10-Q 1 fsgi-2013331x10q.htm 10-Q FSGI-2013.3.31-10Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
_________________________________________________
FORM 10-Q
_________________________________________________
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2013
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
For the transition period from              to             .
COMMISSION FILE NO. 000-49747
_________________________________________________
FIRST SECURITY GROUP, INC.
(Exact Name of Registrant as Specified in its Charter)
_________________________________________________
Tennessee
58-2461486
(State of Incorporation)
(I.R.S. Employer Identification No.)
 
 
531 Broad Street, Chattanooga, TN
37402
(Address of principal executive offices)
(Zip Code)
 
(423) 266-2000
 
 
(Registrant’s telephone number, including area code)
 
 
Not Applicable
 
 
(Former name, former address, and former fiscal year, if changed since last report)
 
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
¨
 
Accelerated filer
¨
Non-accelerated filer
¨
 
Smaller reporting company
ý
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: Common Stock, $0.01 par value: 62,423,367 shares outstanding and issued as of May 15, 2013



First Security Group, Inc. and Subsidiary
Form 10-Q
INDEX
 
 
 
Page
No.
PART I.
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
PART II.
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
Item 5.
 
 
 
Item 6.
 
 



PART I - FINANCIAL INFORMATION
 
ITEM 1.
FINANCIAL STATEMENTS (UNAUDITED)

First Security Group, Inc. and Subsidiary
Consolidated Balance Sheets
 
 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
(in thousands)
(unaudited)
 
 
(unaudited)
ASSETS
 
 
 
 
 
Cash and Due from Banks
$
9,407

 
$
12,806

 
$
8,244

Interest Bearing Deposits in Banks
157,931

 
159,665

 
217,142

Cash and Cash Equivalents
167,338

 
172,471

 
225,386

Securities Available-for-Sale
258,175

 
254,057

 
223,155

Loans Held for Sale
3,708

 
25,920

 
2,136

Loans
540,288

 
541,130

 
601,779

Less: Allowance for Loan and Lease Losses
13,500

 
13,800

 
18,990

Net Loans
526,788

 
527,330

 
582,789

Premises and Equipment, net
29,239

 
29,304

 
29,076

Bank Owned Life Insurance
27,760

 
27,576

 
24,716

Intangible Assets
526

 
600

 
863

Other Real Estate Owned
12,706

 
13,441

 
26,926

Other Assets
14,513

 
12,856

 
15,075

TOTAL ASSETS
$
1,040,753

 
$
1,063,555

 
$
1,130,122



(See Accompanying Notes to Consolidated Financial Statements)
1


First Security Group, Inc. and Subsidiary
Consolidated Balance Sheets

 
 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
(in thousands, except share and per share data)
(unaudited)
 
 
(unaudited)
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
 
 
LIABILITIES
 
 
 
 
 
Deposits
 
 
 
 
 
Noninterest Bearing Demand
$
145,207

 
$
141,400

 
$
168,809

Interest Bearing Demand
88,184

 
86,575

 
59,840

Savings and Money Market Accounts
191,889

 
184,597

 
167,308

Certificates of Deposit less than $100 thousand
224,494

 
228,144

 
231,686

Certificates of Deposit of $100 thousand or more
201,405

 
201,873

 
197,221

Brokered Deposits
139,715

 
165,477

 
213,682

Total Deposits
990,894

 
1,008,066

 
1,038,546

Federal Funds Purchased and Securities Sold under Agreements to Repurchase
13,048

 
12,481

 
16,629

Security Deposits
42

 
58

 
187

Other Liabilities
15,775

 
13,840

 
12,928

Total Liabilities
1,019,759

 
1,034,445

 
1,068,290

SHAREHOLDERS’ EQUITY
 
 
 
 
 
Preferred Stock – no par value – 10,000,000 shares authorized; 33,000 issued as of March 31, 2013, December 31, 2012 and March 31, 2012; Liquidation value of $38,569 as of March 31, 2013, $38,156 as of December 31, 2012 and $36,919 as of March 31, 2012
32,660

 
32,549

 
32,225

Common Stock – $.01 par value – 150,000,000 shares authorized; 1,772,342 shares issued as of March 31, 2013, 1,772,342 issued as of December 31, 2012, and 1,762,342 issued as of March 31, 2012
115

 
115

 
115

Paid-In Surplus
106,622

 
106,531

 
109,027

Common Stock Warrants
2,006

 
2,006

 
2,006

Unallocated ESOP Shares

 

 
(2,746
)
Accumulated Deficit
(123,293
)
 
(115,391
)
 
(82,087
)
Accumulated Other Comprehensive Income
2,884

 
3,300

 
3,292

Total Shareholders’ Equity
20,994

 
29,110

 
61,832

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
1,040,753

 
$
1,063,555

 
$
1,130,122



(See Accompanying Notes to Consolidated Financial Statements)
2


First Security Group, Inc. and Subsidiary
Consolidated Statements of Operations and Comprehensive Loss
(unaudited)
 
Three Months Ended
 
March 31,
(in thousands, except per share data)
2013
 
2012
INTEREST INCOME
 
 
 
Loans, including fees
$
6,670

 
$
8,332

Investment Securities – taxable
812

 
931

Investment Securities – non-taxable
205

 
283

Other
122

 
143

Total Interest Income
7,809

 
9,689

INTEREST EXPENSE
 
 
 
Interest Bearing Demand Deposits
74

 
37

Savings Deposits and Money Market Accounts
222

 
286

Certificates of Deposit of less than $100 thousand
564

 
705

Certificates of Deposit of $100 thousand or more
556

 
651

Brokered Deposits
1,136

 
1,659

Other
16

 
116

Total Interest Expense
2,568

 
3,454

NET INTEREST INCOME
5,241

 
6,235

Provision for Loan and Lease Losses
678

 
1,801

NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES
4,563

 
4,434

NONINTEREST INCOME
 
 
 
Service Charges on Deposit Accounts
736

 
717

Mortgage Banking Income
296

 
175

Other
1,188

 
1,091

Total Noninterest Income
2,220

 
1,983

NONINTEREST EXPENSES
 
 
 
Salaries and Employee Benefits
5,609

 
4,633

Expense on Premises and Fixed Assets, net of rental income
1,447

 
1,243

Other
6,986

 
6,259

Total Noninterest Expenses
14,042

 
12,135

LOSS BEFORE INCOME TAX PROVISION (BENEFIT)
(7,259
)
 
(5,718
)
Income Tax Provision
119

 
109

NET LOSS
(7,378
)
 
(5,827
)
Preferred Stock Dividends
413

 
413

Accretion on Preferred Stock Discount
111

 
104

NET LOSS ALLOCATED TO COMMON SHAREHOLDERS
$
(7,902
)
 
$
(6,344
)
OTHER COMPREHENSIVE LOSS
 
 
 
Net loss
(7,378
)
 
(5,827
)
Unrealized net gain (loss) on securities
(412
)
 
148

Unrealized net loss on cash flow swaps
(4
)
 
(355
)
COMPREHENSIVE LOSS
(7,794
)
 
(6,034
)
NET LOSS PER SHARE:
 
 
 
Net Loss Per Share – Basic
$
(4.90
)
 
$
(3.94
)
Net Loss Per Share – Diluted
$
(4.90
)
 
$
(3.94
)

(See Accompanying Notes to Consolidated Financial Statements)
3


First Security Group, Inc. and Subsidiary
Consolidated Statement of Shareholders’ Equity
(unaudited)
 
 
 
 
Common Stock
 
 
 
 
 
 
 
Accumulated
Other
Comprehensive
Income
 
 
(in thousands)
Preferred
Stock
 
Shares
 
Amount
 
Paid-In
Surplus
 
Common
Stock
Warrants
 
Accumulated
Deficit
 
Total
Balance - December 31, 2012
$
32,549

 
1772
 
$
115

 
$
106,531

 
$
2,006

 
$
(115,391
)
 
$
3,300

 
$
29,110

Net Loss

 
0
 

 

 

 
(7,378
)
 

 
(7,378
)
Other Comprehensive Loss

 
0
 

 

 

 

 
(416
)
 
(416
)
Accretion of Discount Associated with Preferred Stock
111

 
0
 

 

 

 
(111
)
 

 

Preferred Stock Dividend

 
0
 

 

 

 
(413
)
 

 
(413
)
Share-based Compensation, net of forfeitures

 
0
 

 
91

 

 

 

 
91

Balance - March 31, 2013
$
32,660

 
1772
 
$
115

 
$
106,622

 
$
2,006

 
$
(123,293
)
 
$
2,884

 
$
20,994



(See Accompanying Notes to Consolidated Financial Statements)
4


First Security Group, Inc. and Subsidiary
Consolidated Statements of Cash Flow
(unaudited)
 
 
Three Months Ended
 
March 31,
(in thousands)
2013
 
2012
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
Net Loss
$
(7,378
)
 
$
(5,827
)
Adjustments to Reconcile Net Loss to Net Cash From Operating Activities -
 
 
 
Provision for Loan and Lease Losses
678

 
1,801

Amortization, net
594

 
770

Share-Based Compensation
91

 
23

ESOP Compensation

 
24

Depreciation
425

 
341

Gain on Sales of Premises and Equipment, net
(24
)
 

Loss on Sales of Other Real Estate Owned and Repossessions, net
141

 
531

Write-down of Other Real Estate Owned and Repossessions
1,315

 
2,297

Accretion of Fair Value Adjustment, net

(3
)
 
(24
)
Accretion of Terminated Cash Flow Swaps

 
(289
)
Changes in Operating Assets and Liabilities -
 
 
 
Loans Held for Sale
(87
)
 
179

Interest Receivable
(152
)
 
(238
)
Other Assets
(1,683
)
 
2,041

Interest Payable
(72
)
 
127

Other Liabilities
1,578

 
(145
)
Net Cash From Operating Activities
(4,577
)
 
1,611

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
Activity in Securities Available-for-Sale:
 
 
 
Maturities, Prepayments, and Calls
4,276

 
13,537

Sales
1,001

 

Purchases
(10,328
)
 
(44,154
)
Loan Originations and Principal Collections, net
(1,938
)
 
(27,895
)
Proceeds from Sales of Premises and Equipment
157

 

Proceeds from Sales of Other Real Estate and Repossessions
1,078

 
3,677

Proceeds from Sale of Loans to Third Party (see Note 7)
22,296

 

Additions to Premises and Equipment
(493
)
 
(746
)
Net Cash From Investing Activities
16,049

 
(55,581
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
Net Increase (Decrease) in Deposits
(17,172
)
 
19,124

Net Increase in Federal Funds Purchased and Securities Sold Under Agreements to Repurchase
567

 
2,109

Net Decrease of Other Borrowings

 
(58
)
Net Cash From Financing Activities
(16,605
)
 
21,175

NET CHANGE IN CASH AND CASH EQUIVALENTS
(5,133
)
 
(32,795
)
CASH AND CASH EQUIVALENTS – beginning of period
172,471

 
258,181

CASH AND CASH EQUIVALENTS – end of period
$
167,338

 
$
225,386

 
 
Three Months Ended
 
March 31,
(in thousands)
2013
 
2012
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES
 
 
 
Loans and leases transfered to OREO and repossessions
$
1,805

 
$
5,766

Accrued and deferred cash dividends on preferred stock
$
413

 
$
413

SUPPLEMENTAL SCHEDULE OF CASH FLOWS
 
 
 
Interest paid
$
2,496

 
$
3,327

Income taxes paid
$

 
$
70


(See Accompanying Notes to Consolidated Financial Statements)
5


FIRST SECURITY GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1 – BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of financial condition and the results of operations have been included. All such adjustments were of a normal recurring nature. Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net loss or shareholders’ equity.
The consolidated financial statements include the accounts of First Security Group, Inc. (First Security or the Company)and its subsidiary bank, which is wholly-owned. All significant intercompany balances and transactions have been eliminated.
Operating results for the three months ended March 31, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013 or any other period. These interim financial statements should be read in conjunction with the Company’s latest annual consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.


NOTE 2 – MANAGEMENT'S PLANS AND REGULATORY MATTERS
Management's Plans
During 2012, the Company focused on operating under its strategic plan and executing on its capital plan. The execution of the capital plan, as described below, combined with the ongoing performance of the strategic plan should restore profitability and achieve compliance with all aspects of the regulatory agreements over the next twelve months.
On April 11, 2013, the Company completed a restructuring of the Company's Preferred Stock with the U.S. Treasury ("Treasury") by issuing $14.4 million of new common stock for $1.50 per share for the full satisfaction of the Treasury's 2009 investment in the Company. Pursuant to the exchange agreement ("Exchange Agreement"), as previously included in a Current Report on Form 8-K filed on February 26, 2013, the Company restructured the Company's Preferred Stock issued under the Capital Purchase Program ("CPP") by issuing new shares of common stock equal to 26.75% of the $33 million liquidation value of the Preferred Stock plus 100% of the accrued but unpaid dividends in exchange for the Preferred Stock, all accrued but unpaid dividends thereon, and the cancellation of stock warrants granted in connection with the CPP investment ("CPP Restructuring"). Immediately after the issuance of the common stock to the Treasury, the Treasury sold all of the Company's common stock to investors previously identified by the Company at the same $1.50 per share price.
On April 12, 2013, the Company completed the issuance of an additional $76.7 million of new common stock in a private placement to accredited investors. The private placement was previously announced on a Current Report on Form 8-K filed on February 26, 2013, in which the Company announced the execution of definitive stock purchase agreements with institutional investors as part of an approximately $90 million recapitalization ("Recapitalization"). In total, the Company issued 60,735,000 shares of common stock at $1.50 per share for gross proceeds of $91.1 million. The following chart presents pro-forma stockholders' equity based on the Recapitalization.

6


Pro-Forma Stockholders' Equity
 
March 31, 2013
 
Estimated Impact of CPP Restructuring 1
 
Estimated Impact of Recapotalization2
 
Pro-Forma
 
(amount in thousands)
Preferred Stock - no par value - 10,000,000 shares authorized; 33,000 issued as of March 31, 2013; Liquidation value of $38,569
$
32,660

 
$
(32,660
)
 
$

 
$

Common Stock - $0.01 par value - 150,000,000 shared authorized; 1,772,342 shares issued as of March 31, 2013
115

 
99

 
508

 
722

Paid-In Surplus
106,622

 
14,813

 
70,592

 
191,936

Common Stock Warrants
2,006

 
(2,006
)
 

 

Accumulated Deficit
(123,293
)
 
25,728

 

 
(89,663
)
Accumulated Other Comprehensive Income
2,884

 

 

 
2,884

Total Shareholders' Equity
$
20,994

 
5,974

 
71,100

 
105,879

 
 
 
 
 
 
 
 
1 
CPP Restructuring – The Company issued common stock equal to 26.75% of the $33 million liquidation value of the Preferred Stock plus 100% of the accrued but unpaid dividends on April 11, 2013. The net increase of $5,974 thousand represents the conversion of the accrued dividends from a liability into capital. The above is based on the accrued but unpaid dividends as of the transaction date.
2 
Recapitalization – The Company issued $91.1 million of aggregate new shares of common stock, inclusive of the shares issued to the U.S. Treasury as part of the CPP restructuring. The Company has deducted $5.1 million as the estimated transaction expenses that will reduce the net proceeds to the Company. The transaction expenses are an estimate and subject to change.


7


The following chart presents pro-forma regulatory capital ratios based upon the Recapitalization:

Pro-Forma Regulatory Capital Ratios
 
March 31, 2013
 
Estimated Impact of Transaction
 
Pro-Forma
 
Minimum to be Well Capitalized under Prompt Corrective Action Provisions 1
 
(amounts in thousands)
Company Capital Levels
 
 
 
 
 
 
 
Tier 1 capital
$
17,584

 
$
77,074

 
$
94,658

 
 
Total risk-based capital
$
24,967

 
$
77,074

 
$
102,041

 
 
Tier 1 leverage ratio
1.68
%
 
 
 
9.04
%
 
n/a

Total risk-based capital
4.27
%
 
 
 
17.47
%
 
n/a

 
 
 
 
 
 
 
 
FSGBank Capital Levels
 
 
 
 
 
 
 
Tier 1 capital
$
19,932

 
$
65,000

 
$
84,932

 
 
Total risk-based capital
$
27,313

 
$
65,000

 
$
92,313

 
 
Tier 1 leverage ratio
1.90
%
 
 
 
8.12
%
 
5.00
%
Total risk-based capital
4.68
%
 
 
 
15.80
%
 
10.00
%
 
 
 
 
 
 
 
 
1 FSGBank continues to operate under a Consent Order with capital adequacy requirements. Accordingly, FSGBank would be considered “adequately capitalized” based on the estimated pro-forma capital levels.
In addition to the Recapitalization described above, the Company has strengthened its management team and board of directors and maintained evaluated levels of liquidity.
During 2011 and through the first quarter of 2012, the Company underwent significant change within the Board of Directors and executive management. The changes were predicated on strengthening and deepening the Company’s leadership in order to successfully execute a strategic and capital plan to return the Company to profitable operations, satisfy the requirements of the regulatory actions detailed below, and lower the level of problem assets to an acceptable level.
In December 2011, the Company appointed Michael Kramer as President and Chief Executive Officer. Subsequently, the Company appointed a Chief Credit Officer, Retail Banking Officer and Director of FSGBank’s Wealth Management and Trust Department. The Company added three additional directors to the Board in 2011 and added three additional directors in 2012, including a new independent Chairman of the Board, Larry D. Mauldin.
The Bank has successfully maintained elevated liquidity and has chosen to do so primarily by maintaining excess cash at the Federal Reserve. The Company’s cash position as of March 31, 2013 was $167.3 million compared to $172.5 million and $225.4 million at December 31, 2012 and March 31, 2012, respectively. With the completion of the Recapitalization, the Company will begin deploying the excess liquidity into higher-earning assets.
Regulatory Matters
First Security Group, Inc.
On September 7, 2010, the Company entered into a Written Agreement (the "Agreement") with the Federal Reserve Bank of Atlanta (the "Federal Reserve"), the Company’s primary regulator. The Agreement is designed to enhance the Company’s ability to act as a source of strength to the Company's wholly owned subsidiary, FSGBank, National Association ("FSGBank" or the "Bank").
The Agreement prohibits the Company from declaring or paying dividends without prior written consent of the Federal Reserve. The Company is also prohibited from taking dividends, or any other form of payment representing a reduction of capital, from the Bank without prior written consent.

8



Within 60 days of the Agreement, the Company was required to submit to the Federal Reserve a written plan designed to maintain sufficient capital at the Company and the Bank. The Company submitted a copy of the Bank’s capital plan that had previously been submitted to the Bank’s primary regulator, the Office of the Comptroller of the Currency (OCC). Neither the Federal Reserve nor the OCC accepted the initially submitted capital plan. Strategic and capital plans covering five years are being revised to reflect the actual terms and timing of the Recapitalization.
The Company is currently deemed not in compliance with certain provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve. Management believes the successful execution of the strategic initiatives discussed below will ultimately result in full compliance with the Agreement and position the Company for long-term growth and a return to profitability.
On September 14, 2010, the Company filed a Current Report on Form 8-K describing the Agreement. A copy of the Agreement is filed as Exhibit 10.1 to such Form 8-K. The foregoing summary is not complete and is qualified in all respects by reference to the actual language of the Agreement.
FSGBank, N.A.
On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order, FSGBank consented and agreed to the issuance of a Consent Order by the OCC (the Order).
The Bank and the OCC agreed to the areas of the Bank’s operations that warrant improvement and on a plan for making those improvements. The Order required the Bank to develop and submit written strategic and capital plans covering at least a three years period. The Board of Directors is required to ensure that competent management is in place in all executive officer positions to manage the Bank in a safe and sound manner. The Bank is also required to review and revise various policies and procedures, including those associated with credit concentration management, the allowance for loan and lease losses, liquidity management, criticized assets, loan review and credit. The Bank is continuing to work with the OCC to ensure the policies and procedures are both appropriate and fully implemented.
Within 120 days of the effective date of the Order, the Bank was required to achieve and thereafter maintain total capital at least equal to 13.0% of risk-weighted assets and Tier 1 capital at least equal to 9% of adjusted total assets. As of March 31, 2013, the eleventh financial reporting period subsequent to the 120 day requirement, the Bank’s total capital to risk-weighted assets was 4.7% and the Tier 1 capital to adjusted total assets was 1.9%. The Bank has notified the OCC of its non-compliance with the requirements of the Order.
During the third quarter of 2010, the OCC requested additional information and clarifications to the Bank's submitted strategic and capital plans as well as the management assessments. Subsequent to the resignation of the CEO in April 2011, the Bank requested an extension on the submission date for the strategic and capital plans until a new CEO was appointed and had sufficient time to modify the strategic plan. Strategic and capital plans covering five-years are being revised to reflect the actual terms and timing of the Recapitalization.
Effective with the Order, the Bank has been restricted from paying interest on deposits that is more than 0.75% above the rate applicable to the applicable market of the Bank as determined by the Federal Deposit Insurance Corporation (FDIC). Additionally, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.
The Bank is currently deemed not in compliance with some provisions of the Order, including the capital requirements. Management believes that the completed Recapitalization will provide compliance with most, if not all, requirements of the Order.
On April 29, 2010, the Company filed a Current Report on Form 8-K describing the Order. A copy of the Order is filed as Exhibit 10.1 to such Form 8-K. The foregoing summary is not complete and is qualified in all respects by reference to the actual language of the Order.
As of September 30, 2012, the Bank's Tier I leverage ratio fell below the minimum level for an "adequately capitalized" bank of 4%. As described below, there are three classifications for banks that are below "adequately capitalized," as follows: "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." As of December 31, 2012, the Bank was reclassified from "undercapitalized" to "significantly undercapitalized" upon the filing of the Call Report on January 30, 2013. As of March 31, 2013, the Bank was reclassified to "critically undercapitalized" upon the filing of the call report on April 30, 2013.

9



On April 23, 2013, FSGBank filed a cash contribution to capital notice with the OCC certifying a $65 million capital contribution by First Security Group into FSGBank. With the capital contribution, FSGBank's proforma regulatory capital ratios changed as follows: Tier 1 leverage ratio from less than 2.0% to 8.1%, Tier 1 risk-based capital from 3.4% to 14.5% and total risk-based capital from 4.7% to 15.8%. All proforma regulatory capital exceed the percentages of a well capitalized institution as defined under applicable regulatory guidelines. FSGBank will continue to be classified as adequately capitalized due to the capital requirement in the Order.
Regulatory Capital Ratios
Banks and bank holding companies, as regulated institutions, must maintain required levels of capital. OCC and the Federal Reserve, the primary federal regulators for FSGBank and the Company, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are expected to maintain a level of capital commensurate with the risk profile assigned to their assets in accordance with the guidelines. As described above, the Order requires FSGBank to achieve and maintain total capital to risk adjusted assets of at least 13% and a leverage ratio of at least 9%. The Order provided 120 days from April 28, 2010, the effective date of the Order, to achieve these ratios. FSGBank is currently not in compliance with the capital requirements.
The following table compares the required capital ratios maintained by the Company and FSGBank:
CAPITAL RATIOS
 
March 31, 2013
FSGBank
Consent  Order1
 
Minimum
Capital Requirements under Prompt Corrective Action Provisions
 
First
Security
 
FSGBank
Tier 1 capital to risk adjusted assets
n/a

 
4.0
%
 
3.01
%
 
3.41
%
Total capital to risk adjusted assets
13.0
%
 
8.0
%
 
4.27
%
 
4.68
%
Leverage ratio
9.0
%
 
4.0
%
 
1.68
%
 
1.90
%
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
Tier 1 capital to risk adjusted assets
n/a

 
4.0
%
 
4.23
%
 
4.54
%
Total capital to risk adjusted assets
13.0
%
 
8.0
%
 
5.49
%
 
5.80
%
Leverage ratio
9.0
%
 
4.0
%
 
2.31
%
 
2.48
%
 
 
 
 
 
 
 
 
March 31, 2012
 
 
 
 
 
 
 
Tier 1 capital to risk adjusted assets
n/a

 
4.0
%
 
8.60
%
 
8.60
%
Total capital to risk adjusted assets
13.0
%
 
8.0
%
 
9.80
%
 
9.80
%
Leverage ratio
9.0
%
 
4.0
%
 
5.20
%
 
5.20
%
_____________
1 FSGBank was required to achieve and maintain these capital ratios within 120 days from April 28, 2010.
See "Proforma Regulatory Capital Ratios" table to see the effect of the Recapitalization completed on April 12, 2013.

