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FSGI > SEC Filings for FSGI > Form 10-K on 15-Apr-2013All Recent SEC Filings

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Form 10-K for FIRST SECURITY GROUP INC/TN


15-Apr-2013

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operation

The following is management's discussion and analysis (MD&A) which should be read in conjunction with "Selected Financial Data" and our consolidated financial statements and notes included in this Annual Report on Form 10-K. The discussion in this Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report. Our actual results could differ materially from those discussed in this Annual Report on Form 10-K. Year Ended December 31, 2012
The following discussion and analysis sets forth the major factors that affected First Security's financial condition as of December 31, 2012 and 2011, and results of operations for the three years ended December 31, 2012 as reflected in the audited financial statements.
Strategic Initiatives for 2012
During the last 18 months, the executive management team has been restructured and our Board has increased in size and strength. Our focus has largely been two-fold: implementing our business strategy and addressing the capital needs of the Bank. We believe our capital and business plans are positioning us appropriately for both short-term and long-term success.
Strategic Initiative-Strengthening Capital-On April 12, 2013, we announced the completion of our recapitalization. The recapitalization included a conversion of the TARP CPP Preferred Stock to common stock as well as an additional issuance of common stock to institutional and other accredited investors. On April 11, 2013, we issued approximately 9.9 million shares of our common stock to the U.S. Treasury ("Treasury") for full satisfaction of the Treasury TARP CPP investment, including all associated dividends and warrants. The Treasury immediately sold the common stock to institutional and other accredited investors previously identified by First Security for $1.50 per share. On April 12, 2013, we issued an additional approximately 50.8 million shares of common stock at 41.50 per share to institutional and other accredited investors. In aggregate, investors purchased 60,735,000 shares for $91.1 million, or $1.50 per share. On April 12, 2013, we downstreamed $65.0 million to FSGBank to improve FSGBank's regulatory capital ratios and to support future balance sheet growth. See Note 2 to our Consolidated Financial Statements for additional discussion. Strategic Initiative-Strengthening Management-We have completed the restructuring of our executive and senior management team. Michael Kramer was appointed as CEO and President in December 2011. This was followed by the appointment of three executive vice presidents in February 2012; Chief Credit Officer, Retail Banking Officer and Director of FSGBank's Wealth Management and Trust Department. We also promoted two tenured managers to the roles of Chief Administrative Officer in February 2012 and Chief Financial Officer in February 2011.
Strategic Initiative-Strengthening Board of Directors-During 2011, three additional directors were appointed to the Board. During the first quarter of 2012, an additional three directors were appointed. Mr. William F. Grant, III and Mr. Robert R. Lane were appointed pursuant to the terms of the Series A Preferred Stock, as elected by the Treasury. The third director, Larry D. Mauldin, was appointed as the new independent Chairman of the Board. We believe our current Board possesses the level of banking, small business and leadership backgrounds which will allow it to provide a strong level of oversight to our management team. The Board is focused on establishing an overall business strategy that supports out fundamental objectives of creating long-term stockholder value.
Strategic Initiative-Improving Asset Quality- On December 10, 2012, we entered into an asset purchase agreement with a third party to sell certain loans. During the fourth quarter of 2012, we identified $36.2 million of under- and non-performing loans to sell and recorded a $13.9 million loss to reduce the loan balance to the expected net proceeds. In February 2013, we sold these under- and non-performing loans.
Historically, the credit function was decentralized with lending authority and underwriting conducted regionally. During 2009, we began the process to centralize all credit functions, including underwriting and approval, document preparation, and collections. In February 2012, we hired a new Chief Credit Officer who has provided strong oversight in reducing the amount of non-performing assets and revising our loan policy.
For 2012, management implemented an incentive plan for the Special Assets department that rewards both reductions in nonperforming assets and achieving historical realization rates. We expect a continuation of the higher volume of nonperforming asset resolutions in 2013, which, when combined with the expectation of lower inflows into nonperforming loans, should reduce the overall level of nonperforming assets.


