order, we elected not to replace much of this loan run-off in accordance with our efforts to reduce asset size. The average loan yield was 5.42% for 2012 compared to an average loan yield of 5.63% for 2011. We redeployed available liquidity into more liquid but lower yielding investments.

The yield on earning assets averaged 4.01% for 2012 compared to an average yield on earning assets of 4.61% for 2011. This decrease was partially offset by a decrease in our cost of funds, which averaged 1.56% for 2012 compared to an average cost of funds of 1.87% for 2011. Net interest margin as a percent of average earning assets decreased 30 basis points to 2.55% for 2012 compared to 2.85% for 2011.

To decrease our cost of funds and improve net interest income, during the third quarter we prepaid a $10.0 million convertible fixed rate advance having an interest rate of 3.99% and a scheduled maturity date of 2014. In addition, we also prepaid a $5.0 million convertible fixed rate advance having an interest rate of 4.22% and a scheduled date of 2017. We anticipate being able to take . . .

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