10



NOTE 3 –OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss) for the Company consists of changes in net unrealized gains and losses on investment securities available-for-sale and derivatives.  The following tables present a summary of the accumulated other comprehensive income balances, net of tax, as of March 31, 2013 and 2012.

 
 
Unrealized Gain (Loss) on Derivatives
 
Unrealized Gain (Loss) on Securities
 
Accumulated Other Comprehensive Income (Loss)
 
 
(in thousands)
 
 
 
 
 
 
 
Beginning balance, December 31, 2012
 
$
(54
)
 
$
3,354

 
$
3,300

Other comprehensive income before reclassification
 
(3
)
 
(413
)
 
(416
)
Amounts reclassified from accumulated other comprehensive income
 

 

 

Net current period other comprehensive income
 
(3
)
 
(413
)
 
(416
)
Ending balance, March 31, 2013
 
$
(57
)
 
$
2,941

 
$
2,884


 
 
Unrealized Gain (Loss) on Derivatives
 
Unrealized Gain (Loss) on Securities
 
Accumulated Other Comprehensive Income (Loss)
 
 
(in thousands)
 
 
 
 
 
 
 
Beginning balance, December 31, 2011
 
$
202

 
$
3,297

 
$
3,499

Other comprehensive income before reclassification
 
(792
)
 
148

 
(644
)
Amounts reclassified from accumulated other comprehensive income
 
(437
)
 

 
(437
)
Net current period other comprehensive income
 
(355
)
 
148

 
(207
)
Ending balance, March 31, 2012
 
$
(153
)
 
$
3,445

 
$
3,292


For the three months ended March 31, 2013 and 2012, zero and $437 thousand, respectively, were reclassified into interest income due to gains on derivatives. There were no reclassifications from gains or losses on securities for the three months ended March 31, 2013 and 2012.


11



NOTE 4 –SHARE-BASED COMPENSATION
As of March 31, 2013, the Company has three share-based compensation plans, the 2012 Long-Term Incentive Plan (the 2012 LTIP), the 2002 Long-Term Incentive Plan (the 2002 LTIP) and the 1999 Long-Term Incentive Plan (the 1999 LTIP). The plans are administered by the Compensation Committee of the Board of Directors (the Committee), which selects persons eligible to receive awards and determines the number of shares and/or options subject to each award, the terms, conditions and other provisions of the award. The plans are described in further detail below.
The 2012 LTIP was approved by the shareholders of the Company at the 2012 annual meeting as previously reported on a Current Report on Form 8-K filed June 26, 2012. The 2012 Long-Term Incentive Plan permits the Committee to make a variety of awards, including incentive and nonqualified options to purchase shares of First Security's common stock, stock appreciation rights, other share-based awards which are settled in either cash or shares of First Security's common stock and are determined by reference to shares of stock, such as grants of restricted common stock, grants of rights to receive stock in the future, or dividend equivalent rights, and cash performance awards, which are settled in cash and are not determined by reference to shares of First Security's common stock (Awards). These discretionary Awards may be made on an individual basis or through a program approved by the Committee for the benefit of a group of eligible persons. The number of shares available under the 2012 LTIP is 149,000.
The 2002 LTIP was approved by the shareholders of the Company at the 2002 annual meeting and subsequently amended by the shareholders of the Company at the 2004 and 2007 annual meetings to increase the number of shares available for issuance under the 2002 LTIP by 480 thousand and 750 thousand shares, respectively. The total number of shares authorized for awards prior to the 10-for-1 reverse stock split was 1.5 million. As a result of the 10-for-1 reverse stock split in 2011, the total shares currently authorized under the 2002 LTIP is 151,800, of which not more than 20% may be granted as awards of restricted stock. Eligible participants include eligible employees, officers, consultants and directors of the Company or any affiliate. The exercise price per share of a stock option granted may not be less than the fair market value as of the grant date. The exercise price must be at least 110% of the fair market value at the grant date for options granted to individuals, who at the grant date, are 10% owners of the Company’s voting stock (each a 10% owner). Restricted stock may be awarded to participants with terms and conditions determined by the Committee. The term of each award is determined by the Committee, provided that the term of any incentive stock option may not exceed ten years (five years for 10% owners) from its grant date. Each option award vests in approximately equal percentages each year over a period of not less than three years from the date of grant as determined by the Committee subject to accelerated vesting under terms of the 2002 LTIP or as provided in any award agreement. As a result of the Company's participation in TARP CPP, the terms of awards are also subject to compliance with applicable TARP compensation regulations.
Participation in the 1999 LTIP is limited to eligible employees. The total number of shares of stock authorized for awards prior to the 10-for-1 reverse stock split was 936 thousand. As a result of the 10-for-1 reverse stock split in 2011, the total shares currently authorized under the 1999 LTIP is 93,600, of which not more than 10% could be granted as awards of restricted stock. Under the terms of the 1999 LTIP, incentive stock options to purchase shares of the Company’s common stock may not be granted at a price less than the fair market value of the stock as of the date of the grant. Options must be exercised within ten years from the date of grant subject to conditions specified by the 1999 LTIP. Restricted stock could also be awarded by the Committee in accordance with the 1999 LTIP. Generally, each award vests in approximately equal percentages each year over a period of not less than three years and vest from the date of grant as determined by the Committee subject to accelerated vesting under terms of the 1999 LTIP or as provided in any award agreement. As a result of the Company's participation in TARP CPP, the terms of awards are also subject to compliance with applicable TARP compensation regulations.
Stock Options
The following table illustrates the effect on operating results for share-based compensation for the three months ended March 31, 2013 and 2012.
 
Three Months Ended
 
March 31,
 
2013
 
2012
 
(in thousands)
Stock option compensation expense
$
28

 
$
2

Stock option compensation expense, net of tax 1
$
18

 
$
1

__________________
1 Due to the deferred tax valuation allowance, tax benefit is reversed through the valuation allowance.
During the three months ended March 31, 2013 and 2012, no options were exercised.

12


The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model that uses the following assumptions: expected dividend yield, expected volatility, risk-free interest rate, expected life of the option and the grant date fair value. Expected volatilities are based on historical volatilities of the Company's common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
During the three months ended March 31, 2013 and 2012, no options were granted.
The following table represents stock option activity for the three months ended March 31, 2013:
 
Shares
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contractual Term (in years)
 
Aggregate Intrinsic Value
 
Outstanding, January 1, 2013
135,176

 
$
25.54

 
 
 
 
 
Granted

 
$

 
 
 
 
 
Exercised

 
$

 
 
 
 
 
Forfeited
2,980

 
$
82.49

 
 
 
 
 
Outstanding, March 31, 2013
132,196

 
$
24.26

 
7.58
 
$
850

 
Exercisable, March 31, 2013
36,782

 
$
79.19

 
3.43
 

1 
__________________
1 As of March 31, 2013, the exercise price of all exercisable options exceeded the closing price of the Company's common stock of $2.64, resulting in no intrinsic value.
As of March 31, 2013, shares available for future option grants to employees and directors under existing plans were zero, zero, and 149,000 for the 1999 LTIP, 2002 LTIP, and 2012 LTIP, respectively.
As of March 31, 2013, there was $92 thousand of total unrecognized compensation cost related to nonvested stock options granted under the Plans. The cost is expected to be recognized over a weighted-average period of 1.57 years.
Restricted Stock
The Plans described above allow for the issuance of restricted stock awards that may not be sold or otherwise transferred until certain restrictions have lapsed. The unearned share-based compensation related to these awards is being amortized to compensation expense over the period the restrictions lapse. The share-based expense for these awards was determined based on the market price of the Company’s stock at the grant date applied to the total number of shares that were anticipated to fully vest and then amortized over the vesting period.
As of March 31, 2013, unearned share-based compensation associated with these awards totaled $147 thousand. The Company recognized compensation expense, net of forfeitures, of $61 thousand for the three months ended March 31, 2013 and $21 thousand for the three months ended March 31, 2012, related to the amortization of deferred compensation that was included in salaries and benefits in the accompanying consolidated statements of operations. The remaining cost is expected to be recognized over a weighted-average period of 1.29 years.
The following table represents restricted stock activity for the period ended March 31, 2013:
 
Shares
 
Weighted Average Grant-Date Fair Value
Nonvested shares at January 1, 2013
129,781

1 
$
2.85

Granted


 
Vested
(40
)
 
 
Forfeited
(6,700
)
 
 
Nonvested, March 31, 2013
123,041

1 
$
2.89

__________________
1 Includes 93,000 shares issued as an inducement grant from available and unissued shares and not from the Plans.


13


On April 11, 2013, approximately 84,750 restricted stock shares were forfeited in connection with TARP CPP regulations associated with TARP redemptions.


NOTE 5 – LOSS PER SHARE
The difference in basic and diluted weighted average shares is due to the assumed conversion of outstanding stock options, restricted stock awards and common stock warrants using the treasury stock method. The Company has issued certain restricted stock awards, which are unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents. These restricted shares are considered participating securities. Accordingly, the Company calculated net income available to common shareholders pursuant to the two-class method, whereby net income is allocated between common shareholders and participating securities. In periods of a net loss, no allocation is made to participating securities as they are not contractually required to fund net losses. The computation of basic and diluted earnings per share is as follows:

 
Three Months Ended
 
March 31,
 
2013
 
2012
 
(in thousands, except per share amounts)
Numerator:
 
 
 
Net loss
$
(7,378
)
 
$
(5,827
)
Preferred stock dividends
413

 
413

Accretion of preferred stock discount
111

 
104

Net loss allocated to common shareholders
$
(7,902
)
 
$
(6,344
)
Denominator:
 
 
 
Weighted average common shares outstanding including participating securities
1,990

 
1,702

Less: Participating securities
377

 
90

Weighted average basic common shares outstanding
1,613

 
1,612

Effect of diluted securities:
 
 
 
Equivalent shares issuable upon exercise of stock options, stock warrants and restricted stock awards

 

Weighted average diluted common shares outstanding
1,613

 
1,612

Net loss per share:
 
 
 
Basic
$
(4.90
)
 
$
(3.94
)
Diluted
$
(4.90
)
 
$
(3.94
)
Due to the net loss allocated to common shareholders for all periods shown, all stock options, stock warrants, and restricted stock grants are considered anti-dilutive and are not included in the computation of diluted earnings per share. As of March 31, 2013 and March 31, 2012 a total of 172 thousand and 250 thousand stock options, stock warrants and restricted stock grants were considered anti-dilutive, respectively.

14



NOTE 6 – SECURITIES AVAILABLE-FOR-SALE
Investment Securities by Type
The following table presents the amortized cost and fair value of securities, with gross unrealized gains and losses.
 
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(in thousands)
March 31, 2013
 
 
 
 
 
 
 
Debt securities—
 
 
 
 
 
 
 
Federal agencies
$
65,837

 
$
215

 
$
192

 
$
65,860

Mortgage-backed—residential
148,820

 
3,306

 
242

 
151,884

Municipals
35,545

 
960

 
115

 
36,390

Other
4,061

 

 
20

 
4,041

Total
$
254,263

 
$
4,481

 
$
569

 
$
258,175

 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
Debt securities—
 
 
 
 
 
 
 
Federal agencies
$
57,393

 
$
256

 
$
104

 
$
57,545

Mortgage-backed—residential
157,191

 
3,424

 
138

 
160,477

Municipals
35,088

 
1,028

 
122

 
35,994

Other
61

 

 
20

 
41

Total
$
249,733

 
$
4,708

 
$
384

 
$
254,057

 
 
 
 
 
 
 
 
March 31, 2012
 
 
 
 
 
 
 
Debt securities—
 
 
 
 
 
 
 
Federal agencies
$
21,989

 
$
155

 
$
2

 
$
22,142

Mortgage-backed—residential
167,115

 
3,253

 
181

 
170,187

Municipals
29,507

 
1,287

 
14

 
30,780

Other
128

 

 
82

 
46

Total
$
218,739

 
$
4,695

 
$
279

 
$
223,155


During the three months ended March 31, 2013, the Company sold one federal agency security resulting in proceeds of $1.0 million and gross gains of less than 1 thousand dollars. There were no sales of securities for the three months ended March 31, 2012.
At March 31, 2013December 31, 2012 and March 31, 2012, securities with a carrying value of $28.0 million, $28.1 million and $32.0 million, respectively, were pledged to secure public deposits. At March 31, 2013December 31, 2012 and March 31, 2012, the carrying amount of securities pledged to secure repurchase agreements was $16.6 million, $18.5 million and $19.5 million, respectively. At March 31, 2013December 31, 2012 and March 31, 2012, securities of $7.6 million, $6.5 million and $5.9 million were pledged to the Federal Reserve Bank of Atlanta to secure the Company’s daytime correspondent transactions. At March 31, 2013, December 31, 2012, and March 31, 2012 the carrying amount of securities pledged to secure lines of credit with the Federal Home Loan Bank (the "FHLB") totaled $4.0 million, $5.5 million and $10.1 million, respectively. At March 31, 2013, pledged and unpledged securities totaled $56.3 million and $201.9 million, respectively.


15


Maturity of Securities
The following table presents the amortized cost and fair value of debt securities by contractual maturity at March 31, 2013.
 
 
Amortized
Cost
 
Fair
Value
 
(in thousands)
Within 1 year
$
1,131

 
$
1,150

Over 1 year through 5 years
14,980

 
15,440

5 years to 10 years
70,497

 
70,641

Over 10 years
18,835

 
19,060

 
105,443

 
106,291

Mortgage-backed residential securities
148,820

 
151,884

Total
$
254,263

 
$
258,175

Impairment Analysis
The following table shows the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2013December 31, 2012 and March 31, 2012.
 
 
Less than 12 months
 
12 months or greater
 
Totals
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
(in thousands)
March 31, 2013
 
 
 
 
 
 
 
 
 
 
 
Federal agencies
$
29,857

 
$
192

 
$

 
$

 
$
29,857

 
$
192

Mortgage-backed—residential
27,341

 
240

 
2,030

 
2

 
29,371

 
242

Municipals
9,099

 
108

 
199

 
7

 
9,298

 
115

Other
3,993

 
7

 
48

 
13

 
4,041

 
20

Totals
$
70,290

 
$
547

 
$
2,277

 
$
22

 
$
72,567

 
$
569

December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
Federal agencies
$
20,199

 
$
104

 
$

 
$

 
$
20,199

 
$
104

Mortgage-backed—residential
15,509

 
138

 

 

 
15,509

 
138

Municipals
8,012

 
122

 

 

 
8,012

 
122

Other

 

 
41

 
20

 
41

 
20

Totals
$
43,720


$
364

 
$
41

 
$
20

 
$
43,761

 
$
384

March 31, 2012
 
 
 
 
 
 
 
 
 
 
 
Federal agencies
$
2,994

 
$
2

 
$

 
$

 
$
2,994

 
$
2

Mortgage-backed—residential
35,384

 
181

 

 

 
35,384

 
181

Municipals
200

 
14

 

 

 
200

 
14

Other

 

 
45

 
82

 
45

 
82

Totals
$
38,578

 
$
197

 
$
45

 
$
82

 
$
38,623

 
$
279


As of March 31, 2013, the Company performed an impairment assessment of the securities in its portfolio that had unrealized losses to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) the Company intends to sell the security, (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized costs basis or (3) the Company does not expect to recover the security’s entire amortized cost basis, even if the Company does not intend to sell. Additionally, accounting guidance requires that for impaired securities that the Company does not intend to sell and/or that it is not more-likely-than-not that the Company will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined

16


to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.
In evaluating the recovery of the entire amortized cost basis, the Company considers factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.
As of March 31, 2013, gross unrealized losses in the Company’s portfolio totaled $569 thousand, compared to $384 thousand as of December 31, 2012 and $279 thousand as of March 31, 2012. As of March 31, 2013, the unrealized losses in mortgage-backed securities (consisting of twelve securities), municipals (consisting of twenty-three securities) and federal agencies (consisting of twenty securities) are primarily due to widening credit spreads and changes in interest rates subsequent to purchase. The unrealized loss in other securities relates to one pooled trust preferred security. The unrealized loss in the pooled trust preferred security is primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. The Company does not intend to sell the investments with unrealized losses and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity. Based on results of the Company’s impairment assessment, the unrealized losses at March 31, 2013 are considered temporary.


NOTE 7 – LOANS HELD FOR SALE
On December 10, 2012, the Company entered into an asset purchase agreement with a third party to sell certain loans. During the fourth quarter of 2012, the Company 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. Loans held-for-sale due to the asset purchase agreement totaled approximately $22.3 million at December 31, 2012. The Loan sale was completed during February 2013.
Other loans held-for-sale consisted of residential 1-4 family loans and totaled $3.7 million, $3.6 million and $2.1 million at March 31, 2013, December 31, 2012 and March 31, 2012, respectively. In the tables below, the residential 1-4 family real estate loans have been split out between loan originated to be held-for-sale and those loans that were transferred into the loans held-for-sale category. Amounts listed in all other loan categories are from loans transferred to loans held-for-sale.

Loans held for sale by type are summarized as follows:

 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
Loans secured by real estate—
 
 
(in thousands)
Residential 1-4 family originated to be held-for-sale
$
3,708

 
$
3,624

 
$
2,136

Residential 1-4 family transferred to held-for-sale

 
7,964

 

Commercial

 
6,906

 

Construction

 
2,537

 

Multi-family and farmland

 
3,962

 

               Total Real Estate
3,708

 
24,993

 
2,136

Commercial loans

 
895

 

Consumer installment loans

 
32

 

Total loans held for sale
$
3,708

 
$
25,920

 
$
2,136


17



The following table presents the Company’s internal risk rating by loan classification for loans held for sale as of December 31, 2012:

 
Pass
 
Special
Mention
 
Substandard –
Non-impaired
 
Substandard –
Impaired
 
Total
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family originated to be held-for-sale
$
3,624

 
$

 
$

 
$

 
$
3,624

Real estate: Residential 1-4 family transferred to held-for-sale
264

 
511

 
4,229

 
2,960

 
7,964

Real estate: Commercial

 
438

 
2,922

 
3,546

 
6,906

Real estate: Construction
23

 
16

 
754

 
1,744

 
2,537

Real estate: Multi-family and farmland
281

 

 
2,788

 
893

 
3,962

Commercial
21

 

 
372

 
502

 
895

Consumer
22

 

 
2

 
8

 
32

Total Loans
$
4,235

 
$
965

 
$
11,067

 
$
9,653

 
$
25,920


Loans held-for-sale at March 31, 2013 and 2012 of $3.7 million and $2.1 million, respectively, were all rated as pass.
Nonaccrual loans held for sale were $13.4 million at December 31, 2012. There were no non-accrual loans held for sale at March 31, 2013 or 2012. The following table provides nonaccrual loans by type:
 
As of December 31, 2012
 
(in thousands)
Nonaccrual Loans by Classification
 
Real estate: Residential 1-4 family
$
5,311

Real estate: Commercial
4,336

Real estate: Construction
1,967

Real estate: Multi-family and farmland
1,152

Commercial
580

Consumer and other
27

Total Loans
$
13,373

All nonaccrual loans in the held-for-sale category are from loans transferred to loans held-for-sale and not from loans that were originated to be sold.
The following table provides the past due status for all loans held for sale as of December 31, 2012. Nonaccrual loans are included in the applicable classification. There were no past due loans held for sale at March 31, 2013 or 2012.

18



As of December 31, 2012
 
 
30-89
Days
Past Due
 
Greater
than
90 Days
Past Due
 
Total
Past Due
 
Current
 
Total
 
Greater
than
90 Days
Past Due
and
Accruing
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family originated to be held-for-sale
$

 
$

 
$

 
$
3,624

 
$
3,624

 
$

Residential 1-4 family transferred to held-for-sale
436

 
697

 
1,133

 
6,831

 
7,964

 
697

Real estate: Commercial
63

 

 
63

 
6,843

 
6,906

 

Real estate: Construction
16

 

 
16

 
2,521

 
2,537

 

Real estate: Multi-family and farmland
1,428

 

 
1,428

 
2,534

 
3,962

 

Subtotal of real estate secured loans
1,943

 
697

 
2,640

 
22,353

 
24,993

 
697

Commercial
292

 
21

 
313

 
582

 
895

 
21

Consumer

 

 

 
32

 
32

 

Leases

 

 

 

 

 

Other

 

 

 

 

 

Total Loans
$
2,235

 
$
718

 
$
2,953

 
$
22,967

 
$
25,920

 
$
718



NOTE 8 – LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES
Loans by type are summarized in the following table.
 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
Loans secured by real estate—
(in thousands)
Residential 1-4 family
$
181,624

 
$
188,191

 
$
210,557

Commercial
223,737

 
221,655

 
226,367

Construction
37,894

 
33,407

 
49,442

Multi-family and farmland
16,530

 
17,051

 
31,532

 
459,785

 
460,304

 
517,898

Commercial loans
61,904

 
61,398

 
60,835

Consumer installment loans
11,880

 
13,387

 
16,450

Leases, net of unearned income
373

 
568

 
2,072

Other
6,346

 
5,473

 
4,524

Total loans
540,288

 
541,130

 
601,779

Allowance for loan and lease losses
(13,500
)
 
(13,800
)
 
(18,990
)
Net loans
$
526,788

 
$
527,330

 
$
582,789

The allowance for loan and lease losses is composed of two primary components: (1) specific impairments for substandard/nonaccrual loans and leases and (2) general allocations for classified loan pools, including special mention and substandard/accrual loans, as well as all remaining pools of loans. The Company accumulates pools based on the underlying classification of the collateral. Each pool is assigned a loss severity rate based on historical loss experience and various qualitative and environmental factors, including, but not limited to, credit quality and economic conditions. The Company determines the allowance on a quarterly basis. Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may materially change in the near term. However, the amount of the change that is reasonably possible cannot be estimated.
The following table presents an analysis of the activity in the allowance for loan and lease losses for the three months ended March 31, 2013 and March 31, 2012. The provisions for loan and lease losses in the table below do not include the Company’s provision accrual for unfunded commitments of $6 thousand and $6 thousand for the three months ended March 31, 2013 and March 31, 2012, respectively. The reserve for unfunded commitments is included in other liabilities in the consolidated balance sheets and totaled $264 thousand, $258 thousand and $255 thousand at March 31, 2013, December 31, 2012 and March 31, 2012, respectively.