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Strategic Initiative-Growing Deposit Market Share -The Retail Banking Officer is primarily responsible for managing the branch operations, including the implementation of a sales culture for growing core deposits. With significant brokered deposits maturing over the next 18 to 24 months, we have the opportunity to replace these high-cost deposits with traditional low-cost deposits. Clearly defined growth objectives were established for each of our 30 branch locations. The objectives supported the assumptions in the 2012 budget as well as certain aspects of various incentive plans. Leveraging our branches to grow market share with core deposits will reduce our cost of funds, increase our margin and assisting us in achieving overall profitability.
During 2012, we have achieved positive results in implementing our retail deposit strategy. From December 31, 2011 to December 31, 2012, $73 million of brokered deposits matured and we successfully replaced a majority of these high-cost deposits with core deposits. Pure deposits, defined as all transaction accounts, increased $39.9 million, or 10.7%, and core deposits increased $45.6 million, or 7.7%. In total, our customer deposits, defined as total deposits less brokered deposits, increased $61.6 million, which nearly offsets the brokered deposit maturities.
We expect to continue to grow pure and core deposit products per household as well as acquiring new customer relationships.
Strategic Initiative - Investing Excess Liquidity in Loans and Securities Between December of 2009 and the first quarter of 2010, we issued over $180.0 million in brokered deposits to improve our contingent funding capacity. A majority of these funds were placed in our interest bearing account at the Federal Reserve Bank of Atlanta. We executed this liquidity strategy to provide stability and the ability to fund multiple years of obligations without relying on deposit growth or additional borrowings. Our success in growing customer deposits has allowed us to reduce our liquidity reserves during 2012. As of December 31, 2012, our total interest-bearing cash was $159.7 million compared to $249.3 million at December 31, 2011. During 2012, we have prudently reduced our excess cash position by investing in higher yielding assets, primarily investment securities and loans. Effective January 1, 2012, we implemented a lender incentive plan that included clearly defined goals by lending position as well as strong asset quality expectations. We believe this renewed focus on loan growth will result in our loan portfolio stabilizing and growing during 2013. During 2012, our loans declined by 7.1%. The year-to-date change is below our expectations, but we believe that this is largely attributable to loan sales and resolution of problem assets and net charge-offs that improved our asset quality during 2012. The Company has hired a new Chief Credit Officer which is resulting in changes in our credit culture and changes in our underwriting process. Our lenders have adapted to the new expectations and the loan pipeline has continued to increase. Additionally, we have hired multiple new lenders from large regional institutions within our footprint and we are realizing further growth in the loan pipeline. Generally, we do not place a loan on the pipeline unless there is a greater than 50% likelihood of that loan being approved within the next 90 days. Based on the new lenders and the process changes now fully implemented, we anticipate loan growth for 2013. Since December 31, 2011, we have had net growth of approximately $61 million in our investment securities portfolio as we have actively invested our excess liquidity. We have purchased short duration investments to minimize future interest rate risk.
We believe a disciplined approach to allocating our excess liquidity into higher yielding assets will improve our yield on earning assets, increase our margin and assist us in achieving overall profitability. Reverse Stock Split
On September 19, 2011 (the "Effective Date"), we completed a one-for-ten reverse stock split of our common stock. In connection with the reverse stock split, every ten shares of issued and outstanding First Security common stock at the Effective Date were exchanged for one share of newly issued common stock. Fractional shares were rounded up to the next whole share. Other than the number of authorized shares of common stock disclosed in the Consolidated Balance Sheets, all prior period share amounts have been retroactively restated to reflect the reverse stock split. For additional information related to the reverse stock split, see Notes 2 and 16 to our consolidated financial statements.
Regulatory Matters
Effective September 7, 2010, First Security entered into the Agreement with the Federal Reserve Bank. The Agreement is designed to ensure that First Security is a source of strength to FSGBank. Substantially all of the requirements of the Agreement are similar to those already in effect for FSGBank pursuant to the Consent Order that is described below. On September 14, 2010, we filed a Current Report on Form 8-K describing the Agreement. The Form 8-K also provides a copy of the fully executed Agreement.