19


Allowance for Loan and Lease Losses
For the Three Months Ended March 31, 2013
 
 
Real estate:
Residential
1-4 family
 
Real estate:
Commercial
 
Real estate:
Construction
 
Real estate:
Multi-family
and
farmland
 
Commercial
 
Consumer
 
Leases
 
Other
 
Total
 
(in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance, January 1, 2013
$
6,207

 
$
3,736

 
$
667

 
$
741

 
$
2,103

 
$
272

 
$
47

 
$
27

 
$
13,800

Charge-offs
(651
)
 
(126
)
 
(468
)
 

 
(25
)
 
(184
)
 

 

 
(1,454
)
Recoveries
111

 
37

 
40

 
6

 
122

 
104

 
55

 
1

 
476

Provision
312

 
(235
)
 
723

 
359

 
(382
)
 
(3
)
 
(91
)
 
(5
)
 
678

Ending balance, March 31, 2013
$
5,979

 
$
3,412

 
$
962

 
$
1,106

 
$
1,818

 
$
189

 
$
11

 
$
23

 
$
13,500



Allowance for Loan and Lease Losses
For the Three Months Ended March 31, 2012
 
 
Real estate:
Residential
1-4 family
 
Real estate:
Commercial
 
Real estate:
Construction
 
Real estate:
Multi-family
and
farmland
 
Commercial
 
Consumer
 
Leases
 
Other
 
Total
 
(in thousands)
Beginning balance, January 1, 2012
$
6,368

 
$
6,227

 
$
1,485

 
$
728

 
$
3,649

 
$
405

 
$
718

 
$
20

 
$
19,600

Charge-offs
(1,147
)
 
(537
)
 
(638
)
 
(15
)
 
(231
)
 
(89
)
 
(494
)
 

 
(3,151
)
Recoveries
19

 
23

 
486

 
4

 
112

 
55

 
36

 
5

 
740

Provision
1,016

 
(414
)
 
(265
)
 
787

 
446

 
(17
)
 
251

 
(3
)
 
1,801

Ending balance, March 31, 2012
$
6,256

 
$
5,299

 
$
1,068

 
$
1,504

 
$
3,976

 
$
354

 
$
511

 
$
22

 
$
18,990


20



The following table presents an analysis of the end of period balance of the allowance for loan and lease losses as of March 31, 2013.
As of March 31, 2013
 
 
Real estate:
Residential
1-4 family
 
Real estate:
Commercial
 
Real estate:
Construction
 
Real estate:
Multi-family and
farmland
 
Total Real Estate
Loans
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
(in thousands)
Individually evaluated
$
1,155

 
$
51

 
$
710

 
$

 
$
26

 
$

 
$

 
$

 
$
1,891

 
$
51

Collectively evaluated
180,469

 
5,928

 
223,027

 
3,412

 
37,868

 
962

 
16,530

 
1,106

 
457,894

 
11,408

Total evaluated
$
181,624

 
$
5,979

 
$
223,737

 
$
3,412

 
$
37,894

 
$
962

 
$
16,530

 
$
1,106

 
$
459,785

 
$
11,459

 
 
Commercial
 
Consumer
 
Leases
 
Other
 
Grand Total
(continued from above)
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
(in thousands)
Individually evaluated
$
2,042

 
$
6

 
$

 
$

 
$
285

 
$

 
$

 
$

 
$
4,218

 
$
57

Collectively evaluated
59,862

 
1,812

 
11,880

 
189

 
88

 
11

 
6,346

 
23

 
536,070

 
13,443

Total evaluated
$
61,904

 
$
1,818

 
$
11,880

 
$
189

 
$
373

 
$
11

 
$
6,346

 
$
23

 
$
540,288

 
$
13,500


The following table presents an analysis of the end of period balance of the allowance for loan and lease losses as of December 31, 2012.
As of December 31, 2012
 
 
Real estate:
Residential
1-4 family
 
Real estate:
Commercial
 
Real estate:
Construction
 
Real estate:
Multi-family and
farmland
 
Total Real Estate
Loans
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
(in thousands)
Individually evaluated
$
457

 
$

 
$
727

 
$

 
$
1,783

 
$

 
$

 
$

 
$
2,967

 
$

Collectively evaluated
187,734

 
6,207

 
220,928

 
3,736

 
31,624

 
667

 
17,051

 
741

 
457,337

 
11,351

Total evaluated
$
188,191

 
$
6,207

 
$
221,655

 
$
3,736

 
$
33,407

 
$
667

 
$
17,051

 
$
741

 
$
460,304

 
$
11,351

 
 
Commercial
 
Consumer
 
Leases
 
Other
 
Grand Total
(continued from above)
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
Carrying
Value
 
Associated
Allowance
 
(in thousands)
Individually evaluated
$
2,077

 
$
50

 
$

 
$

 
$
392

 
$

 
$

 
$

 
$
5,436

 
$
50

Collectively evaluated
59,321

 
2,053

 
13,387

 
272

 
176

 
47

 
5,473

 
27

 
535,694

 
13,750

Total evaluated
$
61,398

 
$
2,103

 
$
13,387

 
$
272

 
$
568

 
$
47

 
$
5,473

 
$
27

 
$
541,130

 
$
13,800


21


The Company utilizes a risk rating system to evaluate the credit risk of its loan portfolio. The Company classifies loans as: pass, special mention, substandard/non-impaired, substandard/impaired, doubtful or loss. The following describes the Company's classifications and the various risk indicators associated with each rating.
A pass rating is assigned to those loans that are performing as contractually agreed and do not exhibit the characteristics of the criticized and classified risk ratings as defined below. Pass loan pools do not include the unfunded portions of binding commitments to lend, standby letters of credit, deposit secured loans or mortgage loans originated with commitments to sell in the secondary market. Loans secured by segregated deposits held by FSGBank are not required to have an allowance reserve, nor are originated held-for-sale mortgage loans pending sale in the secondary market.
A special mention loan risk rating is considered criticized but is not considered as severe as a classified loan risk rating. Special mention loans contain one or more potential weakness(es), which if not corrected, could result in an unacceptable increase in credit risk at some future date. These loans may be characterized by the following risks and/or trends:
Loans to Businesses:
Downward trend in sales, profit levels and margins
Impaired working capital position compared to industry
Cash flow strained in order to meet debt repayment schedule
Technical defaults due to noncompliance with financial covenants
Recurring trade payable slowness
High leverage compared to industry average with shrinking equity cushion
Questionable abilities of management
Weak industry conditions
Inadequate or outdated financial statements
Loans to Businesses or Individuals:
Loan delinquencies and overdrafts may occur
Original source of repayment questionable
Documentation deficiencies may not be easily correctable
Loan may need to be restructured
Collateral or guarantor offers adequate protection
Unsecured debt to tangible net worth is excessive
A substandard loan risk rating is characterized as having specifically identified weaknesses and deficiencies typically resulting from severe adverse trends of a financial, economic, or managerial nature, and may warrant non-accrual status.
The Company segregates substandard loans into two classifications based on the Company’s allowance methodology for impaired loans. The Company defines a substandard/impaired loan as a substandard loan relationship in excess of $500 thousand that is individually reviewed. Substandard loans have a greater likelihood of loss and may require a protracted work-out plan. In addition to the factors listed for special mention loans, substandard loans may be characterized by the following risks and/or trends:
Loans to Businesses:
Sustained losses that have severely eroded equity and cash flows
Concentration in illiquid assets
Serious management problems or internal fraud
Chronic trade payable slowness; may be placed on COD or collection by trade creditor
Inability to access other funding sources
Financial statements with adverse opinion or disclaimer; may be received late
Insufficient documented cash flows to meet contractual debt service requirements
Loans to Businesses or Individuals:
Chronic or severe delinquency or has met the retail classification standards which is generally past dues greater than 90 days
Frequent overdrafts
Likelihood of bankruptcy exists
Serious documentation deficiencies
Reliance on secondary sources of repayment which are presently considered adequate
Demand letter sent
Litigation may have been filed against the borrower

22



Loans with a risk rating of doubtful are individually analyzed to determine the Company's best estimate of the loss based on the most recent assessment of all available sources of repayment. Doubtful loans are considered impaired and placed on nonaccrual. For doubtful loans, the collection or liquidation in full of principal and/or interest is highly questionable or improbable. The Company estimates the specific potential loss based upon an individual analysis of the relationship risks, the borrower’s cash flow, the borrower’s management and any underlying secondary sources of repayment. The amount of the estimated loss, if any, is then either specifically reserved in a separate component of the allowance or charged-off. In addition to the characteristics listed for substandard loans, the following characteristics apply to doubtful loans:
Loans to Businesses:
Normal operations are severely diminished or have ceased
Seriously impaired cash flow
Numerous exceptions to loan agreement
Outside accountant questions entity’s survivability as a “going concern”
Financial statements may be received late, if at all
Material legal judgments filed
Collection of principal and interest is impaired
Collateral/Guarantor may offer inadequate protection
Loans to Businesses or Individuals:
Original repayment terms materially altered
Secondary source of repayment is inadequate
Asset liquidation may be in process with all efforts directed at debt retirement
Documentation deficiencies not correctable
The consistent application of the above loan risk rating methodology ensures that the Company has the ability to track historical losses and appropriately estimate potential future losses in our allowance. Additionally, appropriate loan risk ratings assist the Company in allocating credit and special asset personnel in the most effective manner. Significant changes in loan risk ratings can have a material impact on the allowance and thus a material impact on the Company's financial results by requiring significant increases or decreases in provision expense. The Company individually reviews these relationships on a quarterly basis to determine the required allowance or loss, as applicable.
The following table presents the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of March 31, 2013:
As of March 31, 2013
 
 
Pass
 
Special
Mention
 
Substandard –
Non-impaired
 
Substandard –
Impaired
 
Total
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
158,350

 
$
8,544

 
$
13,575

 
$
1,155

 
$
181,624

Real estate: Commercial
211,196

 
4,006

 
7,825

 
710

 
223,737

Real estate: Construction
37,018

 
93

 
757

 
26

 
37,894

Real estate: Multi-family and farmland
14,609

 
818

 
1,103

 

 
16,530

Commercial
52,903

 
801

 
6,158

 
2,042

 
61,904

Consumer
11,386

 
105

 
389

 

 
11,880

Leases

 
88

 

 
285

 
373

Other
6,241

 

 
105

 

 
6,346

Total Loans
$
491,703

 
$
14,455

 
$
29,912

 
$
4,218

 
$
540,288


23



The following table presents the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of December 31, 2012:
As of December 31, 2012
 
 
Pass
 
Special
Mention
 
Substandard –
Non-impaired
 
Substandard –
Impaired
 
Total
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
164,555

 
$
7,668

 
$
15,511

 
$
457

 
$
188,191

Real estate: Commercial
207,188

 
4,930

 
8,810

 
727

 
221,655

Real estate: Construction
30,471

 
97

 
1,056

 
1,783

 
33,407

Real estate: Multi-family and farmland
14,025

 
1,794

 
1,232

 

 
17,051

Commercial
51,972

 
756

 
6,593

 
2,077

 
61,398

Consumer
12,793

 
126

 
468

 

 
13,387

Leases
1

 
74

 
101

 
392

 
568

Other
5,365

 

 
108

 

 
5,473

Total Loans
$
486,370

 
$
15,445

 
$
33,879

 
$
5,436

 
$
541,130

The following table presents the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of March 31, 2012:

As of March 31, 2012
 
Pass
 
Special
Mention
 
Substandard –
Non-impaired
 
Substandard –
Impaired
 
Total
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
177,198

 
$
7,417

 
$
22,138

 
$
3,804

 
$
210,557

Real estate: Commercial
188,893

 
9,900

 
18,552

 
9,022

 
226,367

Real estate: Construction
33,243

 
803

 
3,131

 
12,265

 
49,442

Real estate: Multi-family and farmland
21,633

 
2,035

 
7,004

 
860

 
31,532

Commercial
40,685

 
7,040

 
9,401

 
3,709

 
60,835

Consumer
15,905

 
37

 
508

 

 
16,450

Leases

 
359

 
677

 
1,036

 
2,072

Other
4,419

 

 
105

 

 
4,524

Total Loans
$
481,976

 
$
27,591

 
$
61,516

 
$
30,696

 
$
601,779

The Company classifies a loan as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans were $4.2 million, $5.4 million and $30.7 million at March 31, 2013, December 31, 2012 and March 31, 2012, respectively. For impaired loans, the Company generally applies all payments directly to principal. Accordingly, the Company did not recognize any significant amount of interest for impaired loans during the three months ended March 31, 2013 and 2012.

24



The following table presents additional information on the Company’s impaired loans as of March 31, 2013, December 31, 2012 and March 31, 2012:
 
 
As of March 31, 2013
 
As of December 31, 2012
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Balance of
Recorded
Investment
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Balance of
Recorded
Investment
 
(in thousands)
Impaired loans with no related allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
1,104

 
$
1,074

 
$

 
$
3,221

 
$
457

 
$
529

 
$

 
$
3,474

Real estate: Commercial
710

 
762

 

 
7,487

 
727

 
4,438

 

 
10,099

Real estate: Construction
26

 
472

 

 
7,083

 
1,783

 
2,512

 

 
9,875

Real estate: Multi-family and farmland

 

 

 
857

 

 

 

 
1,071

Commercial
2,036

 
2,718

 

 
2,018

 
2,027

 
3,062

 

 
2,214

Consumer

 

 

 
50

 

 

 

 
385

Leases
285

 
285

 

 
523

 
392

 
392

 

 
684

Total
$
4,161

 
$
5,311

 
$

 
$
21,239

 
$
5,386

 
$
10,933

 
$

 
27,802

Impaired loans with an allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
51

 
$
150

 
$
51

 
$
436

 
$

 
$

 
$

 
425

Real estate: Commercial

 

 

 
445

 

 

 

 
445

Real estate: Construction

 

 

 
1,167

 

 

 

 
2,214

Real estate: Multi-family and farmland

 

 

 
71

 

 

 

 
71

Commercial
6

 
394

 
6

 
889

 
50

 
95

 
50

 
1,074

Consumer

 

 

 

 

 

 

 
96

Leases

 

 

 
108

 

 

 

 
108

Total
57

 
544

 
57

 
3,116

 
50

 
95

 
50

 
4,433

Total impaired loans
$
4,218

 
$
5,855

 
$
57

 
$
24,355

 
$
5,436

 
$
11,028

 
$
50

 
32,235



25


 
As of March 31, 2012
 
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Balance of
Recorded
Investment
 
 
(in thousands)
Impaired loans with no related allowance recorded:
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
3,205

 
$
3,337

 
$

 
$
2,786

 
Real estate: Commercial
8,465

 
12,127

 

 
11,120

 
Real estate: Construction
12,265

 
14,982

 

 
13,125

 
Real estate: Multi-family and farmland
860

 
860

 

 
965

 
Commercial
1,070

 
1,070

 

 
2,045

 
Consumer

 

 

 
837

 
Leases
494

 
494

 

 
792

 
Other

 

 

 

 
Total
$
26,359

 
$
32,870

 
$

 
$
31,670

 
Impaired loans with an allowance recorded:
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
599

 
$
599

 
$
33

 
$
300

 
Real estate: Commercial
557

 
557

 
55

 
279

 
Real estate: Construction

 

 

 
2,618

 
Real estate: Multi-family and farmland

 

 

 

 
Commercial
2,640

 
2,640

 
1,490

 
1,784

 
Consumer

 

 

 

 
Leases
541

 
541

 
271

 
271

 
Total
4,337

 
4,337

 
1,849

 
5,252

 
Total impaired loans
$
30,696

 
$
37,207

 
$
1,849

 
$
36,922

 

Nonaccrual loans were $10.2 million, $11.7 million and $43.1 million at March 31, 2013December 31, 2012 and March 31, 2012, respectively. The following table provides nonaccrual loans by type:
 
 
As of March 31, 2013
 
As of December 31, 2012
 
As of March 31, 2012
 
(in thousands)
Nonaccrual Loans by Classification
 
 
 
 
 
Real estate: Residential 1-4 family
$
5,065

 
$
3,906

 
$
10,812

Real estate: Commercial
1,467

 
1,814

 
10,716

Real estate: Construction
462

 
2,549

 
13,353

Real estate: Multi-family and farmland
93

 
94

 
1,644

Commercial
2,484

 
2,524

 
4,586

Consumer and other
310

 
375

 
455

Leases
313

 
436

 
1,571

Total Loans
$
10,194

 
$
11,698

 
$
43,137


26



The Company monitors loans by past due status. The following table provides the past due status for all loans. Nonaccrual loans are included in the applicable classification.
As of March 31, 2013
 
 
30-89
Days
Past Due
 
Greater
than
90 Days
Past Due
 
Total
Past Due
 
Current
 
Total
 
Greater
than
90 Days
Past Due
and
Accruing
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
2,084

 
$
4,298

 
$
6,382

 
$
175,242

 
$
181,624

 
$
369

Real estate: Commercial
1,686

 
2,032

 
3,718

 
220,019

 
223,737

 
565

Real estate: Construction
434

 
187

 
621

 
37,273

 
37,894

 
90

Real estate: Multi-family and farmland
866

 
119

 
985

 
15,545

 
16,530

 
30

Subtotal of real estate secured loans
5,070

 
6,636

 
11,706

 
448,079

 
459,785

 
1,054

Commercial
551

 
2,338

 
2,889

 
59,015

 
61,904

 
189

Consumer
9

 
255

 
264

 
11,616

 
11,880

 

Leases
28

 
340

 
368

 
5

 
373

 
27

Other

 

 

 
6,346

 
6,346

 

Total Loans
$
5,658

 
$
9,569

 
$
15,227

 
$
525,061

 
$
540,288

 
$
1,270


As of December 31, 2012
 
 
30-89
Days
Past Due
 
Greater
than
90 Days
Past Due
 
Total
Past Due
 
Current
 
Total
 
Greater
than
90 Days
Past Due
and
Accruing
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
3,189

 
$
3,066

 
$
6,255

 
$
181,936

 
$
188,191

 
$
312

Real estate: Commercial
885

 
1,973

 
2,858

 
218,797

 
221,655

 
159

Real estate: Construction
626

 
1,653

 
2,279

 
31,128

 
33,407

 

Real estate: Multi-family and farmland
255

 
89

 
344

 
16,707

 
17,051

 

Subtotal of real estate secured loans
4,955

 
6,781

 
11,736

 
448,568

 
460,304

 
471

Commercial
1,223

 
2,360

 
3,583

 
57,815

 
61,398

 
463

Consumer
107

 
270

 
377

 
13,010

 
13,387

 

Leases
28

 
435

 
463

 
105

 
568

 
4

Other

 

 

 
5,473

 
5,473

 

Total Loans
$
6,313

 
$
9,846

 
$
16,159

 
$
524,971

 
$
541,130

 
$
938



27



As of March 31, 2012

 
30-89
Days
Past Due
 
Greater
than
90 Days
Past Due
 
Total
Past Due
 
Current
 
Total
 
Greater
than
90 Days
Past Due
and
Accruing
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
2,932

 
$
6,121

 
$
9,053

 
$
201,504

 
$
210,557

 
$
450

Real estate: Commercial
3,535

 
9,549

 
13,084

 
213,283

 
226,367

 
2,322

Real estate: Construction
2,035

 
10,391

 
12,426

 
37,016

 
49,442

 
223

Real estate: Multi-family and farmland

 
1,366

 
1,366

 
30,166

 
31,532

 
466

Subtotal of real estate secured loans
8,502

 
27,427

 
35,929

 
481,969

 
517,898

 
3,461

Commercial
1,518

 
4,576

 
6,094

 
54,741

 
60,835

 
194

Consumer
26

 
251

 
277

 
16,173

 
16,450

 
1

Leases
137

 
580

 
717

 
1,355

 
2,072

 
44

Other
3

 

 
3

 
4,521

 
4,524

 

Total Loans
$
10,186

 
$
32,834

 
$
43,020

 
$
558,759

 
$
601,779

 
$
3,700


As of March 31, 2013, the Company had four loans, not on non-accrual, that were considered troubled debt restructurings. Two commercial loans of $745 thousand were restructured to an extended term to assist the borrower by reducing the monthly payments. Two residential loans of $285 thousand were restructured with lower interest rates and payments. As of March 31, 2013, these loans are performing under the modified terms.
The Company had $1.1 million and $4.8 million in troubled debt restructurings outstanding as of March 31, 2013 and 2012, respectively. The Company has allocated no specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of March 31, 2013 and $55 thousand in specific reserves as of March 31, 2012. The Company has not committed to lend additional amounts as of March 31, 2013 and 2012 to customers with outstanding loans that are classified as troubled debt restructurings.
The Company completed one modification totaling $61 thousand that would qualify as a troubled debt restructuring during the three months ended March 31, 2013. The Company completed no modifications that would qualify as troubled debt restructurings during the three months ended March 31, 2012.
The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the three months ended March 31, 2013 and 2012:
 
 
As of March 31, 2013
 
As of March 31, 2012
 
Number of
Contracts
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
 
Number of
Contracts
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
 
 
 
(dollar amounts in thousands)
 
 
 
(dollar amounts in thousands)
Troubled Debt Restructurings That Subsequently Defaulted:
 
 
 
 
 
 
 
 
 
 
 
Real estate:
 
 
 
 
 
 
 
 
 
 
 
Residential
1

 
$
70

 
$
70

 
1
 
$
254

 
$
235

Commercial

 

 

 
2
 
1,262

 
432

Total
1

 
$
70

 
$
70

 
3
 
$
1,516

 
$
667

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.
The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses and resulted in zero and $395 thousand in charge offs during the three months ended March 31, 2013 and 2012, respectively.

28




NOTE 9 – SUPPLEMENTAL FINANCIAL DATA
Components of other noninterest income or other noninterest expense in excess of 1% of the aggregate of total interest income and noninterest income are shown in the following table.
 
 
Three Months Ended
 
March 31,
 
2013
 
2012
Other noninterest income—
(in thousands)
Point-of-service fees
315

 
342

Bank-owned life insurance income
241

 
204

Trust fees
147

 
145

Gain on sale of other real estate owned
178

 
125

All other items
307

 
275

Total other noninterest income
$
1,188

 
$
1,091

Other noninterest expense—
 
 
 
Professional fees
$
2,118

 
$
726

FDIC insurance
1,000

 
650

Data processing
371

 
367

Write-downs on other real estate owned and repossessions
1,315

 
2,297

Losses on other real estate owned, repossessions and fixed assets
10

 
328

OREO and repossession holding costs
322

 
530

Communications
108

 
131

ATM/Debit Card fees
186

 
102

Insurance
405

 
217

OCC Assessments
127

 
124

Intangible asset amortization
75

 
119

All other items
949

 
668

Total other noninterest expense
$
6,986

 
$
6,259


NOTE 10 – COMMITMENTS AND CONTINGENCIES
The Company is party to credit related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and the issuance of financial guarantees in the form of financial and performance standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.
The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as they do for on-balance-sheet instruments.
The Company’s maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at March 31, 2013, December 31, 2012, and March 31, 2012 was as follows:
 
 
March 31,
2013
 
December 31, 2012
 
March 31,
2012
 
(in thousands)
Commitments to extend credit - fixed rate
$
17,319

 
$
16,312

 
$
10,481

Commitments to extend credit - variable rate
$
90,322

 
$
94,822

 
$
81,817

   Total commitments to extend credit
$
107,641

 
$
111,134

 
$
92,298

 
 
 
 
 
 
Standby letters of credit
$
2,761

 
$
5,023

 
$
7,916



29


Commitments to extend credit are agreements to lend to customers. Standby letters of credit are contingent commitments issued by the Company to guarantee performance of a customer to a third party under a contractual non-financial obligation for which it receives a fee. Financial standby letters of credit represent a commitment to guarantee customer repayment of an outstanding loan or debt instrument. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company on extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.
The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. Additionally, in the ordinary course of business, the Company is subject to regulatory examinations, information gathering requests, inquiries, and investigations. The Company establishes accruals for litigation and regulatory matters when those matters present loss contingencies that the Company determines to be both probable and reasonably estimable. Based on current knowledge, advice of counsel and available insurance coverage, management does not believe that liabilities arising from legal claims, if any, will have a material adverse effect on the Company’s consolidated financial condition, results of operations, or cash flows. However, in light of the significant uncertainties involved in these matters, the early stage of various legal proceedings, and the indeterminate amount of damages sought in some of these matters, it is possible that the ultimate resolution of these matters, if unfavorable, could be material to the Company’s results of operations for any particular period.
The Company intends to vigorously pursue all available defenses to these claims. There are significant uncertainties involved in any litigation. Although the ultimate outcome of these lawsuits cannot be ascertained at this time, based upon information that presently is available to it, management is unable to predict the outcome of these cases and cannot determine the probability of an adverse result or reasonably estimate a range of potential loss, if any. In addition, management is unable to estimate a range of reasonably possible losses with respect to these claims.

NOTE 11 – SHAREHOLDERS’ EQUITY
Common Stock
On September 7, 2010, the Company entered into the Agreement with the Federal Reserve. Pursuant to the Agreement, the Company is prohibited from declaring or paying dividends without prior written consent from the Federal Reserve. See Note 2 for additional information regarding the Agreement.
Preferred Stock
The Series A Preferred Stock qualifies as Tier 1 capital and pays 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. The 33,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, having a liquidation preference of $1,000 per share (the Series A Preferred Stock), were issued to Treasury as part of as part of the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP). Since the first quarter of 2010, the Board of Directors has elected on a quarterly basis to defer dividend payments for the Series A Preferred Stock. Under the terms of the Series A Preferred Stock, Treasury has the right to appoint up to two directors to the Company's Board of Directors at any time that dividends payable on the Series A Preferred Stock have not been paid for an aggregate of six quarterly dividend periods. As previously reported, William F. Grant, III and Robert R. Lane were elected to the Company's Board of Directors in 2012 pursuant to the terms of the Series A Preferred Stock. 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 on the Series A Preferred Stock for all past dividend periods have been paid. Members of the Board of Directors elected by Treasury have the same fiduciary duties and obligations to all the shareholders of First Security as any other member of the Board of Directors. On April 11, 2013, the Company completed a restructuring of the Company's Preferred Stock with the U.S. Treasury by issuing new common stock for the full satisfaction of the Treasury's 2009 investment in the Company. See Note 2 for additional information and discussion.
The Company recognized $413 thousand and $413 thousand in dividends for the Series A Preferred Stock for the three months ended ended March 31, 2013 and 2012, respectively. As of March 31, 2013, aggregate unpaid, accrued dividends on the Series A Preferred Stock are $5.6 million which is included in other liabilities in the Company’s consolidated balance sheet. For the three months ended March 31, 2013 and 2012, the Company recognized $111 thousand and $104 thousand, respectively, in discount accretion on the Series A Preferred Stock.

30



ESOP Activity
On July 23, 2008, the Board of Directors approved a loan, which was subsequently amended on January 28, 2009, in the amount of $12.7 million from First Security Group, Inc. to the Plan. The purpose of the loan was to purchase Company shares in open market transactions through December 31, 2009. As the loan is repaid, shares are released from collateral based on the proportion of the payment in relation to total payments required to be made on the loan, and those shares are allocated to the ESOP accounts of participants. As of December 31, 2012, the loan has been repaid to the Company and all shares purchased were fully allocated. The shares will be used for future Company matching contributions with the 401(k) and ESOP plan. As of December 31, 2009, the cumulative purchases totaled 70,068 shares at a total cost of $4.1 million, or an average of $57.90 per share. No shares have been purchased by the 401(k) and ESOP plan since December 31, 2009. As of December 31, 2012 all shares purchased by the 401(k) and ESOP plan were fully allocated as shown in the table below.
401(k) Activity
The Company matches contributions of 100% of the employee’s contribution up to 1% of the employee’s compensation for the Plan year. Expense associated with the match was $26 thousand and $24 thousand for the three months ended March 31, 2013 and 2012, respectively.
The Company released shares from the ESOP for the matching contribution of 100% of the employees contribution up to 1% of the employees compensation for the plan year. The number of unallocated, committed to be released, and allocated shares for the ESOP are presented in this table.
 
 
Unallocated
Shares
 
Committed
to be
released
shares
 
Allocated
Shares
 
Compensation
Expense
 

 
 
 
 
 
(in thousands)
Shares as of December 31, 2012

 

 
120,074

 
 
Shares allocated during 2013

 

 

 
$

Shares as of March 31, 2013

 

 
120,074

 
 


NOTE 12 – INCOME TAXES
The Company accounts for income taxes in accordance with ASC 740, which requires an asset and liability approach for the financial accounting and reporting of income taxes. Under this method, deferred income taxes are recognized for the expected future tax consequences of differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. These balances are measured using the enacted tax rates expected to apply in the year(s) in which these temporary differences are expected to reverse. The effect on deferred income taxes of a change in tax rates is recognized in income in the period when the change is enacted.
In accordance with ASC 740, the Company is required to establish a valuation allowance for deferred tax assets when it is “more likely than not” that a portion or all of the deferred tax assets will not be realized. The evaluation requires significant judgment and extensive analysis of all available positive and negative evidence, the forecasts of future income, applicable tax planning strategies and assessments of the current and future economic and business conditions.
During 2010, the Company established a deferred tax asset valuation allowance after evaluating all available positive and negative evidence. The Company evaluates the valuation allowance quarterly. Positive evidence includes the existence of taxes paid in available carryback years. Negative evidence includes a cumulative loss in recent years and general business and economic trends. As business and economic conditions change, the Company will re-evaluate the valuation allowance. As of March 31, 2013, the valuation allowance totals $53.5 million resulting in a net deferred tax asset of zero.
On October 24, 2012, the Board of Directors of the Company authorized the adoption by the Company of a Tax Benefits Preservation Plan and declared a dividend of one preferred stock purchase right for each outstanding share of the Company's common stock, payable to holders of record as of the close of business on November 12, 2012. The purpose of the Plan is to help preserve the value of the Company's deferred tax assets, such as its net operating losses, for U.S. federal income tax purposes.

31



For the three months ended March 31, 2013 and 2012, the Company recognized an income tax provision of $119 thousand and an income tax benefit of $109 thousand, respectively. The following reconciles the income tax provision to Federal taxes at the statutory rate:
 
 
Three Months Ended
 
March 31,
 
2013
 
2012
 
(in thousands)
Federal taxes at statutory tax rate
$
(2,298
)
 
$
(1,944
)
Tax exempt earnings on loans and securities
(70
)
 
(96
)
Tax exempt earnings on bank owned life insurance
(62
)
 
(59
)
Low-income housing tax credits
(83
)
 
(91
)
Other, net
58

 
14

State tax provision, net of federal effect
(290
)
 
(242
)
Change in reserve for uncertain tax positions

 

Changes in the deferred tax asset valuation allowance
2,864

 
2,527

Income tax provision (benefit)
$
119

 
$
109


The increases in the deferred tax valuation allowance offset the income tax benefits recognized for the three months ended March 31, 2013. The benefit recognized before the valuation allowance primarily related to the year-to-date operating loss.
The Company evaluated its material tax positions as of March 31, 2013. Under the “more-likely-than-not” threshold guidelines, the Company believes it has identified all significant uncertain tax benefits. The Company evaluates, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be accrued, in accordance with Internal Revenue Service guidelines, and recorded as a component of income tax expense in the Company’s consolidated financial statements.

NOTE 13 – FAIR VALUE MEASUREMENTS
The authoritative accounting guidance for fair value measurements defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Authoritative guidance establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.
There are three levels of inputs that may be used to measure fair values:
Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity can access as of the measurement date.
Level 2 - Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3 - Significant unobservable inputs that reflect a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of March 31, 2013, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels

32


of the hierarchy. In such cases, the fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety.
The Company used the following methods and significant assumptions to estimate fair value:
Cash and cash equivalents: The carrying value of cash and cash equivalents approximates fair value.
Interest bearing deposits in banks: The carrying amounts of interest bearing deposits in banks approximate fair value.
Federal Home Loan Bank Stock and Federal Reserve Bank Stock: It is not practical to determine the fair value of FHLB stock or FRB Stock due to restrictions placed on their transferability. As such, these instruments are carried at cost.
Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations. Our municipal securities valuations are supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions for similar securities and market quotations for similar securities. As these securities are not rated by the rating agencies and trading volumes are thin, it was determined that these were valued using Level 2 inputs.
Derivatives: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2).
Loans: For variable-rate loans that reprice frequently and have no significant changes in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans and other consumer loans are estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans and leases is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers of similar credit ratings quality. Fair value for impaired loans and leases are estimated using discounted cash flow analysis or underlying collateral values, where applicable. The fair value may not approximate the exit price.
Impaired Loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower's financial statements, or aging reports, adjusted or discounted based on management's historical knowledge, changes in market conditions from the time of the valuation, and management's expertise and knowledge of the client and client's business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Appraisals for both collateral-dependent impaired loans and other real estate owned are performed annually by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Special Assets Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with via independent data sources such as recent market data or industry-wide statistics. On an annual basis, the Company compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value. The most recent analysis performed indicated that a discount of approximately 17% should be applied.

33


Loans Held For Sale: Fair value for loans originated to be held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2). Fair value of loans transferred to held for sale is determined using the sales price of the loans which has no observable market, resulting in a Level 3 fair value classification.
Accrued interest receivable: The carrying value of accrued interest receivable approximates fair value.
Deposit liabilities: The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value for fixed-rate certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregate expected maturities on time deposits.
Federal funds purchased and securities sold under agreements to repurchase: These borrowings generally mature in 90 days or less and, accordingly, the carrying amount reported in the consolidated balance sheets approximates fair value.
Accrued interest payable: The carrying value of accrued interest payable approximates fair value.
Other borrowings: Other borrowings carrying amount reported in the consolidated balance sheets approximates fair value.
Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:
 
 
Fair Value Measurements at
 
March 31, 2013 Using:
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
Securities available-for-sale—
 
 
 
 
 
 
 
Federal Agencies
$

 
$
65,860

 
$

 
$
65,860

Mortgage-backed—residential

 
151,884

 

 
151,884

Municipals

 
36,390

 

 
36,390

Other

 
3,993

 
48

 
4,041

Total securities available-for-sale
$

 
$
258,127

 
$
48

 
$
258,175

Loans held for sale
$

 
$
3,708

 
$

 
$
3,708

Financial liabilities
 
 
 
 
 
 
 
Forward loan sales contracts
$

 
$
28

 
$

 
$
28


 
Fair Value Measurements at
 
December 31, 2012 Using:
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
Securities available-for-sale—
 
 
 
 
 
 
 
Federal agencies
$

 
$
57,545

 
$

 
$
57,545

Mortgage-backed—residential

 
160,477

 

 
160,477

Municipals

 
35,994

 

 
35,994

Other

 

 
41

 
41

Total securities available-for-sale
$

 
$
254,016

 
$
41

 
$
254,057

Loans held for sale
$

 
$
3,624

 
$

 
$
3,624

Financial liabilities
 
 
 
 
 
 
 
Forward loan sales contracts
$

 
$
25

 
$

 
$
25

 

34


 
Fair Value Measurements at
 
March 31, 2012 Using:
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
Securities available-for-sale—
 
 
 
 
 
 
 
Federal agencies
$

 
$
22,142

 
$

 
$
22,142

Mortgage-backed—residential

 
170,187

 

 
170,187

Municipals

 
29,443

 
1,337

 
30,780

Other

 

 
46

 
46

Total securities available-for-sale
$

 
$
221,772

 
$
1,383

 
$
223,155

Loans held for sale
$

 
$
2,136

 
$

 
$
2,136

Forward loan sales contracts
$

 
$
61

 
$

 
$
61

Financial liabilities
 
 
 
 
 
 
 
None
 
 
 
 
 
 
 

The following table presents additional information about changes in assets and liabilities measured at fair value on a recurring basis and for which the Company utilized Level 3 inputs to determine fair value as of March 31, 2013.
 
 
Balance as of December 31, 2012
 
Total
Realized
and
Unrealized
Gains or
Losses
 
Sales
 
Net
Transfers
In and/or
Out of
Level 3
 
Balance as of March 31, 2013
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
 
 
Securities available-for-sale—
 
 
 
 
 
 
 
 
 
Other
$
41

 
7

 

 

 
$
48


At March 31, 2013, the Company also had assets and liabilities measured at fair value on a non-recurring basis. Items measured at fair value on a non-recurring basis include other real estate owned (OREO), and collateral-dependent impaired loans. Such measurements were determined utilizing Level 3 inputs.

35


The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis for which impairment was recognized during the three months ended March 31, 2013.
 
 
Carrying Value as of March 31, 2013
 
Level 1
Fair Value
Measurement
 
Level 2
Fair Value
Measurement
 
Level 3
Fair Value
Measurement
 
Valuation Allowance as of March 31, 2013
 
(in thousands)
Other real estate owned –
 
 
 
 
 
 
 
 
 
Construction/development loans
$
4,951

 
$

 
$

 
$
4,951

 
$
(3,668
)
Residential real estate loans
1,058

 

 

 
1,058

 
(508
)
Multi-family and farmland
840

 

 

 
840

 
(263
)
Commercial real estate loans
3,079

 

 

 
3,079

 
(1,557
)
Commercial and industrial loans
273

 

 

 
273

 
(150
)
Other real estate owned
10,201

 

 

 
10,201

 
(6,146
)
Collateral-dependent loans –
 
 
 
 
 
 
 
 
 
Real Estate: Residential 1-4 family
1,005

 

 

 
1,005

 

Real Estate: Commercial
350

 

 

 
350

 

Real Estate: Construction
26

 

 

 
26

 

Commercial
436

 

 

 
436

 

Collateral-dependent loans
1,817

 

 

 
1,817

 

Totals
$
12,018

 
$

 
$

 
$
12,018

 
$
(6,146
)

The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis for which impairment was recognized during the twelve months ended December 31, 2012.
 
 
Carrying Value as of December 31, 2012
 
Level 1
Fair Value
Measurement
 
Level 2
Fair Value
Measurement
 
Level 3
Fair Value
Measurement
 
Valuation Allowance as of December 31, 2012
 
(in thousands)
Loans transferred to held for sale
$
22,296

 
$

 
$

 
$
22,296

 
$

Other real estate owned –
 
 
 
 
 
 
 
 
 
Construction/development loans
5,279

 

 

 
5,279

 
(2,921
)
Residential real estate loans
1,489

 

 

 
1,489

 
(450
)
Commercial real estate loans
2,901

 

 

 
2,901

 
(1,081
)
Multi-family and farmland loans
873

 

 

 
873

 
(229
)
Commercial and industrial loans
273

 

 

 
273

 
(150
)
Other real estate owned
10,815

 

 

 
10,815

 
(4,831
)
Collateral-dependent loans –
 
 
 
 
 
 
 
 
 
Real Estate: Residential 1-4 family
457

 

 

 
457

 

Real Estate: Commercial
727

 

 

 
727

 

Real Estate: Construction
1,783

 

 

 
1,783

 

Commercial
436

 

 

 
436

 

Collateral-dependent loans
3,403

 

 

 
3,403

 

Totals
$
14,218

 
$

 
$

 
$
14,218

 
$
(4,831
)

36



The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis for which impairment was recognized for during the three months ended March 31, 2012.
 
 
Carrying Value as of March 31, 2012
 
Level 1
Fair Value
Measurement 
 
 
Level 2
Fair Value
Measurement 
 
 
Level 3
Fair Value
Measurement 
 
 
Valuation Allowance as of March 31, 2012
 
(in thousands)
Other real estate owned -
 
 
 
 
 
 
 
 
 
Construction/development loans
$
7,946

 
$

 
$

 
$
7,946

 
$
(5,593
)
Residential real estate loans
2,860

 

 

 
2,860

 
(1,627
)
Multi-family and farmland loans
429

 

 

 
429

 
(112
)
Commercial real estate loans
3,555

 

 

 
3,555

 
(3,244
)
Other real estate owned
14,790

 

 

 
14,790

 
(10,576
)
 
 
 
 
 
 
 
 
 
 
Collateral-dependent loans -
 

 
 
 
 
 
 

 
 

Real Estate: Residential 1-4 family
2,906

 

 

 
2,906

 
(33
)
Real Estate: Commercial
6,059

 

 

 
6,059

 

Real Estate: Construction
12,265

 

 

 
12,265

 

Real Estate: Multi-family and farmland
369

 

 

 
369

 

Commercial
1,564

 

 

 
1,564

 

Collateral-dependent loans
23,163

 

 

 
23,163

 
(33
)
Totals
$
37,953

 
$

 
$

 
$
37,953

 
$
(10,609
)
For the three month period ended March 31, 2013, the Company established, increased or decreased its valuation allowance on $10.2 million of other real estate owned. The Company recorded write-downs on other real estate owned of $1.3 million during the three months ended March 31, 2013and $2.3 million during the three months ended March 31, 2012. For collateral-dependent loans, zero of provision for loan loss was recorded to establish or increase its valuation allowance during the three months ended March 31, 2013 as compared to $519 thousand for the same period in the prior year. Any changes in the valuation allowance for a collateral-dependent loan are included in the allowance analysis and may result in additional provision expense.
There have been no transfers into or out of Level 3 during 2013 or 2012. There were no transfers between Level 1 and Level 2 during 2013 or 2012.
For impaired loans and OREO properties, the Company utilizes independent, third-party appraisals to determine fair value. Independent appraisals are ordered at least annually. As part of the normal appraisal process, the appraisers generally provide the appraised value using one of following techniques: the sales comparison approach, the income approach or a combination thereof.  Under the sales comparison approach, the appraiser may make certain adjustments from the sold property to the appraised property, including, but not limited to, differences in square footage, lot size, absorption rates or location. As of March 31, 2013, the adjustments between the appraised property and the comparison property range from (75.8)% to 102.9% with a weighted average adjustment of (8.60)%. Under the income approach, the appraiser may make certain adjustments including, but not limited to, capitalization rates and differences in operating income expectations.  The Company's current third-party appraisals provides capitalization rates up to 11.0% with a weighted average of 6.44%. The Company's current third-party appraisals do not provide a range of adjustments to net operating income expectations. Company monitors the realization rate between proceeds received and appraised value for all sold OREO properties.  This discount, defined as the weighted average percentage difference between appraised values and proceeds, is then applied to all remaining appraisals associated with impaired loans and OREO properties.  The Company monitors and applies this adjustment to the Company's Level 3 properties. The weighted average discount is approximately 17% as of March 31, 2013.

37


The following table presents quantitative information about Level 3 fair value measurements for significant financial instruments measured at fair value on a non-recurring basis at March 31, 2013.
 
Fair value (in thousands)
 
Valuation technique(s)
 
Unobservable input(s)
 
Range
 
Weighted average
Impaired Loans - CRE
$
350

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(70.0
)%
 
21.0
%
 
(13.7
)%
 
 
 
 
 
Capitalization rate
 
 %
 
12.5
%
 
9.9
 %
Impaired Loans - Residential
1,005

 
Sales Approach
 
Adjustment for differences between the comparable sales
 
(43.9
)%
 
183.9
%
 
3.4
 %
 
 
 
 
 
Capitalization rate
 
N/A

 
10.8
%
 
10.8
 %
Impaired Loans - Construction
26

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(21.6
)%
 
27.8
%
 
3.1
 %
OREO-Residential
1,058

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(37.8
)%
 
6.1
%
 
(1.5
)%
OREO-Commercial
3,079

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(75.8
)%
 
82.0
%
 
2.3
 %
 
 
 
 
 
Capitalization rate
 
N/A

 
9.6
%
 
9.2
 %
OREO-Construction
4,951

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(63.4
)%
 
83.4
%
 
(0.5
)%
OREO- Commercial and industrial
273

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(63.9
)%
 
102.9
%
 
(2.6
)%
 
 
 
 
 
Capitalization rate
 
N/A

 
11.0
%
 
5.8
 %
For impaired loans and OREO properties at December 31, 2012, the Company utilized independent, third-party appraisals to determine fair value. Independent appraisals are ordered at least annually. As part of the normal appraisal process, the appraisers generally provide the appraised value using one of following techniques: the sales comparison approach, the income approach or a combination thereof.  Under the sales comparison approach, the appraiser may make certain adjustments from the sold property to the appraised property, including, but not limited to, differences in square footage, lot size, absorption rates or location. The adjustments between the appraised property and the comparison property ranged from (85.0)% to 131.8% with a weighted average adjustment of 6.00%. Under the income approach, the appraiser may make certain adjustments including, but not limited to, capitalization rates and differences in operating income expectations.  The Company's third-party appraisals provided a range of capitalization rates between 8.5% to 18.0% with a weighted average of 7.77%. The Company's third-party appraisals provided a range of adjustments to net operating income expectations of (60.0)% to 100.0% with a weighted average of 26.92%. Due to these adjustments, the appraisals are considered Level 3 measurements.  Additionally, the Company monitors the realization rate between proceeds received and appraised value for all sold OREO properties.  This discount, defined as the weighted average percentage difference between appraised values and proceeds, is then applied to all remaining appraisals associated with impaired loans and OREO properties.  The Company monitors and applies this adjustment to the Company's Level 3 properties. The weighted average discount was approximately 7.82% as of December 31, 2012.

38


The following table presents quantitative information about Level 3 fair value measurements for significant items measured at fair value on a non-recurring basis at December 31, 2012.
 
Fair value (in thousands)
 
Valuation technique(s)
 
Unobservable input(s)
 
Range
 
Weighted average
Impaired Loans - CRE
$
727

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(47.5
)%
 
60.0
%
 
4.8
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
(10.0
)%
 
15.0
%
 
1.3
 %
 
 
 
 
 
Capitalization rate
 
8.0
 %
 
14.8
%
 
8.0
 %
Impaired Loans - Residential
457

 
Sales Approach
 
Adjustment for differences between the comparable sales
 
(51.9
)%
 
74.0
%
 
1.1
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
6.0
 %
 
6.0
%
 
6.0
 %
 
 
 
 
 
Capitalization rate
 
8.8
 %
 
10.0
%
 
9.7
 %
Impaired Loans - Construction
1,783

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(35.0
)%
 
40.0
%
 
3.9
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
(44.0
)%
 
22.0
%
 
(9.0
)%
 
 
 
Development Loans
 
Absorption Rate
 
3.0
 %
 
33.3
%
 
20.8
 %
 
 
 
Development Loans
 
Discount Rate
 
18.0
 %
 
24.0
%
 
22.5
 %
 
 
 
 
 
Capitalization rate
 
10.0
 %
 
12.0
%
 
11.8
 %
 
 
 
 
 
 
 
 
 
 
 
 
Impaired Loans - Commercial and Industrial
436

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(74.5
)%
 
43.5
%
 
17.0
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
N/A

 
29.2
%
 
15.3
 %
 
 
 
 
 
Capitalization rate
 
N/A

 
22.0
%
 
10.3
 %
 
 
 
 
 
 
 
 
 
 
 
 
OREO-Residential
1,489

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(41.6
)%
 
58.4
%
 
8.8
 %
OREO-Commercial
2,901

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(85.0
)%
 
129.1
%
 
(5.6
)%
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
(60.0
)%
 
100.0
%
 
31.3
 %
 
 
 
 
 
Capitalization rate
 
8.5
 %
 
18.0
%
 
7.2
 %
OREO-Construction
5,279

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(79.0
)%
 
131.8
%
 
10.1
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
5.0
 %
 
10.0
%
 
5.7
 %
 
 
 
 
 
Capitalization rate
 
12.0
 %
 
12.0
%
 
12.0
 %
OREO- Multifamily and Farmland
873

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(10.8
)%
 
20.8
%
 
1.0
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
8.0
 %
 
11.6
%
 
8.5
 %
 
 
 
 
 
Capitalization rate
 
10.0
 %
 
11.0
%
 
10.8
 %

39


For impaired loans and OREO properties at March 31, 2012, the Company utilized independent, third-party appraisals to determine fair value. Independent appraisals are ordered at least annually. As part of the normal appraisal process, the appraisers generally provide the appraised value using one of following techniques: the sales comparison approach, the income approach or a combination thereof.  Under the sales comparison approach, the appraiser may make certain adjustments from the sold property to the appraised property, including, but not limited to, differences in square footage, lot size, absorption rates or location. The adjustments between the appraised property and the comparison property ranged from (61.4)% to 126.1% with a weighted average adjustment of 6.7%. Under the income approach, the appraiser may make certain adjustments including, but not limited to, capitalization rates and differences in operating income expectations.  The Company's third-party appraisals provided a range of capitalization rates between 8.5% to 12.0% with a weighted average of 10.1%. The Company's third-party appraisals provided a range of adjustments to net operating income expectations of (10.0)% to 100.0% with a weighted average of 12.5%. Due to these adjustments, the appraisals are considered Level 3 measurements.  Additionally, the Company monitors the realization rate between proceeds received and appraised value for all sold OREO properties.  This discount, defined as the weighted average percentage difference between appraised values and proceeds, is then applied to all remaining appraisals associated with impaired loans and OREO properties.  The Company monitors and applies this adjustment to the Company's Level 3 properties. The weighted average discount was approximately 15% as of March 31, 2012.

40



The following table presents quantitative information about Level 3 fair value measurements for significant financial instruments measured at fair value on a non-recurring basis at March 31, 2012.
 
Fair value (in thousands)
 
Valuation technique(s)
 
Unobservable input(s)
 
Range
 
Weighted average
Impaired Loans - CRE
$
6,059

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(10.0
)%
 
60.0
%
 
1.9
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
(10.0
)%
 
10.0
%
 
(4.7
)%
 
 
 
 
 
Capitalization rate
 
9.0
 %
 
9.5
%
 
9.4
 %
Impaired Loans - Residential
2,906

 
Sales Approach
 
Adjustment for differences between the comparable sales
 
(15.1
)%
 
36.1
%
 
1.1
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
N/A

 
6.0
%
 
6.0
 %
 
 
 
 
 
Capitalization rate
 
N/A

 
10.0
%
 
10.0
 %
Impaired Loans - Construction
12,265

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(10.0
)%
 
10.8
%
 
(7.7
)%
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
N/A

 
12.0
%
 
9.4
 %
 
 
 
Development Loans
 
Absorption Rate
 
3.0
 %
 
33.3
%
 
20.8
 %
 
 
 
Development Loans
 
Discount Rate
 
18.0
 %
 
24.0
%
 
22.3
 %
 
 
 
 
 
Capitalization rate
 
N/A

 
12.0
%
 
12.0
 %
OREO-Residential
2,860

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(10.7
)%
 
44.8
%
 
8.4
 %
OREO-Commercial
3,555

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(61.4
)%
 
126.1
%
 
0.8
 %
 
 
 
Income Approach
 
Adjustment for differences in net operating income expectations
 
2.9
 %
 
100.0
%
 
23.5
 %
 
 
 
 
 
Capitalization rate
 
8.5
 %
 
11.5
%
 
9.4
 %
OREO-Construction
7,946

 
Sales comparison approach
 
Adjustment for differences between the comparable sales
 
(50.0
)%
 
90.3
%
 
22.6
 %
 
 
 
 
 
Capitalization rate
 
N/A

 
12.0
%
 
12.0
 %



41


The following table presents the estimated fair values of the Company’s financial instruments at March 31, 2013, December 31, 2012 and March 31, 2012.
 