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We are currently deemed not in compliance with some provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve Bank. We can provide no assurances that we will be able to comply fully with the Agreement, that efforts to comply with the Agreement will not have a material adverse effect on the operations and financial condition of First Security, or that further enforcement actions will not be imposed on First Security.
Effective April 28, 2010, FSGBank reached an agreement with its primary regulator, the OCC, regarding the issuance of a Consent Order. The Order is a result of the OCC's regular examination of FSGBank in the fall of 2009 and directs FSGBank to take actions intended to strengthen its overall condition. All customer deposits remain fully insured by the FDIC to the maximum extent allowed by law; the Order does not impact this coverage in any manner. On April 29, 2010, First Security filed a Current Report on Form 8-K describing the Order and the related actions taken by the Bank to date. The Form 8-K also provides a copy of the fully executed Order.
We are currently deemed not in compliance with certain provisions of the Order, including the capital requirements. The Order required FSGBank to maintain certain capital ratios within 120 days of it execution. The December 31, 2012 Call Report was the tenth public financial statement related to a period subsequent to the 120 day requirement. As of December 31, 2012, the Bank's total capital to risk-weighted assets was 5.8% and the Tier 1 capital to adjusted total assets was 2.5%. The Bank has notified the OCC of the non-compliance with the requirements of the Order. As of April 15, 2013, the OCC has not accepted the submitted strategic or capital plans, as discussed in Note 2 to our consolidated financial statements, however, the OCC is currently reviewing the latest plans.
Any material noncompliance may result in further enforcement actions by the OCC, including the OCC requiring that FSGBank develop a plan to sell, merge or liquidate. Management believes the successful execution of the strategic initiatives discussed below will ultimately result in full compliance with the Order and position the Bank for long-term growth and a return to profitability. Overview
Market Conditions
Most indicators point toward the overall U.S. economy continuing to improve during 2013. As our financial results can be a reflection of our regional economy, we closely monitor and evaluate local and regional economic trends. Amazon.com opened two distribution centers in our markets in 2011. The $139 million investments created more than 2,000 full-time jobs and an additional 2,000 seasonal jobs in Hamilton and Bradley counties. Amazon is currently in the process of expanding its Chattanooga facility and anticipates the expansion will translate to additional hiring, with a peak of 5,000 positions in 2012. The $1 billion Volkswagen automotive production facility has produced more than 100,000 Passats since beginning production on May 24, 2011. Volkswagen has invested $1 billion in the local economy for the Chattanooga plant and created more than 2,200 direct jobs in the region. According to independent studies, the Volkswagen plant is expected to generate $12 billion in income growth and an additional 9,500 jobs related to the project.
Wacker Chemical is building a $1.8 billion polysilicon production plant for the solar power industry near Cleveland, Tennessee. The plant is expected to create an additional 600 direct jobs for our market area, with the current staffing level of approximately 280. We believe the positive economic impact on Chattanooga and the surrounding region from Amazon, Volkswagen and other recently announced large economic investments will be significant and it may stabilize and possibly increase real estate values and enhance economic activity within our market area.
While the national economy continues to struggle to recover from the recession, with higher unemployment across the country, our larger market areas benefit from more stable rates of employment. Our major market areas of Chattanooga and Knoxville have a lower unemployment rate of 7.2% and 6.0%, respectively, as of December 2012, than the Tennessee rate of 7.6%. The economy of the Dalton, Georgia MSA is primarily centered on the carpet and floor-covering industries. With the decline in housing starts and the overall economy, Dalton has been the most negatively impacted region in our footprint, with the Dalton, Georgia MSA experiencing layoffs of approximately 4,600 jobs from June 2011 to June 2012. The unemployment rate in the Dalton MSA is 11.3% (as of December 2012) compared to the Georgia rate of 8.7%. All three MSAs have experienced a decrease in the number of unemployed workers since December 2011, with declines of 23.9% in Chattanooga, 29.2% in Knoxville and 21.3% in Dalton since the peak in June 2009. We believe these positive employment trends will continue into 2013.