 
 
 
Fair Value Measurements at
 
 
 
March 31, 2013 Using:
 
Carrying
Value
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
 
 
Cash and due from banks
$
9,407

 
$
9,407

 
$

 
$

 
$
9,407

Interest bearing deposits in banks
157,931

 
157,931

 

 

 
157,931

Securities available-for-sale
258,175

 

 
258,127

 
48

 
258,175

Federal Home Loan Bank stock
2,276

 
N/A

 
N/A

 
N/A

 
N/A

Federal Reserve Bank stock
1,382

 
N/A

 
N/A

 
N/A

 
N/A

Loans held for sale
3,708

 

 
3,708

 

 
3,708

Loans, net
526,788

 

 

 
528,601

 
528,601

Accrued interest receivable
3,125

 

 
1,079

 
2,046

 
3,125

Financial liabilities
 
 
 
 
 
 
 
 
 
Deposits
990,894

 
425,280

 
569,516

 

 
994,796

Federal funds purchased and securities sold under agreements to repurchase
13,048

 
13,048

 

 

 
13,048

Accrued interest payable
1,493

 
13

 
1,480

 

 
1,493


 
 
 
Fair Value Measurements at
 
 
 
December 31, 2012 Using:
 
Carrying
Value
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
 
 
Cash and due from banks
$
12,806

 
$
12,806

 
$

 
$

 
$
12,806

Interest bearing deposits in banks
159,665

 
159,665

 

 

 
159,665

Securities available-for-sale
254,057

 

 
254,016

 
41

 
254,057

Federal Home Loan Bank stock
2,276

 
N/A

 
N/A

 
N/A

 
N/A

Federal Reserve Bank stock
1,382

 
N/A

 
N/A

 
N/A

 
N/A

Loans held for sale
25,920

 

 
3,624

 
22,296

 
25,920

Loans, net
527,330

 

 

 
545,076

 
545,076

Accrued interest receivable
2,973

 

 
2,026

 
947

 
2,973

Financial liabilities
 
 
 
 
 
 
 
 
 
Deposits
1,008,066

 
412,572

 
600,226

 

 
1,012,798

Federal funds purchased and securities sold under agreements to repurchase
12,481

 
12,481

 

 

 
12,481

Accrued interest payable
1,565

 
12

 
1,553

 

 
1,565


42


 
 
 
Fair Value Measurements at
 
 
 
March 31, 2012 Using:
 
Carrying
Value
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
Financial assets
 
 
 
 
 
 
 
 
 
Cash and due from banks
$
8,244

 
$
8,244

 
$

 
$

 
$
8,244

Interest bearing deposits in banks
217,142

 
217,142

 

 

 
217,142

Securities available-for-sale
223,155

 

 
221,772

 
1,383

 
223,155

Federal Home Loan Bank stock
2,276

 
N/A

 
N/A

 
N/A

 
N/A

Federal Reserve Bank stock
2,310

 
N/A

 
N/A

 
N/A

 
N/A

Loans held for sale
2,136

 

 
2,136

 

 
2,136

Loans, net
582,789

 

 

 
585,081

 
585,081

Accrued interest receivable
3,036

 

 
998

 
2,038

 
3,036

Financial liabilities
 
 
 
 
 
 
 
 
 
Deposits
1,038,546

 
395,957

 
646,236

 

 
1,042,193

Federal funds purchased and securities sold under agreements to repurchase
16,629

 
16,629

 

 

 
16,629

Accrued interest payable
2,033

 
66

 
1,967

 

 
2,033


NOTE 14 – FAIR VALUE OPTION
Authoritative accounting guidance provides a fair value option election (FVO) that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. The guidance permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.
The Company records all newly-originated loans held for sale under the fair value option. Origination fees and costs are recognized in earnings at the time of origination. The servicing value is included in the fair value of the loan and recognized at origination of the loan. The Company uses derivatives to hedge changes in servicing value as a result of including the servicing value in the fair value of the loan. The estimated impact from recognizing servicing value, net of related hedging costs, as part of the fair value of the loan is captured in mortgage banking income.
As of March 31, 2013December 31, 2012 and March 31, 2012, there were $3.7 million, $3.6 million and $2.1 million in loans held for sale recorded at fair value, respectively. For the three months ended March 31, 2013 and 2012, approximately $296 thousand and $175 thousand, respectively, in mortgage banking income was recognized.
For the three months ended March 31, 2013, the Company recognized a loss of $14 thousand due to changes in fair value for loans held for sale in which the fair value option was elected. For the three months ended March 31, 2012, the Company recognized a loss of $43 thousand due to changes in fair value for loans held for sale in which the fair value option was elected. This amount does not reflect the change in fair value attributable to the related hedges the Company used to mitigate the interest rate risk associated with loans held for sale. The changes in the fair value of the hedges were also recorded in mortgage banking income, and provided income of $16 thousand for the three months ended March 31, 2013. The changes in the fair value of the hedges reduced income by $39 thousand for the three months ended March 31, 2012.
The following table provides the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale for which the fair value option has been elected as of March 31, 2013.
 
 
Aggregate fair value
 
Aggregate unpaid principal balance under FVO
 
Fair value carrying amount over (under) unpaid principal
 
(in thousands)
Loans held for sale
$
3,708

 
$
3,680

 
$
28



43



NOTE 15 – DERIVATIVE FINANCIAL INSTRUMENTS
The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity, as necessary, to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of March 31, 2013, the Company has not entered into a transaction in a dealer capacity.
When a derivative is intended to be a qualifying hedged instrument, the Company prepares written hedge documentation that designates the derivative as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or (2) a hedge of a forecasted transaction, such as the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).
The written documentation includes identification of, among other items, the risk management objective, hedging instrument, hedged item, and methodologies for assessing and measuring hedge effectiveness and ineffectiveness, along with support for management’s assertion that the hedge will be highly effective. Methodologies related to hedge effectiveness and ineffectiveness include (1) statistical regression analysis of changes in the cash flows of the actual derivative and a perfectly effective hypothetical derivative, (2) statistical regression analysis of changes in fair values of the actual derivative and the hedged item and (3) comparison of the critical terms of the hedged item and the hedging derivative. Changes in fair value of a derivative that is highly effective and that has been designated and qualifies as a fair value hedge are recorded in current period earnings, along with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. Changes in the fair value of a derivative that is highly effective and that has been designed and qualifies as a cash flow hedge are initially recorded in other comprehensive income and reclassified to earnings in conjunction with the recognition of the earnings impacts of the hedged item; any ineffective portion is recorded in current period earnings. Designated hedge transactions are reviewed at least quarterly for ongoing effectiveness. Transactions that are no longer deemed to be effective are removed from hedge accounting classification and the recorded impacts of the hedge are recognized in current period income or expense in conjunction with the recognition of the income or expense on the originally hedged item.
The Company’s derivatives are based on underlying risks, primarily interest rates. The Company has utilized swaps to reduce the risks associated with interest rates. Swaps are contracts in which a series of net cash flows, based on a specific notional amount that is related to an underlying risk, are exchanged over a prescribed period. The Company also utilizes forward contracts on the held for sale loan portfolio. The forward contracts hedge against changes in fair value of the held for sale loans.
Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk is equal to the fair value gain of the derivative. The credit exposure for swaps is the replacement cost of contracts that have become favorable. Credit risk is minimized by entering into transactions with high quality counterparties that are initially approved by the Board of Directors and reviewed periodically by the Asset/Liability Committee. It is the Company’s policy of requiring that all derivatives be governed by an International Swap and Derivatives Associations Master Agreement (ISDA). Bilateral collateral agreements may also be required.
On August 28, 2007 and March 26, 2009, the Company elected to terminate a series of interest rate swaps with a total notional value of $150 million and $50 million, respectively. At termination, the swaps had market values of $2.0 million and $5.8 million, respectively. These gains are being accreted into interest income over the remaining lives of the originally hedged items. The Company recognized zero and $437 thousand, respectively, for the three months ended March 31, 2013 and 2012. As of December 31, 2012 the swaps were fully accreted into interest income.

The following table presents the cash flow hedges as of March 31, 2013.
 
 
Notional
Amount
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Accumulated
Other
Comprehensive
Income
Maturity
Date
 
(in thousands)
Asset hedges
 
 
 
 
 
 
 
 
Cash flow hedges:
 
 
 
 
 
 
 
 
Forward loan sales contracts
$
3,708

 
$

 
$
28

 
$
(57
)
Various
 
$
3,708

 
$

 
$
28

 
$
(57
)
 


44



The following table presents additional information on the active derivative positions as of March 31, 2013.
 
 
 
Consolidated Balance
Sheet Presentation
 
Consolidated Income
Statement Presentation
 
 
Assets
 
Liabilities
 
Gains
 
Notional
Classification
 
Amount
 
Classification
 
Amount
 
Classification
 
Amount
Recognized
 
(in thousands)
Hedging Instrument:
 
 
 
 
 
 
 
 
 
 
 
 
Forward contracts
$
3,708

Other assets
 
N/A

 
Other liabilities
 
$

 
Noninterest
income – other
 
$
(3
)
Hedged Items:
 
 
 
 
 
 
 
 
 
 
 
 
Loans held for sale
N/A

Loans held for
sale
 
$
3,708

 
N/A
 
N/A

 
Noninterest
income – other
 
N/A


For the three months ended March 31, 2013, no significant amounts were recognized for hedge ineffectiveness.

NOTE 16 – RECENT ACCOUNTING PRONOUNCEMENTS
In February 2013, the FASB issued Accounting Standards Update ("ASU") No. 2013-02, "Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income." The amendments in this Update supersede the presentation requirements for reclassification out of accumulated other comprehensive income in ASU No. 2011-05 and ASU No. 2011-12. The amendments require the Company to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, the Company is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. The ASU is effective during the interim and annual periods beginning after December 15, 2012. The Company adopted the standard as of January 1, 2013. The adoption did not have an impact on the Company's financial position, results of operations or earnings per share.
 

NOTE 17 – SUBSEQUENT EVENTS
On April 11, 2013, the Company completed a restructuring of the Company's Preferred Stock with the Treasury by issuing $14.4 million of new common stock for $1.50 per share for the full satisfaction of the Treasury's 2009 investment in the Company. Pursuant to the Exchange Agreement, as previously included in a Current Report on Form 8-K filed on February 26, 2013, the Company restructured the Company's Preferred Stock issued under the Capital Purchase Program ("CPP") by issuing new shares of common stock equal to 26.75% of the $33 million liquidation value of the Preferred Stock plus 100% of the accrued but unpaid dividends in exchange for the Preferred Stock, all accrued but unpaid dividends thereon, and the cancellation of stock warrants granted in connection with the CPP investment ("CPP Restructuring"). Immediately after the issuance of the common stock to the Treasury, the Treasury sold all of the Company's common stock to investors previously identified by the Company at the same $1.50 per share price.
On April 12, 2013, the Company completed the issuance of an additional $76.7 million of new common stock in a private placement to accredited investors. The private placement was previously announced on a Current Report on Form 8-K filed on February 26, 2013, in which the Company announced the execution of definitive stock purchase agreements with institutional investors as part of an approximately $90 million recapitalization ("Recapitalization"). In total, the Company issued 60,735,000 shares of common stock at $1.50 per share for gross proceeds of $91.1 million.



45



ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In this Form 10-Q, “First Security,” “we,” “us,” “the Company” and “our” refer to First Security Group, Inc.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain of the statements made under the caption “Management's Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this Form 10-Q are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements relate to future events or our future financial performance and include statements about the Company's plans for raising capital, the Company's future growth and market position, and the execution of its business plans. When we use words like “may,” “plan,” “contemplate,” “anticipate,” “believe,” “intend,” “continue,” “expect,” “project,” “predict,” “estimate,” “could,” “should,” “would,” “will,” and similar expressions, you should consider them as identifying forward-looking statements, although we may use other phrasing. These forward-looking statements involve risks and uncertainties and are based on our beliefs and assumptions, and on the information available to us at the time that these disclosures were prepared.
These forward-looking statements involve risks and uncertainties and may not be realized due to a variety of factors. There can be no assurance that the results, performance or achievements of the Company will not differ materially from those expressed or implied by forward-looking statements. Factors that could cause actual events or results to differ significantly from those described in the forward-looking statements include, but are not limited to, the effects of future economic conditions, governmental monetary and fiscal policies, as well as legislative and regulatory changes; the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities; the costs of evaluating possible acquisitions and the risks inherent in integrating acquisitions; the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in First Security's market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the Internet; and, the failure of assumptions underlying the establishment of reserves for possible loan losses. For details on these and other factors that could affect expectations, see the cautionary language included under the headings “Risk Factors” and “Management's Discussion and Analysis of Financial Condition and Results of Operations” in the Company's Annual Report on Form 10-K for the year ended December 31, 2012 and other filings with the SEC.
Many of these risks are beyond our ability to control or predict, and you are cautioned not to put undue reliance on such forward-looking statements. First Security does not intend to update or reissue any forward-looking statements contained in this release as a result of new information or other circumstances that may become known to First Security, and undertakes no obligation to provide any such updates.
All written or oral forward-looking statements attributable to us are expressly qualified in their entirety by this Note. Our actual results and condition may differ significantly from those we discuss in these forward-looking statements.

FIRST QUARTER 2013 AND RECENT EVENTS
The following discussion and analysis sets forth the major factors that affected the results of operations and financial condition reflected in the unaudited financial statements for the three month periods ended March 31, 2013 and 2012. Such discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and the notes attached thereto.
Company Overview
First Security Group, Inc. is a bank holding company headquartered in Chattanooga, Tennessee, with $1.0 billion in assets as of March 31, 2013. Founded in 1999, First Security’s community bank subsidiary, FSGBank, N.A. (FSGBank), currently has 30 full-service banking offices, including the headquarters, along the interstate corridors of eastern and middle Tennessee and northern Georgia and 325 full-time equivalent employees. In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank; along the Interstate 40 corridor in Tennessee, FSGBank operates under the name of Jackson Bank & Trust. FSGBank provides retail and commercial banking services, trust and investment management, mortgage banking, financial planning and Internet banking (www.FSGBank.com) services.

46


Strategic Initiatives for 2013
During the past two years, 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 (collectively, the "Recapitalization"). 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 during 2012. 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 the first quarter of 2012, three additional directors were appointed to our board. 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.
As a result of the Recapitalization, Mr. Grant and Mr. Lane resigned from the board, pursuant to the TARP CPP regulations. Both Mr. Grant and Mr. Lane were simultaneously re-appointed to the board. The Recapitalization also provided MFP Partners, L.P. ("MFP") and Ulysses Partners, L.P. ("Ulysses") the right to each designate an individual to serve as a director, subject to regulatory non-objection. On May 15, 2013, we elected Mr. Adam Hurwich to the boards of First Security Group and FSGBank as Ulysses representative. Mr. Hurwich has served as portfolio manager for Ulysses since 2009. In addition to his investment management background, Mr. Hurwich also serves as a member of the Financial Accounting Standards Advisory Council, an advisory committee for the Financial Accounting Standards Board. MFP has designated Ms. Henchy Enden to serve on the boards of the First Security Group and FSGBank. As of this filing, regulatory non-objections for Ms. Enden have not been received.
On March 19, 2013, Mr. Ralph Kendall, a founding director, resigned from the boards. Mr. Kendall recently moved to Texas to be closer to his family.
We believe our current Board members possess 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.

47



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 15 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 2013 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 2013, we are generating positive results in implementing our retail deposit strategy. From December 31, 2012 to March 31, 2013, $25.8 million of brokered deposits matured and core deposits decreased $4.1 million. Pure deposits, defined as all transaction accounts, increased $12.7 million, or 3.1% from December 31, 2012 to March 31, 2013. In total, our customer deposits, defined as total deposits less brokered deposits, increased $8.6 million, which partially offsets the brokered deposit maturities. Comparing March 31, 2013 to March 31, 2012, brokered deposits decreased $74 million, while core deposits decreased $3.0 million. Pure deposits increased $29.3 million, or 7.4% from March 31, 2012 to March 31, 2013, while customer deposits increased $26.3 million for the same period, which partially 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
We have maintained excess liquidity since 2009, as described below, to reduce our liquidity risk given our financial condition. The Recapitalization allows the full investment of the remaining excess liquidity. We anticipate investing appropriately $100 million in investment securities prior to June 30, 2013 and utilizing the remaining excess liquidity to fund maturing brokered deposits and loan growth. Additional deployments of cash will be monitored based on our liquidity position throughout 2013.
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 and 2013.
As of March 31, 2013, our total interest-bearing cash was $157.9 million compared to $217.1 million at March 31, 2012. During 2012, we prudently reduced our excess cash position by investing in higher yielding assets, primarily investment securities. We expect to continue this strategy throughout 2013. During 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. At March 31, 2013, the amount of our loan portfolio has not materially changed since December 31, 2012. We believe that loan sales and resolution of problem assets and net charge-offs have improved our asset quality during 2012 and 2013. 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.
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.
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.
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.

48



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 March 31, 2013 Call Report was the eleventh public financial statement related to a period subsequent to the 120 day requirement. As of March 31, 2013, the Bank’s total capital to risk-weighted assets was 4.68% and the Tier 1 capital to adjusted total assets was 1.90%. The Bank has notified the OCC of the non-compliance with the requirements of the Order. See Note 2 to our consolidated financial statements for additional information regarding our strategic and capital plans.
Many aspects of the Written Agreement and Consent Order, directly or indirectly, required a significant increase in capital for full satisfaction of the enforcement actions. Management believes the Recapitalization and continued execution of the strategic initiatives discussed below will result in full compliance with the Order and Agreement and will position us for long-term growth and a return to profitability.
As of March 31, 2013, the Bank's Tier 1 leverage ratio remained below the minimum level for an "adequately capitalized" bank of 4%. On April 23, 2013, FSGBank filed a cash contribution to capital notice with the OCC certifying a $65 million capital contribution by First Security Group into FSGBank. With the capital contribution, FSGBank's pro-forma regulatory capital ratios are: Tier 1 leverage ratio from less than 2.0% to 8.1%, Tier 1 risk-based capital from 3.4% to 14.5% and total risk-based capital from 4.7% to 15.8%. All pro-forma regulatory capital exceed the percentages of a well capitalized institution as defined under applicable regulatory guidelines. FSGBank will continue to be classified as adequately capitalized due to the capital requirement in the Order.
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.
Engineered Floors will invest $450 million to build two manufacturing complexes over the next five years that will create approximately 2,400 jobs. The new manufacturing complexes will be in Murray and Whitfield counties in Georgia. This will help replace some of the jobs lost in the Dalton market area.
Alcoa and Viam Manufacturing are planning to expand their current plants with investments of $275 million and $9 million, respectively. Alcoa expect to add approximately 200 permanent jobs over the next three years. Viam expects to add approximately 75 jobs. Both companies support Tennessee's automotive industry.
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 production began 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 that it may stabilize and possibly increase real estate values and enhance economic activity within our market area.
While the national economy continues to recover from the recession, with high unemployment across the country, our larger market areas benefit from more stable rates of employment. Our major market areas of Chattanooga and Knoxville have unemployment rates of 7.4% and 6.6%, respectively, as of March 2013, lower than the Tennessee rate of 8.1% The economy of the Dalton, Georgia market area 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 carpet industry in the Dalton area experiencing layoffs of approximately 4,600 jobs from June 2011 to June 2012. The unemployment rate in the Dalton market area is 10.3% as of March 31, 2013, compared to the Georgia rate of 8.1%. Based on the market activity and

49


recent trends in the national economy, we believe these positive employment trends will continue through the remainder of 2013.
CPP Investment
On January 9, 2009, as part of the CPP under TARP of the Treasury, we agreed to issue and sell, and the Treasury agreed to purchase (1) 33,000 shares of our 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 exchanged the Series A Preferred Stock and the Warrant for shares of our common stock; Treasury immediately sold such shares of common stock to investors.
Financial Results
As of March 31, 2013, we had total consolidated assets of $1.0 billion, total loans of $540.3 million, total deposits of $1.0 billion and shareholders’ equity of $21.0 million. For the three months ended March 31, 2013, our net loss allocated to common shareholders was $7.9 million resulting in basic net loss of $4.90 per share and diluted net loss of $4.90 per share for the quarter.
As of March 31, 2012, we had total consolidated assets of $1.1 billion, total loans of $601.8 million, total deposits of $1.0 billion and shareholders’ equity of $61.8 million. For the three months ended March 31, 2012, our net loss allocated to common shareholders was $6.3 million resulting in basic net loss of $3.94 per share and diluted net loss of $3.94 per share for the quarter.
For the three month period ended March 31, 2013, net interest income decreased by $994 thousand and noninterest income increased by $237 thousand compared to the same period in 2012. For the three months ended March 31, 2013, noninterest expense increased by $1.9 million compared to the same period in 2012. The decline in net interest income is primarily attributable to a reduction in our average loan portfolio. Noninterest income increased primarily due to higher fees related to origination of loans held for sale and gains on sale or other real estate owned (OREO), while noninterest expense increased for the quarter primarily due to higher salary and benefit expenses, largely attributable to filling vacant executive positions. The increase in the year-to-date period is associated with higher salary and benefit expense and higher costs associated with nonperforming assets, including write-downs, losses, holding costs, and professional fees. Full-time equivalent employees were 325 at March 31, 2013, compared to 311 at March 31, 2012.
The provision for loan and lease losses decreased $1.1 million for the three month period ended March 31, 2013 compared to the same period in 2012. The provision expense is based on the quarterly evaluation of the adequacy of the allowance for loan and lease losses, as described below.
Our efficiency ratio increased in the first quarter of 2013 to 188.2% compared to 147.7% in the same period of 2012 primarily due to a reduction in net interest income combined with an increase in noninterest expense. We anticipate our efficiency ratio to begin to improve during the second quarter of 2013 as we focus on enhancing revenue while continuing to reduce certain overhead expenses. However, the stabilization and possible improvement of our efficiency ratio over the balance of 2013 is contingent on both macro-economic factors, such as potential changes to the federal funds target rate, and micro-economic factors, such as local unemployment and real estate values.
Net interest margin in the first quarter of 2013 was 2.25%, or 0.27% lower than the prior year period of 2.52%. We anticipate that our margin will improve during the remainder of 2013 as higher cost brokered deposits mature and are replaced with lower cost core deposits as well as anticipated loan growth. The projected improvement of our net interest margin is dependent on multiple factors including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, maturities of brokered deposits, and any possible action by the Federal Reserve Board to the target federal funds rate.
Pursuant to the Agreement, the Company is prohibited from declaring or paying dividends without the prior written consent of the Federal Reserve. Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our Board of Directors may deem relevant. Our ability to distribute cash dividends in the future may be limited by regulatory restrictions and the need to maintain sufficient consolidated capital.

50


RESULTS OF OPERATIONS
We reported a net loss allocated to common shareholders for the three month periods ended March 31, 2013 of $7.9 million compared to a net loss allocated to common shareholders for the same periods in 2012 of $6.3 million. For the three months ended March 31, 2013, basic net loss per share was $4.90 and diluted net loss per share was $4.90 on approximately 1.6 million weighted average shares outstanding for both basic and diluted.
Net loss on a quarterly basis in 2013 was above the comparable amount in 2012 as a result of lower net interest income. As of March 31, 2013, we had 30 banking offices, including the headquarters, and 325 full-time equivalent employees.

The following table summarizes the components of income and expense and the changes in those components for the three month period ended March 31, 2013 compared to the same period in 2012.

CONDENSED CONSOLIDATED INCOME STATEMENT

 
 
For the Three Months Ended
 
Change from Prior
Year
March 31,
2013
Amount
 
Percentage
 
(in thousands, except percentages)
Interest income
$
7,809

 
$
(1,880
)
 
(19.4
)%
Interest expense
2,568

 
(886
)
 
(25.7
)%
Net interest income
5,241

 
(994
)
 
(15.9
)%
Provision for loan and lease losses
678

 
(1,123
)
 
(62.4
)%
Net interest income after provision for loan and lease losses
4,563

 
129

 
2.9
 %
Noninterest income
2,220

 
237

 
12.0
 %
Noninterest expense
14,042

 
1,907

 
15.7
 %
Net loss before income taxes
(7,259
)
 
(1,541
)
 
26.9
 %
Income tax (benefit) provision
119

 
10

 
9.2
 %
Net loss
(7,378
)
 
(1,551
)
 
26.6
 %
Preferred stock dividends and discount accretion
524

 
7

 
1.4
 %
Net loss allocated to common shareholders
$
(7,902
)
 
$
(1,558
)
 
24.6
 %

Net Interest Income
Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. For the three months ended March 31, 2013, net interest income decreased by $994 thousand, or 15.9%, to $5.2 million compared to $6.2 million for the same period in 2012.
We monitor and evaluate the effects of certain risks on our earnings and seek balance between the risks assumed and returns sought. Some of these risks include interest rate risk, credit risk and liquidity risk.
The level of net interest income is determined primarily by the average balances (volume) of interest earning assets and the various rate spreads between our interest earning assets and our funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest earning assets and interest bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits.

51



The following tables summarize net interest income and average yields and rates paid for the quarters ended March 31, 2013 and 2012.
AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS
FULLY TAX EQUIVALENT BASIS
 
For the Three Months Ended
 
March 31,
 
2013
 
2012
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate
 
(in thousands, except percentages)
ASSETS
 
 
 
 
 
 
 
 
 
 
 
Earning assets:
 
 
 
 
 
 
 
 
 
 
 
Loans, net of unearned income (1) (2)
$
554,204

 
$
6,670

 
4.88
%
 
$
594,579

 
$
8,332

 
5.64
%
Securities – taxable
232,488

 
819

 
1.43
%
 
182,556

 
943

 
2.08
%
Securities – non-taxable (2) 
20,777

 
312

 
6.09
%
 
30,880

 
432

 
5.63
%
Other earning assets
156,117

 
122

 
0.32
%
 
214,219

 
143

 
0.27
%
Total earning assets
963,586

 
7,923

 
3.33
%
 
1,022,234

 
9,850

 
3.88
%
Allowance for loan and lease losses
(14,365
)
 
 
 
 
 
(20,294
)
 
 
 
 
Intangible assets
574

 
 
 
 
 
934

 
 
 
 
Cash & due from banks
13,423

 
 
 
 
 
12,329

 
 
 
 
Premises & equipment
29,244

 
 
 
 
 
28,720

 
 
 
 
Other assets
54,722

 
 
 
 
 
69,684

 
 
 
 
TOTAL ASSETS
$
1,047,184

 
 
 
 
 
$
1,113,607

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
 
 
 
 
 
 
 
 
Interest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest bearing demand deposits
$
86,342

 
74

 
0.35
%
 
$
57,396

 
37

 
0.26
%
Money market accounts
147,588

 
208

 
0.57
%
 
122,384

 
264

 
0.87
%
Savings deposits
39,818

 
14

 
0.14
%
 
39,336

 
22

 
0.22
%
Time deposits of less than $100 thousand
225,314

 
564

 
1.02
%
 
227,872

 
705

 
1.24
%
Time deposits of $100 thousand or more
199,749

 
556

 
1.13
%
 
191,288

 
651

 
1.37
%
Brokered CDs and CDARS®
153,741

 
1,136

 
3.00
%
 
219,560

 
1,659

 
3.04
%
Repurchase agreements
13,299

 
16

 
0.49
%
 
15,214

 
115

 
3.04
%
Other borrowings

 

 
%
 
50

 
1

 
8.04
%
Total interest bearing liabilities
865,851

 
2,568

 
1.20
%
 
873,100

 
3,454

 
1.59
%
Net interest spread
 
 
$
5,355

 
2.13
%
 
 
 
$
6,396

 
2.29
%
Noninterest bearing demand deposits
140,496

 
 
 
 
 
159,319

 
 
 
 
Accrued expenses and other liabilities
13,653

 
 
 
 
 
14,734

 
 
 
 
Shareholders’ equity
27,184

 
 
 
 
 
66,454

 
 
 
 
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
1,047,184

 
 
 
 
 
$
1,113,607

 
 
 
 
Impact of noninterest bearing sources and other changes in balance sheet composition
 
 
 
 
0.12
%
 
 
 
 
 
0.23
%
Net interest margin
 
 
 
 
2.25
%
 
 
 
 
 
2.52
%
__________________
 
(1)
Nonaccrual loans have been included in the average balance. Only the interest collected on such loans has been included as income.
(2)
Interest income from securities and loans includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for both years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $114 thousand and $161 thousand for the quarters ended March 31, 2013 and 2012, respectively.


52


The following table presents the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.
CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS
FOR THE THREE MONTHS ENDED March 31, 2013 COMPARED TO 2012
 
 
Increase (Decrease) in Interest
Income and Expense Due to
Changes in:
 
Volume
 
Rate
 
Total
 
(in thousands)
Interest earning assets:
 
 
 
 
 
Loans, net of unearned income
$
(560
)
 
$
(1,102
)
 
$
(1,662
)
Securities – taxable
254

 
(378
)
 
(124
)
Securities – non-taxable
(140
)
 
20

 
(120
)
Other earning assets
(37
)
 
16

 
(21
)
Total earning assets
(483
)
 
(1,444
)
 
(1,927
)
Interest bearing liabilities:
 
 
 
 
 
Interest bearing demand deposits
19

 
18

 
37

Money market accounts
53

 
(109
)
 
(56
)
Savings deposits

 
(8
)
 
(8
)
Time deposits of less than $100 thousand
(8
)
 
(133
)
 
(141
)
Time deposits of $100 thousand or more
29

 
(124
)
 
(95
)
Brokered CDs and CDARS®
(494
)
 
(29
)
 
(523
)
Repurchase agreements
(14
)
 
(85
)
 
(99
)
Other borrowings
(1
)
 

 
(1
)
Total interest bearing liabilities
(416
)
 
(470
)
 
(886
)
Increase (decrease) in net interest income
$
(67
)
 
$
(974
)
 
$
(1,041
)


Net Interest Income – Volume and Rate Changes

Interest income for the three months ended March 31, 2013 was $7.8 million a 19.4% decrease compared to the same period in 2012. Average earning assets decreased $58.6 million, or 5.7%, in the first quarter of 2013 compared to the same period in 2012. Average loans declined in the first quarter of 2013 by $40.4 million, offset by a $39.8 million increase in investment securities and a $58.1 million decrease in other earning assets. The change in mix and volume of earning assets decreased interest income by $483 thousand comparing the three months of 2013 to the same period in 2012. For other earning assets, we maintained an elevated balance at the Federal Reserve Bank of Atlanta, which averaged approximately $153.2 million for the three months ended March 31, 2013. The yield on this account is approximately 0.25%. The purpose of maintaining an elevated balance in liquid assets is to reduce liquidity risk resulting from deteriorating asset quality and the Order. Additional details relating to liquidity risk is provided below in "Liquidity." We anticipate average loans to grow over the next year as previously discussed in the strategic initiatives section. We anticipate average earning assets to remain consistent for the remainder of 2013.
The tax equivalent yield on earning assets decreased by 0.55% for the three months ended March 31, 2013 compared to the same period in 2012. The yield on loans declined by 0.76% to 4.88% for the three months ended March 31, 2013 compared to the same period in 2012. We anticipate the yield on loans to remain consistent or decline slightly over the balance of 2013 as we continue to operate in a competitive lending environment and we have invested in approximately $48.9 million government guaranteed loans. We anticipate that the yield on investment securities for the second quarter of 2013 will be consistent with the yield for first quarter 2013 and lower than the comparable 2012 period due to the changes in bond prices year-over-year. We are maintaining an asset-sensitive balance sheet and will benefit from an eventual increase in the federal funds rate. As of March 31, 2013, approximately 31% of our loan portfolio is either variable or adjustable rate. The variable rate loans reprice simultaneously with changes in the associated index, such as the Prime, LIBOR or Treasury bond rates, while the repricing of adjustable rate loans are based on a time component in addition to changes in the associated index. Accordingly, changes in the target federal funds rate have an immediate impact on the yield of our earning assets.

53


Total interest expense was $2.6 million for the three months ended March 31, 2013, 25.7% lower than the same period in 2012. Average interest bearing liabilities decreased by $7.2 million for the three month period ended March 31, 2013 compared to the same period in 2012. Comparing the first quarter of 2013 to the same period in 2012, average brokered deposits declined by $65.8 million while retail certificates of deposits declined by $2.6 million and jumbo certificates of deposit increased $8.5 million. The reductions in volume reduced interest expense by $416 thousand for the three month period ended March 31, 2013. Further reducing interest expense $470 thousand for the three month period ended March 31, 2013, respectively, was the decline in rates paid on deposits, primarily in retail and jumbo certificates of deposits. The decrease in rates is due primarily to term deposits maturing and repricing at lower current market rates.
We expect average earning assets to stabilize through the remainder of 2013 as loan volume improves and investment securities increase through the reallocation of our excess cash reserves into higher yielding assets. We expect average brokered deposits to decline through the remainder of 2013 while all other interest bearing liabilities are expected to increase compared to 2012 levels. Rates paid on deposits are expected to continue to decline compared to 2012 rates as higher cost brokered CDs mature and are replaced with lower rate core deposits or funded from our excess liquidity.
Net Interest Income – Net Interest Spread and Net Interest Margin
The banking industry uses two key ratios to measure profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The net interest rate spread does not consider the impact of noninterest bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest bearing deposits in earning assets.
Our net interest rate spread (on a tax equivalent basis) was 2.13% for the three months ended March 31, 2013 compared to 2.29% for the same period in 2012. Our net interest margin (on a tax equivalent basis) was 2.25% for the three months ended March 31, 2013 compared to 2.52% for the same period in 2012. The decrease in the net interest spread and net interest margin comparing 2013 to 2012 was primarily due to reductions in our loan portfolio as well as the negative spread created by the issuance of brokered deposits in late 2009 and early 2010. Noninterest bearing deposits contributed 12 and 23 basis points to the margin during the three months ended March 31, 2013 and 2012, respectively. The remaining funds were placed in our interest bearing account at the Federal Reserve Bank of Atlanta. As of March 31, 2013, our balance at the Federal Reserve Bank was approximately $154.9 million.
In prior years, we terminated two sets of interest rate swaps. The combined gains at termination were $7.8 million, which are being accreted into interest income over the remaining life of the originally hedged items. The interest rate swaps were fully accreted as of December 31, 2012. For the three months ended March 31, 2012, the accretion of the swaps added approximately $437 thousand to interest income.
We currently anticipate our net interest spread and net interest margin to stabilize and improve during the remainder of 2013. However, improvement is dependent on multiple factors including our ability to raise core deposits, maturities of brokered deposits, our growth or contraction in loans, our deposit and loan pricing, and any possible further action by the Federal Reserve Board to adjust the target federal funds rate.
Provision for Loan and Lease Losses
The provision for loan and lease losses charged to operations during the three month period ended March 31, 2013 was $678 thousand compared to $1.8 million for the same period in 2012. Net charge-offs for the three months ended March 31, 2013 were $978 thousand compared to net charge-offs of $2.4 million for the same period in 2012. Annualized net charge-offs as a percentage of average loans were 0.71% for the three months ended March 31, 2013 compared to 1.62% for the same period in 2012. Our peer group’s average annualized net charge-offs (as reported in the March 31, 2013 Uniform Bank Performance Report) were 0.27%.
The decrease in our provision for loan and lease losses for the first three months of 2013 compared to the same period in 2012 resulted from our analysis of probable incurred losses in the loan portfolio in relation to the reduction of our portfolio, the reduction in the amount of nonperforming loans, as well as general economic conditions. As of March 31, 2013, specific reserves for impaired loans totaled $57 thousand compared to $50 thousand as of December 31, 2012 and $1.8 million as of March 31, 2012. At March 31, 2013, due to less charge-offs and fewer non-performing loans, our ratio of the allowance to total loans was 2.50% compared to 2.55% at December 31, 2012 and 3.16% at March 31, 2012.
As of March 31, 2013, management determined our allowance of $13.5 million was adequate to provide for probable incurred credit losses, which we describe more fully below in the Allowance for Loan and Lease Losses section. We analyze the allowance on at least a quarterly basis, and the next review will be at June 30, 2013, or sooner if needed; the provision expense will be adjusted accordingly, if necessary.

54


We will continue to provide provision expense to maintain an allowance level adequate to absorb known and probable incurred losses inherent in our loan portfolio. As the determination of provision expense is a function of the adequacy of the allowance for loan and lease losses, we cannot reasonably estimate the provision expense for the remainder of 2013. Furthermore, the provision expense could materially increase or decrease in 2013 depending on a number of factors, including, among others, the level of net charge-offs, the amount of classified loans and the value of collateral associated with impaired loans.
Noninterest Income
Noninterest income totaled $2.2 million for the three months ended March 31, 2013, an increase of $237 thousand or 12% from the same period in 2012. The quarterly increase is primarily a result of higher mortgage banking income and gains on sales of assets.
The following table presents the components of noninterest income for the three month periods ended March 31, 2013 and 2012.
NONINTEREST INCOME
 
 
Three Months Ended
 
March 31,
 
2013
 
Percent
Change
 
2012
 
(in thousands, except percentages)
Service charges on deposit accounts
736

 
2.6
 %
 
717

Point-of-sale (POS) fees
315

 
(7.9
)%
 
342

Bank-owned life insurance income
241

 
18.1
 %
 
204

Mortgage banking income
296

 
69.1
 %
 
175

Gains on sales of assets
178

 
42.4
 %
 
125

Other income
454

 
8.1
 %
 
420

Total noninterest income
$
2,220

 
12.0
 %
 
$
1,983


Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including NSF fees, were $736 thousand for the three months ended March 31, 2013, an increase of $19 thousand, or 2.6% from the same period in 2012. While service charges and fees on deposit accounts typically correspond to the level and mix of our customer deposits, the continued implementation of the Dodd-Frank financial reform legislation may directly or indirectly impact the fee structure of our deposit products; therefore, we cannot reasonably estimate deposit fees for future periods.
Point-of-sale fees decreased 7.9% to $315 thousand thousand for the three months ended March 31, 2013 compared to the same period in 2012. POS fees are primarily generated when our customers use their debit cards for retail purchases. We anticipate POS fees to continue to grow as customer trends show increased use of debit cards, although it is unclear if certain provisions affecting interchange fees for card issuers included in the Dodd-Frank financial reform legislation will have a future material impact on this product and its revenue.
Bank-owned life insurance income was $241 thousand for the three month period ended March 31, 2013, an increase of $37,000 or 18.1% from 2012 levels. The Company is the owner and beneficiary of these contracts. The income generated by the cash value of the insurance policies accumulates on a tax-deferred basis and is tax-free to maturity. In addition, the insurance death benefit will be a tax-free payment to the Company. On a fully tax-equivalent basis, the weighted average interest rate earned on the policies was approximately 3.96% through March 31, 2013.
Mortgage banking income for the three months ended March 31, 2013 increased $121 thousand, or 69.1%, to $296 thousand,compared to $175 thousand in the same period of 2012. As discussed in the notes to our consolidated financial statements, we elected the fair value option for all held for sale loan originations. This election impacts the timing and recognition of origination fees and costs, as well as the value of servicing rights. The recognition of the income and fees is concurrent with the origination of the loan.
Our process to originate and sell a conforming mortgage in the secondary market typically takes 30 to 60 days from the date of mortgage origination to the date the mortgage is sold to an investor in the secondary market. Due to the normal processing time, we will have a certain amount of held for sale loans at any time. Mortgages originated for sale in the secondary market totaled $12.7 million for the three months ended March 31, 2013, $45.3 million at December 31, 2012 and $13.1 million for the three months ended March 31, 2012. Mortgages sold in the secondary market totaled $12.6 million for the three months ended March 31, 2013, $43.9 million at December 31, 2012 and $13.1 million for the three months ended March 31, 2012. We

55


sold these loans with the right to service the loan being released to the purchaser for a fee. Mortgage income for the remainder of the year is dependent on mortgage rates as well as our ability to generate higher levels of held for sale loans.
Other income for the three months ended March 31, 2013 was $454 thousand compared to $420 thousand for the same period in 2012. The components of other income primarily consist of ATM fee income, trust fee income, underwriting revenue, safe deposit box fee income and gains on sales of other real estate, repossessions, leased equipment and premises and equipment.
Noninterest Expense
Noninterest expense increased $1.9 million, or 15.7% to $14.0 million for the three months ended March 31, 2013, compared to $12.1 million for the same period in 2012. Total noninterest expense increased mostly due to salary and benefit cost and professional fees partially offset by lower asset quality charges.
The following table represents the components of noninterest expense for the three month periods ended March 31, 2013 and 2012.

NONINTEREST EXPENSE
 
 
Three Months Ended
 
March 31,
 
2013
 
Percent
Change
 
2012
 
(in thousands, except percentages)
Salaries & benefits
$
5,609

 
21.1
 %
 
$
4,633

Occupancy
818

 
2.5
 %
 
798

Furniture and equipment
629

 
41.3
 %
 
445

Professional fees
2,118

 
191.7
 %
 
726

FDIC insurance
1,000

 
53.8
 %
 
650

Write-downs on OREO and repossessions
1,315

 
(42.8
)%
 
2,297

Losses on other real estate owned, repossessions and fixed assets
10

 
(97.0
)%
 
328

OREO and repossession holding costs
322

 
(39.2
)%
 
530

Data processing
371

 
1.1
 %
 
367

Communications
108

 
(17.6
)%
 
131

ATM/Debit Card fees
186

 
82.4
 %
 
102

Intangible asset amortization
75

 
(37.0
)%
 
119

Printing & supplies
90

 
4.7
 %
 
86

Advertising
98

 
81.5
 %
 
54

Insurance
405

 
86.6
 %
 
217

OCC Assessments
127

 
2.4
 %
 
124

Other expense
761

 
44.1
 %
 
528

Total noninterest expense
$
14,042

 
15.7
 %
 
$
12,135


Salaries and benefits for the three months ended March 31, 2013 increased $1.0 million or 21.1% compared to the same period in 2012. The increase in salaries and benefits is primarily related to 26 full-time equivalent employees hired during 2012, partially offset by retirements and resignations during the year. As of March 31, 2013, we had 30 full-service banking offices with 325 full-time equivalent employees. As of March 31, 2012, we had 36 full-service banking offices with 311 full-time equivalent employees.
Occupancy expense increased $20 thousand thousand or 2.5% for the three months ended March 31, 2013 compared to the same period in 2012, primarily the result of adjustments to lease expenses. As of March 31, 2013, First Security leased six facilities and the land for three branches. As a result, current period occupancy expense is higher than if we owned these facilities, including the real estate, but conversely, we have been able to deploy the capital into earning assets rather than capital expenditures for facilities.

56



Professional fees increased $1.4 million for the three months ended March 31, 2013 compared to the same period in 2012. The increase is primarily due to cost associated with the execution of our capital plan in early 2013 and an increase in directors fees compared to 2012. See Note 2 of our consolidated financial statements for further discussion on the execution of our capital plan. Professional fees include fees related to investor relations, outsourcing compliance and a portion of internal audit to Professional Bank Services, as well as external audit, tax services and legal and accounting advice related to, among other things, foreclosures, lending activities, employee benefit programs, prospective capital offerings and regulatory matters.
FDIC deposit premium insurance increased $350 thousand thousand to $1.0 million for the three months ended March 31, 2013 compared to the same period in 2012. The increase is an indirect result of the bank's operating condition at March 31, 2013.
Insurance increased $188 thousand to $405 thousand for the three months ended March 31, 2013, compared to the same period in 2012. The increase is mostly due to an increase in insurance premiums paid.
At foreclosure or repossession, the fair value of the OREO property or repossession is determined and a charge-off to the allowance is recorded, if applicable. The fair value is generally determined based the valuation of a third-party appraisal, discounted by our historical realization rate as well as a cost to sell factor. The discount and cost to sell factor are monitored and re-assessed, if necessary, on a quarterly basis. An increase to the discount factor may result in additional write-downs to some or all of our properties. Any decreases in value subsequent to the initial determination of fair value are recorded as a write-down. As a general policy, we re-assess the fair value of OREO and repossessions on at least an annual basis or sooner if there are indicators that deterioration in value has occurred. Write-downs are based on property-specific appraisals or valuations. Write-downs on OREO and repossessions decreased $982 thousand, or 42.8% for the three month period ended March 31, 2013 compared to the same period in 2012. Write-downs for the remainder of 2013 are dependent on multiple factors, including, but not limited to, the assumptions used by the independent appraisers, real estate market conditions, and our ability to liquidate properties.
Losses on OREO, repossessions and fixed assets decreased $318 thousand to $10 thousand, or 97.0%, for the three month period ended March 31, 2013, compared to the same period in 2012. As discussed above, we continue to monitor our fair value assumptions and recognize additional write-downs when appropriate. Generally, gains and losses on the sale of OREO should be minimized by our fair value assumptions applied to OREO, as discussed above.
OREO and repossession holding costs include, among other items, maintenance, repairs, utilities, taxes and storage costs. Holding costs decreased $208 thousand, or 39.2%, for the three months ended March 31, 2013 compared to the same period in 2012. We anticipate the level of holding costs to remain directionally consistent with the level of OREO for 2013.
Data processing fees increased 1.1% for the three month period ended March 31, 2013 compared to the same period in 2012. During the third quarter of 2012, we completed a core systems conversion to a more robust system.
Intangible asset amortization expense declined $44 thousand, or 37.0% for the three month periods ended March 31, 2013 compared to the same period in 2012. Our core deposit intangible assets amortize on an accelerated basis in which the expense recognized declines over the estimated useful life of ten years. We anticipate slight decreases in amortization expense throughout the remainder of 2013.
Other expense increased $233 thousand thousand for the three months ended March 31, 2013, respectively, compared to the same periods in 2012. The increase was due to immaterial increases in a large number of accounts.
Income Taxes
We recorded an income tax provision of $119 thousand for the three month period ended March 31, 2013 compared to an income tax provision of $109 thousand for the same period in 2012. For the three months ended March 31, 2013, we recorded $2.9 million in additional deferred tax valuation allowance to offset the tax benefits generated during the first quarter of 2013.
At March 31, 2013, we evaluated our significant uncertain tax positions. Under the “more-likely-than-not” threshold guidelines, we believe we have identified all significant uncertain tax benefits. We evaluate, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be recorded as a component of income tax expense in our consolidated financial statements. With the resolution of our primary uncertain tax position, as described above, we have not identified any additional significant uncertain tax positions.
A valuation allowance is required when it is “more likely than not” that the deferred tax assets will not be realized. The evaluation requires significant judgment and extensive analysis of all available positive and negative evidence, the forecasts of future income, applicable tax planning strategies and assessments of the current and future economic and business conditions. We identified as positive evidence the existence of taxes paid in available carryback years. Negative evidence included a

57


cumulative loss in recent years as well as current business trends. As conditions change, we will evaluate the need to increase or decrease the valuation allowance. Currently, we anticipate increasing the valuation allowance to offset any future recorded tax benefit to result in minimal, if any, income tax expense or benefit. As business and economic conditions change, we will re-evaluate the valuation allowance.
On October 30, 2012, the Company adopted a Tax Benefits Preservation Plan (the "NOL Rights Plan") and declared a dividend of one preferred stock purchase right (each a “Right” and collectively, the “Rights”) for each outstanding share of the Company's common stock, payable to holders of record as of the close of business on November 12, 2012 (the “Record Date”). Each Right entitles the registered holder to purchase from the Company one one-thousandth of one share of Series B Participating Preferred Stock, no par value, of the Company (the “Series B Preferred Stock”), at a purchase price equal to $20.00 per one one-thousandth of a share, subject to adjustment (the “Rights or Series B Purchase Price”). The description and terms of the Rights are set forth in the Plan, dated October 30, 2012, as the same may be amended from time to time, between the Company and Registrar and Transfer Company, as Rights Agent.
Purpose of the NOL Rights Plan
The Company has previously experienced substantial net operating losses, which it may carryforward in certain circumstances to offset current and future taxable income and thus reduce its federal income tax liability, subject to certain requirements and restrictions. The purpose of the NOL Rights Plan is to help preserve the value of the Company's deferred tax assets, such as its net operating losses (“Tax Benefits”), for U.S. federal income tax purposes.
These Tax Benefits can be valuable to the Company. However, if the Company experiences an “ownership change,” as defined in Section 382 (“Section 382”) of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder, its ability to use the Tax Benefits could be substantially limited and/or delayed, which would significantly impair the value of the Tax Benefits. Generally, the Company would experience an “ownership change” under Section 382 if one or more “5 percent shareholders” increase their aggregate percentage ownership by more than 50 percentage points over the lowest percentage of stock owned by such shareholders over the preceding three-year period. As a result, the Company has utilized a 5% “trigger” threshold in the Plan that is intended to act as a deterrent to any person or entity seeking to acquire 5% or more of the outstanding Common Stock without the prior approval of the Board.
On October 30, 2012, in connection with the adoption of the NOL Rights Plan, the Company filed Articles of Amendment to the Charter of Incorporation (the “Articles Amendment”) with the Secretary of State of the State of Tennessee. Further details about the Plan and the Articles Amendment can be found in Exhibits 3.1 and 4.1 to the Current Report on Form 8-K filed with the SEC on October 30, 2012.