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Our market area has also benefited from an increasingly stable housing environment. According to the National Association of REALTORS, the median sales prices of existing single-family homes increased significantly in 2012, with the Chattanooga MSA increasing 11.5% and the Knoxville MSA increasing 4.1% year-over-year. The increase in the median sales price from 2010 to 2012 was 6.34% for the Chattanooga MSA and 0.3% for the Knoxville MSA compared to 2.2% increase for the nation and a 2.8% increase for the census region identified as the South as of December 31, 2012. The National Association of REALTORS forecasts median home prices to continue increasing in 2013 for both new and existing homes.
CPP Investment
On January 9, 2009, as part of the Capital Purchase Program ("CPP") under the Troubled Asset Relief Program ("TARP") of the United States Department of Treasury ("Treasury"), we agreed to issue and sell, and the Treasury agreed to purchase (1) 33,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the "Series A Preferred Stock"), having a liquidation preference of $1,000 per share and (2) a ten-year warrant to purchase up to 82,363 shares of our common stock, $0.01 par value, at an exercise price of $60.10 per share (the 'Warrant"), for an aggregate purchase price of $33 million in cash. The Preferred Shares qualify as Tier 1 capital and pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Dividends are payable quarterly on February 15, May 15, August 15 and November 15 of each year.
On April 11, 2013, as part of the recapitalization, Treasury will exchange the Series A Preferred Stock and the Warrant for shares of our common stock; Treasury will immediately sell such shares of common stock to investors. As previously reported, William F. Grant, III and Robert R. Lane were elected to the First Security Board of Directors, in 2012. Both were elected to the pursuant to the terms of First Security's outstanding Series A Preferred Stock. Under the terms of the Series A Preferred Stock, Treasury has the right to appoint up to two directors to First Security's Board of Directors at any time that dividends payable on the Series A Preferred Stock have not been paid for an aggregate of nine quarterly dividend periods. The terms of the Series A Preferred Stock provide that Treasury will retain the right to appoint such directors at subsequent annual meetings of shareholders until all accrued and unpaid dividends for all past dividend periods have been paid or until Treasury no longer holds our securities. Members of the Board of Directors elected by Treasury have the same fiduciary duties and obligations to all of the shareholders of First Security as any other member of the Board of Directors. While Treasury's contractual rights do not address service on First Security's subsidiary FSGBank's Board of Directors, First Security has reviewed the qualifications of Mr. Lane and Mr. Grant and believes their respective appointments to the FSGBank Board of Directors is in the best interests of First Security and its stockholders.
Following the redemption of the securities held by Treasury on April 11, 2013, Treasury no longer has a contractual right to appoint directors to the Board of Directors. However, the Board of Directors requested that Mr. Grant and Mr. Lane continue their service on the Boards of both First Security and FSGBank, and each agreed to continue to serve.
Financial Results
As of December 31, 2012, we had total consolidated assets of $1.1 billion, total loans of $541.1 million, total deposits of $1.0 billion and stockholders' equity of $29.1 million. In 2012, our net loss allocated to common stockholders was $39.6 million, resulting in a net loss of $24.58 per share (basic and diluted). During 2012, we recognized $20.9 million in provision for loan and lease losses. As of December 31, 2011, we had total consolidated assets of $1.1 billion, total loans of $582.3 million, total deposits of $1.0 billion and stockholders' equity of $68.2 million. In 2011, our net loss allocated to common stockholders was $25.1 million, resulting in a net loss of $15.79 per share (basic and diluted). During 2011, we recognized $10.9 million in provision for loan and lease losses. As of December 31, 2010, we had total consolidated assets of $1.2 billion, total loans of $727.1 million, total deposits of $1.0 billion and stockholders' equity of $93.4 million. In 2010, our net loss allocated to common stockholders was $46.4 million, resulting in a net loss of $29.46 per share (basic and diluted). During 2010, we recognized $33.6 million in provision for loan and lease losses as well as a deferred tax asset valuation allowance of $24.6 million. All prior periods have been restated to give retroactive effect to the one-for-ten reverse stock split that took effect on September 19, 2011.
Net interest income for 2012 declined by $4.2 million compared to 2011 primarily as a result of the reduction in the loan portfolio as well as the negative spread caused by brokered deposits issued in 2010. The provision for loan and lease losses increased $9.9 million, mostly as a result of the write-down on loans identified to be included as part of the loan sale described in note 29 to our consolidated financial statements. Noninterest income increased by $645 thousand primarily as a result of increased mortgage loan service fees and the gain on the sale of OREO. Noninterest expense increased by $630 thousand. The increase was largely due to increases in salary and benefit expense, partially offset by reduced write-downs and holding costs on OREO. Full-time equivalent employees were 322 at December 31, 2012 compared to 303 at December 31, 2011.