58


FINANCIAL CONDITION

As of March 31, 2013, we had total consolidated assets of $1.0 billion, total loans of $540.3 million, total deposits of $1.0 billion and shareholders’ equity of $21.0 million. 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 million and shareholders' equity of $29.1 million. As of March 31, 2012, we had total assets of $1.1 billion, total loans of $601.8 million, total deposits of $1.0 billion and shareholders' equity of $61.8 million.
Loans
The effects of the economic recession, as well as our active efforts to reduce certain credit exposures and their related balance sheet risk, resulted in declining loan balances since September 30, 2011. Certain strategic initiatives, as discussed in the Strategic Initiatives for 2013 section of MD&A above, have partially mitigated the decrease in loans for the first three months in 2013. As of March 31, 2013, total loans decreased by $842 thousand, or 0.1% (1.7% annualized), from December 31, 2012 and decreased by $61.5 million, or 10.2%, from March 31, 2012.
The following table presents our loan portfolio by type.
LOAN PORTFOLIO
 
 
 
 
 
 
 
 
Percent change from
 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
 
December 31,
2012
 
March 31,
2012
 
(in thousands, except percentages)
Loans secured by real estate –
 
 
 
 
 
 
 
 
 
Residential 1-4 family
$
181,624

 
$
188,191

 
$
210,557

 
(3.5
)%
 
(13.7
)%
Commercial
223,737

 
221,655

 
226,367

 
0.9
 %
 
(1.2
)%
Construction
37,894

 
33,407

 
49,442

 
13.4
 %
 
(23.4
)%
Multi-family and farmland
16,530

 
17,051

 
31,532

 
(3.1
)%
 
(47.6
)%
 
459,785

 
460,304

 
517,898

 
(0.1
)%
 
(11.2
)%
Commercial loans
61,904

 
61,398

 
60,835

 
0.8
 %
 
1.8
 %
Consumer installment loans
11,880

 
13,387

 
16,450

 
(11.3
)%
 
(27.8
)%
Leases, net of unearned income
373

 
568

 
2,072

 
(34.3
)%
 
(82.0
)%
Other
6,346

 
5,473

 
4,524

 
16.0
 %
 
40.3
 %
Total loans
540,288

 
541,130

 
601,779

 
(0.2
)%
 
(10.2
)%
Allowance for loan and lease losses
(13,500
)
 
(13,800
)
 
(18,990
)
 
(2.2
)%
 
(28.9
)%
Net loans
$
526,788

 
$
527,330

 
$
582,789

 
(0.1
)%
 
(9.6
)%

Loans year-to-date have remained consistent with an decrease of approximately $842 thousand. This is mostly due to a decrease in residential 1-4 family real estate loans of $6.6 million offset by increases in construction real estate and commercial real estate of $4.5 million and $2.1 million, respectively. The largest declining loan balance was 1-4 family residential real estate loans of $6.6 million, or 3.5% and consumer installment loans of $1.5 million, or 11.3%. Commercial real estate loans increased $2.1 million, or 1.0% and construction real estate loans increased $4.5 million, or 13.4%.
Comparing March 31, 2013 to March 31, 2012, loans decreased by $61.5 million, or 10.2%. The largest declining loan balances were residential 1-4 family loans of $28.9 million, a decrease of 13.7%, construction real estate loans of $11.5 million, a decrease of 23.4%, multi-family and farmland loans of $15.0 million, or 47.6%, and consumer installment loans of $4.6 million, a decrease of 27.8%.
As we develop and implement lending initiatives, we will focus on extending prudent loans to creditworthy consumers and businesses. We anticipate our loan portfolio to start growing during 2013. Funding of future loans may be restricted by our ability to raise core deposits, although we may use current cash reserves, as necessary and appropriate. Loan growth may also be restricted by the necessity for us to maintain appropriate capital levels.

59



Allowance for Loan and Lease Losses
The allowance for loan and lease losses reflects our assessment and estimate of the risks associated with extending credit and our evaluation of the quality of the loan portfolio. We regularly analyze our loan portfolio in an effort to establish an allowance that we believe will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, we review the size, quality and risk of loans in the portfolio. We also consider such factors as:
our loan loss experience;
specific known risks;
the status and amount of past due and non-performing assets;
underlying estimated values of collateral securing loans;
current and anticipated economic conditions; and
other factors which we believe affect the allowance for potential credit losses.
The allowance is composed of two primary components: (1) specific impairments for substandard/nonaccrual loans and leases and (2) general allocations for classified loan pools, including special mention and substandard/accrual loans, as well as general allocations for the remaining pools of loans. We accumulate pools based on the underlying classification of the collateral. Each pool is assigned a loss severity rate based on historical loss experience and various qualitative and environmental factors, including, but not limited to, credit quality and economic conditions.
The following loan portfolio segments have been identified: (1) Real estate: Residential 1-4 family, (2) Real estate: Commercial, (3) Real estate: Construction, (4) Real estate: Multi-family and farmland, (5) Commercial, (6) Consumer, (7) Leases and (8) Other. We evaluate the risks associated with these segments based upon specific characteristics associated with the loan segments. The risk associated with the Real estate: Construction portfolio is most directly tied to the probability of declines in value of the residential and commercial real estate in our market area and secondarily to the financial capacity of the borrower. The risk associated with the Real estate: Commercial portfolio is most directly tied to the lease rates and occupancy rates for commercial real estate in our market area and secondarily to the financial capacity of the borrower. The other portfolio segments have various risk characteristics, including, but not limited to: the borrower’s cash flow, the value of the underlying collateral, and the capacity of guarantors.
An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan and lease losses is prepared jointly by our accounting and credit administration departments and presented to our Board of Directors or the Directors’ Loan Committee on at least a quarterly basis. Based on our analysis, we may determine that our future provision expense needs to increase or decrease in order for us to remain adequately reserved for probable, incurred loan losses. As stated earlier, we make this determination after considering both quantitative and qualitative factors under appropriate regulatory and accounting guidelines.
Our allowance for loan and lease losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance compared to a group of peer banks. During their routine examinations of banks, the regulators may require a bank to make additional provisions to its allowance for loan losses when, in the opinion of the regulators, their credit evaluations and allowance methodology differ materially from the bank’s methodology. We believe our allowance methodology is in compliance with regulatory inter-agency guidance as well as applicable GAAP guidance.
While it is our policy to charge-off all or a portion of certain loans in the current period when a loss is considered probable, there are additional risks of future losses that cannot be quantified precisely or attributed to particular loans or classes of loans. Because the assessment of these risks includes assumptions regarding local and national economic conditions, our judgment as to the adequacy of the allowance may change from our original estimates as more information becomes available and events change.
Allowance—Loan Pools
As indicated in the Allowance—Overview above, we analyze our allowance by segregating our portfolio into two primary categories: impaired loans and non-impaired loans. Impaired loans are individually evaluated, as further discussed below. Non-impaired loans are segregated first by loan risk rating and then into homogeneous pools based on loan type, collateral or purpose of proceeds. We believe our loan pools conform to regulatory and accounting guidelines.
Impaired loans generally include those loan relationships in excess of $500 thousand with a risk rating of substandard/nonaccrual or doubtful. For these loans, we determine the impairment based upon one of the following methods: (1) discounted cash flows, (2) observable market pricing or (3) the fair value of the collateral. The amount of the estimated loss, if any, is then specifically reserved in a separate component of the allowance unless the relationship is considered collateral dependent, in which the estimated loss is charged-off in the current period.

60


For non-impaired loans, we first segregate special mention and non-impaired substandard loans into two distinct pools. All remaining loans are further segregated into homogeneous pools based on loan type, collateral or purpose of proceeds. Each of these pools is evaluated individually and is assigned a loss factor based on our best estimate of the loss that potentially could be realized in that pool of loans. The loss factor is the sum of an objectively calculated historical loss percentage and a subjectively calculated risk percentage. The actual annual historical loss factor is typically a weighted average of each period’s loss. For the historical loss factor, we utilize a migration loss analysis. Each period may be assigned a different weight depending on certain trends and circumstances. The subjectively calculated risk percentage is the sum of eight qualitative and environmental risk categories. These categories are evaluated separately for each pool. The eight risk categories are: (1) underlying collateral value, (2) lending practices and policies, (3) local and national economies, (4) portfolio volume and nature, (5) staff experience, (6) credit quality, (7) loan review and (8) competition, regulatory and legal issues.
Allowance—Loan Risk Ratings
A consistent and appropriate loan risk rating methodology is a critical component of the allowance. We classify loans as: pass, special mention, substandard/impaired, substandard/non-impaired, doubtful or loss. The following describes our loan classifications and the various risk indicators associated with each risk rating.
A pass rating is assigned to those loans that are performing as contractually agreed and do not exhibit the characteristics of the criticized and classified risk ratings as defined below. Pass loan pools do not include the unfunded portions of binding commitments to lend, standby letters of credit, deposit secured loans or mortgage loans originated with commitments to sell in the secondary market. Loans secured by segregated deposits held by FSGBank are not required to have an allowance reserve, nor are originated held-for-sale mortgage loans pending sale in the secondary market.
A special mention loan risk rating is considered criticized but is not considered as severe as a classified loan risk rating. Special mention loans contain one or more potential weakness(es), which if not corrected, could result in an unacceptable increase in credit risk at some future date. These loans may be characterized by the following risks and/or trends:
Loans to Businesses:
Downward trend in sales, profit levels and margins
Impaired working capital position compared to industry
Cash flow strained in order to meet debt repayment schedule
Technical defaults due to noncompliance with financial covenants
Recurring trade payable slowness
High leverage compared to industry average with shrinking equity cushion
Questionable abilities of management
Weak industry conditions
Inadequate or outdated financial statements
Loans to Businesses or Individuals:
Loan delinquencies and overdrafts may occur
Original source of repayment questionable
Documentation deficiencies may not be easily correctable
Loan may need to be restructured
Collateral or guarantor offers adequate protection
Unsecured debt to tangible net worth is excessive
A substandard loan risk rating is characterized as having specifically identified weaknesses and deficiencies typically resulting from severe adverse trends of a financial, economic, or managerial nature, and may warrant non-accrual status. Substandard loans have a greater likelihood of loss and may require a protracted work-out plan. Substandard/impaired loans are relationships in excess of $500 thousand and are individually reviewed. In addition to the factors listed for special mention loans, substandard loans may be characterized by the following risks and/or trends:
Loans to Businesses:
Sustained losses that have severely eroded equity and cash flows
Concentration in illiquid assets
Serious management problems or internal fraud
Chronic trade payable slowness; may be placed on COD or collection by trade creditor
Inability to access other funding sources
Financial statements with adverse opinion or disclaimer; may be received late
Insufficient documented cash flows to meet contractual debt service requirements

61



Loans to Businesses or Individuals:
Chronic or severe delinquency or has met the retail classification standards which is generally past dues greater than 90 days
Frequent overdrafts
Likelihood of bankruptcy exists
Serious documentation deficiencies
Reliance on secondary sources of repayment which are presently considered adequate
Demand letter sent
Litigation may have been filed against the borrower
Loans with a risk rating of doubtful are individually analyzed to determine our best estimate of the loss based on the most recent assessment of all available sources of repayment. Doubtful loans are considered impaired and placed on nonaccrual. For doubtful loans, the collection or liquidation in full of principal and/or interest is highly questionable or improbable. We estimate the specific potential loss based upon an individual analysis of the relationship risks, the borrower’s cash flow, the borrower’s management and any underlying secondary sources of repayment. The amount of the estimated loss, if any, is then either specifically reserved in a separate component of the allowance or charged-off. In addition to the characteristics listed for substandard loans, the following characteristics apply to doubtful loans:
Loans to Businesses:
Normal operations are severely diminished or have ceased
Seriously impaired cash flow
Numerous exceptions to loan agreement
Outside accountant questions entity’s survivability as a “going concern”
Financial statements may be received late, if at all
Material legal judgments filed
Collection of principal and interest is impaired
Collateral/Guarantor may offer inadequate protection
Loans to Businesses or Individuals:
Original repayment terms materially altered
Secondary source of repayment is inadequate
Asset liquidation may be in process with all efforts directed at debt retirement
Documentation deficiencies not correctable
The consistent application of the above loan risk rating methodology ensures we have the ability to track historical losses and appropriately estimate potential future losses in our allowance. Additionally, appropriate loan risk ratings assist us in allocating credit and special asset personnel in the most effective manner. Significant changes in loan risk ratings can have a material impact on the allowance and thus a material impact on our financial results by requiring significant increases or decreases in provision expense.

The following table presents an analysis of the changes in the allowance for loan and lease losses for the three months ended March 31, 2013 and 2012. The provision for loan and lease losses in the table below does not include our provision for losses on unfunded commitments of $6 thousand and $6 thousand for the three month periods ended March 31, 2013 and 2012, respectively. The reserve for unfunded commitments totaled $264 thousand and $247 thousand as of March 31, 2013 and 2012, respectively, and is included in other liabilities in the accompanying consolidated balance sheets.

62



ANALYSIS OF CHANGES IN ALLOWANCE FOR LOAN AND LEASE LOSSES
 
 
For the Three Months Ended
 
March 31,
 
2013
 
2012
 
(in thousands, except percentages)
Allowance for loan and lease losses –
 
 
 
Beginning of period
$
13,800

 
$
19,600

Provision for loan and lease losses
678

 
1,801

Sub-total
14,478

 
21,401

Charged-off loans:
 
 
 
Real estate – residential 1-4 family
651

 
1,147

Real estate – commercial
126

 
537

Real estate – construction
468

 
638

Real estate – multi-family and farmland

 
15

Commercial loans
25

 
231

Consumer installment and other loans
184

 
89

Leases, net of unearned income

 
494

Total charged-off
1,454

 
3,151

Recoveries of charged-off loans:
 
 
 
Real estate – residential 1-4 family
111

 
19

Real estate – commercial
37

 
23

Real estate – construction
40

 
486

Real estate – multi-family and farmland
6

 
4

Commercial loans
122

 
112

Consumer installment and other loans
104

 
55

Leases, net of unearned income
55

 
36

Other
1

 
5

Total recoveries
476

 
740

Net charged-off loans
978

 
2,411

Allowance for loan and lease losses – end of period
$
13,500

 
$
18,990

Total loans – end of period
$
540,288

 
$
601,779

Average loans
$
554,204

 
$
594,579

Net loans charged-off to average loans, annualized
0.71
%
 
1.62
%
Provision for loan and lease losses to average loans, annualized
0.16
%
 
0.40
%
Allowance for loan and lease losses as a percentage of:
 
 
 
Period end loans
2.50
%
 
3.16
%
Nonperforming loans
117.76
%
 
40.54
%

63



The following table presents the allocation of the allowance for loan and lease losses for each respective loan category with the corresponding percentage of loans in each category to total loans. The comprehensive allowance analysis developed by our financial reporting and credit administration group enables us to allocate the allowance based on risk elements within the portfolio.
ALLOCATION OF THE ALLOWANCE FOR LOAN AND LEASE LOSSES
 
 
As of March 31, 2013
 
As of December 31, 2012
 
As of March 31, 2012
 
Amount
 
Percent
of
Portfolio1
 
Amount
 
Percent
of
Portfolio1
 
Amount
 
Percent
of
Portfolio1
 
(in thousands, except percentages)
Real estate – residential 1-4 family
$
5,979

 
33.6
%
 
$
6,207

 
34.8
%
 
$
6,256

 
35.2
%
Real estate – commercial
3,412

 
41.4
%
 
3,736

 
41.0
%
 
5,299

 
37.6
%
Real estate – construction
962

 
7.0
%
 
667

 
6.2
%
 
1,068

 
8.2
%
Real estate – multi-family and farmland
1,106

 
3.1
%
 
741

 
3.1
%
 
1,504

 
5.2
%
Commercial loans
1,818

 
11.5
%
 
2,103

 
11.3
%
 
3,976

 
10.1
%
Consumer installment loans
189

 
2.2
%
 
272

 
2.5
%
 
354

 
2.7
%
Leases, net of unearned income
11

 
0.1
%
 
47

 
0.1
%
 
511

 
0.3
%
Other
23

 
1.1
%
 
27

 
1.0
%
 
22

 
0.7
%
Total
$
13,500

 
100.0
%
 
$
13,800

 
100.0
%
 
$
18,990

 
100.0
%
__________________ 
1 Represents the percentage of loans in each category to total loans.
Throughout the duration of this economic cycle, the ratio of the allowance to total loans was significantly increased and has remained elevated largely because of the level of nonperforming loans and the associated decline in real estate values. These two factors have contributed to elevated levels of classified loans, which is a driving component of the allowance.
We utilize a risk rating system to evaluate the credit risk of our loan portfolio. We classify loans as: pass, special mention, substandard, doubtful or loss. We assign a pass rating to loans that are performing as contractually agreed and do not exhibit the characteristics of heightened credit risk. A special mention risk rating is assigned to loans that are criticized but not considered to have weaknesses as serious as those of a classified loan. Special mention loans generally contain one or more potential weaknesses, which if not corrected, could result in an unacceptable increase in the credit risk at some future date. A substandard risk rating is assigned to loans that have specifically identified weaknesses and deficiencies typically resulting from severe adverse trends of a financial, economic or managerial nature and may require nonaccrual status. Substandard loans have a greater likelihood of loss. We assign a doubtful risk rating to loans that the collection or liquidation in full of principal and/or interest is highly questionable or improbable. Any loans that are assigned a risk rating of loss are fully charged-off in the period of the downgrade.
We segregate substandard loans into two classifications based on our allowance methodology for impaired loans. An impaired loan is defined as a substandard loan relationship in excess of $500 thousand that is also on nonaccrual status. These relationships are individually reviewed on a quarterly basis to determine the required allowance or loss, as applicable.
For the allowance analysis, the primary categories are: pass, special mention, substandard – non-impaired, and substandard – impaired. Loans in the substandard and doubtful loan categories are combined and impaired loans are segregated from non-impaired loans.

64



The following tables present our internal risk rating by loan classification as utilized in the allowance analysis as of March 31, 2013, December 31, 2012 and March 31, 2012:
As of March 31, 2013
 
 
Pass
 
Special
Mention
 
Substandard –
Non-impaired
 
Substandard –
Impaired
 
Total
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
158,350

 
$
8,544

 
$
13,575

 
$
1,155

 
$
181,624

Real estate: Commercial
211,196

 
4,006

 
7,825

 
710

 
223,737

Real estate: Construction
37,018

 
93

 
757

 
26

 
37,894

Real estate: Multi-family and farmland
14,609

 
818

 
1,103

 

 
16,530

Commercial
52,903

 
801

 
6,158

 
2,042

 
61,904

Consumer
11,386

 
105

 
389

 

 
11,880

Leases

 
88

 

 
285

 
373

Other
6,241

 

 
105

 

 
6,346

Total Loans
$
491,703

 
$
14,455

 
$
29,912

 
$
4,218

 
$
540,288


As of December 31, 2012
 
 
Pass
 
Special
Mention
 
Substandard –
Non-impaired
 
Substandard –
Impaired
 
Total
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
164,555

 
$
7,668

 
$
15,511

 
$
457

 
$
188,191

Real estate: Commercial
207,188

 
4,930

 
8,810

 
727

 
221,655

Real estate: Construction
30,471

 
97

 
1,056

 
1,783

 
33,407

Real estate: Multi-family and farmland
14,025

 
1,794

 
1,232

 

 
17,051

Commercial
51,972

 
756

 
6,593

 
2,077

 
61,398

Consumer
12,793

 
126

 
468

 

 
13,387

Leases
1

 
74

 
101

 
392

 
568

Other
5,365

 

 
108

 

 
5,473

Total Loans
$
486,370

 
$
15,445

 
$
33,879

 
$
5,436

 
$
541,130


As of March 31, 2012
 
 
Pass
 
Special
Mention
 
Substandard –
Non-impaired
 
Substandard –
Impaired
 
Total
 
(in thousands)
Loans by Classification
 
 
 
 
 
 
 
 
 
Real estate: Residential 1-4 family
$
177,198

 
$
7,417

 
$
22,138

 
$
3,804

 
$
210,557

Real estate: Commercial
188,893

 
9,900

 
18,552

 
9,022

 
226,367

Real estate: Construction
33,243

 
803

 
3,131

 
12,265

 
49,442

Real estate: Multi-family and farmland
21,633

 
2,035

 
7,004

 
860

 
31,532

Commercial
40,685

 
7,040

 
9,401

 
3,709

 
60,835

Consumer
15,905

 
37

 
508

 

 
16,450

Leases

 
359

 
677

 
1,036

 
2,072

Other
4,419

 

 
105

 

 
4,524

Total Loans
$
481,976

 
$
27,591

 
$
61,516

 
$
30,696

 
$
601,779




65


We classify a loan as impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans were $4.2 million at March 31, 2013, $5.4 million at December 31, 2012 and $30.7 million at March 31, 2012. For impaired loans, any payments made by the borrower are generally applied directly to principal.

The allowance associated with impaired loans totaled $57 thousand as of March 31, 2013, compared to $50 thousand as of December 31, 2012. General reserves totaled $13.4 million as of March 31, 2013, compared to $13.7 million as of December 31, 2012. Specific reserves are based on our evaluation of each impaired relationship. The general reserve is determined by applying the historical loss factor and qualitative and environmental factors to the applicable loan pools. Our allowance as a percentage of total loans has decreased mostly due to a decrease in the loan portfolio and a decrease in non-performing loans. The ratio of the general reserves to the applicable loan pools has declined from 2.55% as of December 31, 2012 to 2.50% as of March 31, 2013.

We believe that the allowance for loan and lease losses as of March 31, 2013 is sufficient to absorb probable incurred losses in the loan portfolio based on our assessment of the information available, including the results of ongoing internal reviews of our loan portfolio, as discussed in the Asset Quality and Non-Performing Assets section below. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examinations, may require additional charges to the provision for loan losses in future periods if the results of their reviews warrant.
Asset Quality and Non-Performing Assets
Asset Quality Strategic Initiatives
Our ability to return to profitability is largely dependent on properly addressing and improving asset quality. As of March 31, 2013, our loan portfolio was 51.9% of total assets. Over the past three and a half years, we have implemented a number of significant strategies to further address our asset quality. We believe our continued implementation of these and related strategies will enable us to show further improvement in our asset quality in 2013.
During the fourth quarter of 2009, we began the process of restructuring our credit administration department to add additional depth and expertise and to fully centralize our credit underwriting process. With the additional depth and expertise of the restructured credit department, in 2010 we centralized our loan underwriting, document preparation and collections processes. This centralization has improved consistency, increased quality and provided higher levels of operational efficiencies. Collectively, we believe these changes will assist in reducing current and future non-performing assets.
Our internal loan review department performs risk-based reviews and historically targets 60% to 70% of our portfolio over an 18-month cycle. To achieve such coverage, we have continued to use third parties to supplement the coverage of our internal loan review department. During 2012, we achieved the 60% to 70% review of our portfolio over a 12-month cycle, focusing on a risk-based approach. We anticipate similar coverage during the remainder of 2013.
During the second half of 2010, we began outsourcing the marketing and sales process of our OREO properties to market leading real estate companies. We experienced higher volumes of OREO sales in 2011 and 2012, and we expect to continue seeing high levels of sales through the remainder of 2013.
On February 9, 2012, we hired Christopher G. Tietz as Executive Vice President and Chief Credit Officer. Mr. Tietz has over 25 years of banking knowledge with extensive experience in credit administration. Mr. Tietz joined First Security from First Place Bank in Warren, Ohio, a $3 billion bank, where he served as EVP and Chief Credit Officer since May 2011. From 2005 to April 2011, Mr. Tietz worked for Monroe Bank in Bloomington, Indiana as Chief Credit Officer. Mr. Tietz began his career in Nashville, Tennessee with First American National Bank where he spent fifteen years, with the final five years serving as EVP and Regional Senior Credit Officer.