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Net interest income for 2011 declined by $6.9 million compared to 2010 primarily as a result of the reduction in the loan portfolio as well as the negative spread caused by brokered deposits issued in 2010 and the associated increase in interest bearing cash. The provision for loan and lease losses decreased $22.7 million as a result of the decreased level of charge-offs. Noninterest income declined by $853 thousand primarily a result of lower deposit fees. Noninterest expense increased by $2.9 million. The increase was largely due to increases in write-downs and holding costs on OREO and repossessions, professional fees, and data processing expenses, partially offset by reductions in salary and benefit expense and FDIC insurance expense. Full-time equivalent employees were 303 at December 31, 2011, compared to 311 at December 31, 2010.
Our efficiency ratio increased to 148.5% in 2012 versus 132.3% in 2011 and 102.4% in 2010. The efficiency ratio for 2012 increased as a result of the combined $3.6 million decline in net interest income and noninterest income and the $630 thousand increase in noninterest expense. The stabilization and improvement of our efficiency ratio to more historical levels is dependent on our ability to stabilize the loan portfolio and reduce expenses associated with nonperforming assets.
Net interest margin in 2012 was 2.45%, or 32 basis points lower, compared to the prior period of 2.77%. The net interest margin of our peer group (as reported on the December 31, 2012 Uniform Bank Performance Report) was 3.75% and 3.81% for 2012 and 2011, respectively. During the fourth quarter of 2009 and first quarter of 2010, we issued over $255 million in brokered deposits to build excess cash reserves to reduce liquidity risk resulting from deteriorating asset quality and the Consent Order. Average other earning assets decreased to $196.0 million in 2012 from $219.3 million in 2011 and $217.4 million in 2010. The impact of the excess liquidity is estimated to have reduced our net interest margin by approximately 100 basis points. We anticipate that our margin will improve during 2013 as brokered deposits mature and the excess liquidity declines. Our expectations are dependent on our ability to raise core deposits, our loan and deposit pricing, and any possible actions by the Federal Reserve Board to the target federal funds rate.
Critical Accounting Policies
Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our significant accounting policies are described in Note 1 under, "Accounting Policies, to the consolidated financial statements" and are integral to understanding this MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that we reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan and lease losses and reduced through loan and lease charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that we exercise judgment to estimate an appropriate allowance. Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact our net income as a result of the change in the provision for loan and lease losses. Refer to the "Provision for Loan and Lease Losses" and "Allowance" sections within MD&A for a discussion of our methodology of establishing the allowance as well as Note 1 to our notes to the consolidated financial statements. Estimates of Fair Value
Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Our available-for-sale securities and held for sale loans are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a non-recurring basis. We use fair value on a non-recurring basis for other real estate owned, repossessions and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.
Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that we make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or


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liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analysis. These modeling techniques incorporate our assessments regarding assumptions that market participants would use in pricing the asset or the liability.
Changes in fair value could materially impact our financial results. Refer to Note 18, "Fair Value Measurements" in the notes to our consolidated financial statements for a discussion of our methodology of calculating fair value. Income Taxes
We are subject to various taxing jurisdictions where we conduct business and we estimate income tax expense based on amounts that we expect to owe to these jurisdictions. We evaluate the reasonableness of our effective tax rate based on . . .

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