Asset Quality and Non-Performing Assets Analysis and Discussion
As of March 31, 2013, our allowance for loan and lease losses as a percentage of total loans was 2.50%, which is a decrease from the 2.55% as of December 31, 2012 and a decrease from the 3.16% as of March 31, 2012.  Net charge-offs as a percentage of average loans (annualized) decreased to 0.71% for the three months ended March 31, 2013 compared to 1.62% for the same period in 2012. As of March 31, 2013, non-performing assets decreased to $24.2 million, or 2.32% of total assets, from $40.2 million, or 3.78% of total assets as of December 31, 2012 and decreased from $71.8 million, or 6.35% as of March 31, 2012. The allowance as a percentage of total non-performing loans was 117.8% as of March 31, 2013 compared to 51.6% at December 31, 2012 and 40.5% at March 31, 2012.

66


We believe that overall asset quality has stabilized and will continue to improve in the following quarters. From December 31, 2012 to March 31, 2013, we have seen positive results in improving our asset quality. Special mention loans, generally regarded as the gateway or leading indicator of future non-performing loans, decreased $1.0 million, or 6.4%, from $15.4 million as of December 31, 2012 to $14.5 million as of March 31, 2013. Comparing March 31, 2013 to March 31, 2012, special mention loans declined by $13.5 million, or 48.9%. Substandard loans decreased $5.2 million, or 13.2%, from $39.3 million at December 31, 2012 to $34.1 million. Comparing March 31, 2013 to March 31, 2012, substandard loans decreased by $58.1 million, or 63%. Based on the trends in special mention and substandard loans, we believe there is minimal additional migration to nonperforming loans from the performing loans. We have also achieved steady reductions in other real estate owned. OREO declined by $735 thousand, or 5.5%, from $13.4 million as of December 31, 2012 to $12.7 million as of March 31, 2013. Comparing March 31, 2013 to March 31, 2012, OREO declined by $14.2 million, or 52.8%. This is a direct result of our increased efforts to liquidate and sell our OREO properties.
Nonperforming assets include nonaccrual loans, loans past-due over ninety days and still accruing, restructured loans, OREO and repossessed assets. We place loans on non-accrual status when we have concerns relating to our ability to collect the loan principal and interest, and generally when such loans are 90 days or more past due. The following table, which includes both loans held-for-sale and loans held-for-investment, presents our non-performing assets and related ratios.
NON-PERFORMING ASSETS BY TYPE
 
 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
 
(in thousands, except percentages)
Nonaccrual loans
$
10,194

 
$
25,071

 
$
43,137

Loans past due 90 days and still accruing
1,270

 
1,656

 
3,700

Total nonperforming loans, including loans 90 days and still accruing
$
11,464

 
$
26,727

 
$
46,837

 
 
 
 
 
 
Other real estate owned
$
12,706

 
$
13,441

 
$
24,716

Repossessed assets
16

 
8

 
216

Total nonperforming assets
$
24,186

 
$
40,176

 
$
71,769

 
 
 
 
 
 
Nonperforming loans as a percentage of total loans
2.12
%
 
4.94
%
 
7.78
%
Nonperforming assets as a percentage of total assets
2.32
%
 
3.78
%
 
6.35
%

67



The following table provides the classifications for nonaccrual loans and other real estate owned as of March 31, 2013December 31, 2012 and March 31, 2012.
NON-PERFORMING ASSETS – CLASSIFICATION AND NUMBER OF UNITS
 
 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
 
Amount
 
Units
 
Amount
 
Units
 
Amount
 
Units
 
(dollar amounts in thousands)
Nonaccrual loans
 
 
 
 
 
 
 
 
 
 
 
Construction/development loans
$
462

 
6

 
$
4,516

 
41

 
$
13,353

 
13

Residential real estate loans
5,065

 
59

 
9,217

 
217

 
12,456

 
98

Commercial real estate loans
1,560

 
12

 
6,150

 
69

 
10,716

 
19

Commercial and industrial loans
2,484

 
21

 
3,104

 
56

 
4,586

 
24

Commercial leases
313

 
28

 
436

 
42

 
1,571

 
61

Consumer and other loans
310

 
11

 
1,648

 
34

 
455

 
10

Total
$
10,194

 
137

 
$
25,071

 
459

 
$
43,137

 
225

Other real estate owned
 
 
 
 
 
 
 
 
 
 
 
Construction/development loans
$
5,391

 
241

 
$
6,163

 
351

 
$
11,032

 
59

Residential real estate loans
1,830

 
30

 
1,921

 
86

 
5,146

 
73

Commercial real estate loans
4,372

 
24

 
4,211

 
39

 
7,535

 
33

Multi-family and farmland
840

 
2

 
873

 
3

 
1,003

 
3

Commercial and industrial loans
273

 
1

 
273

 
2

 

 

Total
$
12,706

 
298

 
$
13,441

 
481

 
$
24,716

 
168


Nonaccrual loans totaled $10.2 million, $25.1 million and $43.1 million as of March 31, 2013December 31, 2012 and March 31, 2012, respectively. Of the non-accrual loans as of December 31, 2012, $11.7 million relate to loans held-for-investment and $13.4 million relate to loans transferred to loans held-for-sale. Loans past due ninety days and still accruing include $718 thousand from loans held-for-investment and $938 thousand of loans transferred to loans held-for-sale at December 31, 2012. We place loans on nonaccrual when we have concerns related to our ability to collect the loan principal and interest, and generally when loans are 90 or more days past due. As of March 31, 2013, we are not aware of any additional material loans that we have doubts as to the collectability of principal and interest that are not classified as nonaccrual. As previously described, we have individually reviewed each nonaccrual loan in excess of $500 thousand for possible impairment. We measure impairment by adjusting loans to either the present value of expected cash flows, the fair value of the collateral or observable market prices.
As of March 31, 2013, nonaccrual loans decreased by $14.9 million, or 59.3%, compared to year-end 2012. Comparing March 31, 2013 to December 31, 2012, nonaccrual construction and development loans decreased by $3.7 million, residential real estate loans decreased by $4.1 million and commercial real estate loans decreased by $4.6 million. The decreases were primarily due to the loan sale that closed in February of 2013 as well as charge-offs and principal payments. See Note 7 of our consolidated financial statements for additional discussion regarding the loan sale. We continue to actively pursue the appropriate strategies to reduce the current level of nonaccrual loans.
OREO decreased $735 thousand from December 31, 2012 to March 31, 2013. As previously mentioned, we have outsourced the marketing and sales process of our OREO properties to market-leading real estate firms. During 2012, we sold 205 properties for $15.1 million. During the three months ended March 31, 2013, we sold 11 properties for $1.3 million. During April 2012, we conducted a bulk auction on approximately 90 properties consisting of smaller balance 1-4 family residential and lot properties. This auction resulted in an approximate 50% decline in the number of properties, thus allowing our special assets department to focus on the larger value properties remaining in our portfolio. We expect continued OREO resolutions during 2013 due to our new approach to marketing these properties and general stabilization in the real estate markets in our footprint.
Loans 90 days past due and still accruing decreased $386 thousand for the quarter. As of March 31, 2013, the $1.3 million in loans 90 days past due and still accruing was composed of $565 thousand in commercial real estate loans, $189 thousand in commercial loans, $369 thousand in residential real estate loans and the remainder in other categories.
Total non-performing assets as of the first quarter of 2013 were $24.2 million compared to $40.2 million at December 31, 2012 and $71.8 million at March 31, 2012.

68


Our asset ratios are generally less favorable as compared to our peer group. Our peer group, as defined by the Uniform Bank Performance Report (UBPR), is all commercial banks between $1 billion and $3 billion in total assets. The following table provides our asset quality ratios and our UBPR peer group ratios as of March 31, 2013, which is the latest available information.
NONPERFORMING ASSET RATIOS
 
 
First Security
Group, Inc.
 
UBPR
Peer Group
Nonperforming loans1 as a percentage of gross loans
2.12
%
 
1.86
%
Nonperforming loans1 as a percentage of the allowance
84.92
%
 
104.43
%
Nonperforming loans1 as a percentage of equity capital
54.61
%
 
11.03
%
Nonperforming loans1 plus OREO as a percentage of gross loans plus OREO
4.37
%
 
2.85
%
__________________ 
1 Nonperforming loans are nonaccrual loans plus loans 90 days past due and still accruing

Investment Securities and Other Earning Assets
The composition of our securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. Our securities portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for investing available funds, furnishing liquidity and supplying securities to pledge as required collateral for certain deposits and borrowed funds. Currently, all of our investments are classified as available-for-sale. As of March 31, 2013, we have no plans to liquidate a significant amount of available-for-sale securities. However, the securities classified as available-for-sale may be used for liquidity purposes should we deem it to be in our best interest.
Available-for-sale securities totaled $258.2 million at March 31, 2013, $254.1 million at December 31, 2012 and $223.2 million at March 31, 2012. We maintain a level of securities to provide an appropriate level of liquidity and to provide a proper balance to our interest rate and credit risk in our loan portfolio. The increase in the first three quarters represented a decision that liquidity was sufficient to warrant the shifting of additional cash into investment securities, and further purchases throughout 2013 may be warranted. At March 31, 2013 and 2012, the available-for-sale securities portfolio had gross unrealized gains of approximately $4.5 million and $4.7 million, and gross unrealized losses of $569 thousand and $279 thousand, respectively. All investment securities purchased to date have been classified as available-for-sale. Our securities portfolio at March 31, 2013 consisted of tax-exempt municipal securities, federal agency bonds, federal agency issued Real Estate Mortgage Investment Conduits (REMICs), federal agency issued pools.
The following table provides the amortized cost of our available-for-sale securities by their stated maturities (this maturity schedule excludes security prepayment and call features), as well as the tax equivalent yields for each maturity range.
MATURITY OF AFS INVESTMENT SECURITIES – AMORTIZED COST
 
 
Less
than One
Year
 
One to
Five
Years
 
Five to
Ten
Years
 
More Than
Ten Years
 
Totals
 
(in thousands, except percentages)
Municipal-tax exempt
$
1,131

 
$
11,980

 
$
5,045

 
$
2,209

 
$
20,365

Municipal - taxable

 

 
11,934

 
3,246

 
15,180

Agency bonds

 
3,000

 
53,518

 
9,319

 
65,837

Agency issued REMICs
2,167

 
71,139

 

 

 
73,306

Agency issued mortgage pools
102

 
52,943

 
14,223

 
8,246

 
75,514

Other

 

 
4,000

 
61

 
4,061

Total
$
3,400

 
$
139,062

 
$
88,720

 
$
23,081

 
$
254,263

Tax Equivalent Yield
4.58
%
 
2.69
%
 
2.02
%
 
2.85
%
 
2.50
%

We currently have the ability and intent to hold our available-for-sale investment securities to maturity. However, should conditions change, we may sell unpledged securities. We consider the overall quality of the securities portfolio to be high. All securities held are historically traded in liquid markets, except for one bond, which is valued utilizing Level 3 inputs. The Level 3 security was a pooled trust preferred security with a book value of $61 thousand.

69


As of March 31, 2013, we performed an impairment assessment of the securities in our portfolio that had an unrealized loss to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) we intend to sell the security, (2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis or (3) we do not expect to recover the security’s entire amortized cost basis, even if we do not intend to sell. Additionally, accounting guidance requires that for impaired securities that we do not intend to sell and/or that it is not more-likely-than-not that we will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.
In evaluating the recovery of the entire amortized cost basis, we consider factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.
As of March 31, 2013, gross unrealized losses in our portfolio totaled $569 thousand, compared to $384 thousand and $279 thousand as of December 31, 2012 and March 31, 2012, respectively. The unrealized losses in mortgage-based residential, municipal, and federal agency securities are primarily a result of widening credit spreads subsequent to purchase. The unrealized losses in other securities is a pooled trust preferred security. The unrealized losses associated with the trust preferred security are primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. Based on results of our impairment assessment, the unrealized losses at March 31, 2013 are considered temporary.
As of March 31, 2013, we owned securities from issuers in which the aggregate amortized cost from such issuers exceeded 5% of our shareholders’ equity. The following table presents the amortized cost and market value of the securities from each such issuer as of March 31, 2013.
 
 
Amortized Cost
 
Market
Value
 
(in thousands)
Federal National Mortgage Association (FNMA)
$
79,477

 
$
80,791

Federal Home Loan Mortgage Corporation (FHLMC)
$
36,584

 
$
37,527

Government National Mortgage Association (GNMA)
$
60,474

 
$
61,257


We held no federal funds sold as of March 31, 2013December 31, 2012 or March 31, 2012. As of March 31, 2013, we held $157.9 million in interest bearing deposits, primarily at the Federal Reserve Bank of Atlanta, compared to $159.7 million at December 31, 2012 and $217.1 million as of March 31, 2012. The yield on our account at the Federal Reserve Bank is approximately 25 basis points.
As of March 31, 2013, we held approximately $3.0 million in certificates of deposit at FDIC insured financial institutions. At March 31, 2013, we held $27.8 million in bank-owned life insurance, compared to $27.6 million at December 31, 2012 and $24.7 million at March 31, 2012.


Deposits and Other Borrowings
As of March 31, 2013, deposits decreased by 1.7% ((6.8)% annualized) from December 31, 2012 and decreased by 4.6% from March 31, 2012. Excluding brokered deposits, our deposits increased by 1.0% (4.1% annualized) from December 31, 2012 and increased 3.2% from March 31, 2012. In the first three months of 2013, the fastest growing sectors of our core deposit base were savings and money market accounts, which grew 4.0% (15.8% annualized). We define our core deposits to include interest bearing and noninterest bearing demand deposits, savings and money market accounts, as well as retail certificates of deposit with denominations less than $100,000. Core deposits increased by $9.1 million, or 1.4% from December 31, 2012. We consider our retail certificates of deposit to be a stable source of funding because they are in-market, relationship-oriented deposits. Core deposit growth is an important tenet of our business strategy.

70



Brokered certificates of deposits decreased $72.9 million from March 31, 2012 to March 31, 2013 due to scheduled and called maturities. In addition to brokered certificates of deposits, we are a member bank of the Certificate of Deposit Account Registry Service (CDARS) network. CDARS is a network of banks that allows customers’ CDs to receive full FDIC insurance of up to $50 million. Additionally, members have the opportunity to purchase or sell one-way time deposits. As of March 31, 2013, our CDARS balance consists of $372 thousand in purchased time deposits and no reciprocal customer accounts.
Brokered deposits at March 31, 2013December 31, 2012 and March 31, 2012 were as follows:

BROKERED DEPOSITS
 
 
March 31,
2013
 
December 31,
2012
 
March 31,
2012
 
(in thousands)
Brokered certificates of deposits
$
139,343

 
$
165,106

 
$
212,274

CDARS®
372

 
371

 
1,408

Total
$
139,715

 
$
165,477

 
$
213,682


As discussed in Note 2 of our consolidated financial statements, the presence of a capital requirement in our Consent Order restricts our ability to accept, renew, or roll over brokered deposits without prior approval of the FDIC. The liquidity enhancement over the last two years was in part to ensure we have adequate funding to meet our short-term contractual obligations. We believe that our current liquidity, along with maintaining or increasing core deposits, will provide for our short-term contractual obligations, including maturing brokered deposits. The table below is a maturity schedule for our certificates of deposit, including brokered CDs, in amounts of $100 thousand or more as of March 31, 2013.

BROKERED DEPOSITSBY MATURITY
 
 
Less
than three
months
 
Three
months
to six
months
 
Six
months
to twelve
months
 
One to
two
years
 
Greater
than two
years
 
(in thousands)
Brokered certificates of deposit
$
29,833

 
$
20,896

 
$
24,329

 
$
62,309

 
$
1,976

CDARS®

 

 

 
372

 

Total
$
29,833

 
$
20,896

 
$
24,329

 
$
62,681

 
$
1,976


As of March 31, 2013December 31, 2012 and March 31, 2012, we had no Federal funds purchased.
Securities sold under agreements to repurchase with commercial checking customers were $13.0 million as of March 31, 2013, compared to $12.5 million and $6.6 million as of December 31, 2012 and March 31, 2012, respectively. We also had a structured repurchase agreement with another financial institution of $10.0 million. The agreement had a five year term with a variable rate of three-month LIBOR minus 75 basis points for the first year and a fixed rate of 3.93% for the remaining term. The agreement matured in November 2012.
Liquidity
Liquidity refers to our ability to adjust future cash flows to meet the needs of our daily operations. We rely primarily on management fees from FSGBank to fund our daily operations’ liquidity needs. Our cash balance on deposit with FSGBank, which totaled approximately $800 thousand as of March 31, 2013, is available for funding activities for which FSGBank would not receive direct benefit, such as shareholder relations and holding company operations. These funds should adequately meet our cash flow needs. As discussed in Note 2 to our consolidated financial statements, the Written Agreement with the Federal Reserve requires prior written authorization for any payment to First Security that reduces the equity of FSGBank, including management fees. If we determine that our cash flow needs will be satisfactorily met, we may deploy a portion of the funds into FSGBank.
The liquidity of FSGBank refers to the ability or financial flexibility to adjust its future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost effective basis. The primary sources of funds for FSGBank are cash generated by repayments of outstanding loans, interest payments on loans and new deposits. Additional

71


liquidity is available from the maturity and earnings on securities and liquid assets, as well as the ability to liquidate available-for-sale securities.
As of March 31, 2013, our interest bearing account at the Federal Reserve Bank of Atlanta totaled approximately $154.9 million. This liquidity is available to fund our contractual obligations and prudent investment opportunities.
As of March 31, 2013, the unused borrowing capacity (using 1-4 family residential mortgages) for FSGBank at the FHLB required the individual pledging of loans.
Another source of funding is loan participations sold to other commercial banks (in which we retain the servicing rights). As of quarter-end, we had approximately $500 thousand in loan participations sold. FSGBank may sell loan participations as a source of liquidity. An additional source of short-term funding would be to pledge investment securities against a line of credit at a commercial bank. As of quarter-end, FSGBank had $56.3 million in investment securities pledged for repurchase agreements, treasury tax and loan deposits, and public-fund deposits attained in the ordinary course of business. As of March 31, 2013, our unpledged investment securities totaled $201.9 million.
Historically, we have utilized brokered deposits to provide an additional source of funding. As of March 31, 2013, we had $139.3 million in brokered CDs outstanding with a weighted average remaining life of approximately 15 months, a weighted average coupon rate of 2.79% and a weighted average all-in cost (which includes fees paid to deposit brokers) of 3.00%. Our CDARS product had $372 thousand at March 31, 2013, with a weighted average coupon rate of 2.70% and a weighted average remaining life of approximately 18 months. Our certificates of deposit greater than $100 thousand were generated in our communities and are considered relatively stable. We are also approved to use the Federal Reserve discount window. We applied to utilize the Federal Reserve window as an abundance of caution due to the economic climate. As discussed in Note 2 of our consolidated financial statements, the presence of a capital requirement in our Order restricts our ability to accept, renew or roll over brokered deposits without prior approval of the FDIC.
Management believes that our liquidity sources are adequate to meet our current operating needs. We continue to study our contingency funding plans and update them as needed paying particular attention to the sensitivity of our liquidity and deposit base to positive and negative changes in our asset quality.
We also have contractual cash obligations and commitments, which include certificates of deposit, other borrowings, operating leases and loan commitments. Unfunded loan commitments and standby letters of credit totaled $110.4 million at March 31, 2013. The following table illustrates our significant contractual obligations at March 31, 2013 by future payment period.
CONTRACTUAL OBLIGATIONS
 
 
 
Less than
One Year
 
One to
Three
Years
 
Three to
Five
Years
 
More
than
Five
Years
 
Total
 
 
(in thousands)
Certificates of deposit
(1
)
$
331,705

 
$
90,929

 
$
3,265

 
$

 
$
425,899

Brokered certificates of deposit
(1
)
75,058

 
62,309

 
1,976

 

 
139,343

CDARS®
(1
)

 
372

 

 

 
372

Federal funds purchased and securities sold under agreements to repurchase
(2
)
13,048

 

 

 

 
13,048

Operating lease obligations
(3
)
753

 
2,100

 
1,394

 
2,724

 
6,971

Total
 
$
420,564

 
$
155,710

 
$
6,635

 
$
2,724

 
$
585,633

 __________________
1.
Certificates of deposits give customers rights to early withdrawal which may be subject to penalties. The penalty amount depends on the remaining time to maturity at the time of early withdrawal. For more information regarding certificates of deposit, see “Deposits and Other Borrowings.”
2.
We expect securities repurchase agreements to be re-issued and, as such, do not necessarily represent an immediate need for cash.
3.
Operating lease obligations include existing and future property and equipment non-cancelable lease commitments.

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Net cash provided by operations during the three months of 2013 totaled $4.6 million compared to net cash provided by operations of $1.6 million for the same period in 2012. The increase in net cash provided is primarily due to the sale of loans held-for-sale to a third party of $22.3 million, partially offset by an increase in other assets of approximately $3.7 million, mostly due to the increase in BOLI, as well as a higher net loss during the first quarter of 2013. Net cash used in investing activities totaled $6.2 million compared to net cash used in investing activities of $55.6 million for the same period in 2012. The decrease in cash used is associated with a decrease in the purchase of investment securities of $33.9 million and an increase in loan originations and principal collections. Net cash used in financing activities was $16.6 million for the first three months of 2013 compared to net cash provided by financing activities of $21.2 million in the comparable 2012 period. The decrease in cash used in financing activities is primarily related to a decrease in deposits of $36.3 million.

Derivative Financial Instruments
Derivatives are used as a risk management tool and to facilitate client transactions. We utilize derivatives to hedge the exposure to changes in interest rates or other identified market risks. Derivatives may also be used in a dealer capacity to facilitate client transactions by creating customized loan products for our larger customers. These products allow us to meet the needs of our customers, while minimizing our interest rate risk. We currently have not entered into any transactions in a dealer capacity.
The Asset/Liability Committee of the Board of Directors (ALCO) provides oversight by ensuring that policies and procedures are in place to monitor our significant derivative positions. We believe the use of derivatives will reduce our interest rate risk and potential earnings volatility caused by changes in interest rates.
Our derivatives are based on underlying risks, primarily interest rates. Historically, we have utilized cash flow swaps to reduce the risks associated with interest rates. On August 28, 2007 and March 26, 2009, we elected to terminate a series of interest rate swaps with a total notional value of $150 million and $50 million, respectively. At termination, the swaps had a market value of $2.0 million and $5.8 million, respectively. These gains are being accreted into interest income over the remaining life of the originally hedged items. The gains were fully accreted into income at December 31, 2012. We recognized $437 thousand in interest income for the three months ended March 31, 2012.
We also use forward contracts to hedge against changes in interest rates on our held for sale loan portfolio. Our practice is to enter into a best efforts contract with the investor concurrently with providing an interest rate lock to a customer. The use of the fair value option on the closed held for sale loans and the forward contracts minimize the volatility in earnings from changes in interest rates.
The following table presents information on the cash flow hedges as of March 31, 2013.
 
 
Notional
Amount
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Maturity Date
 
(in thousands)
Asset hedges
 
 
 
 
 
 
 
 
 
Cash flow hedges:
 
 
 
 
 
 
 
 
 
Forward contracts
$
3,708

 
$

 
$
28

 
$
(57
)
 
Various
 
$
3,708

 
$

 
$
28

 
$
(57
)
 
 
 

73



The following table presents additional information on the active derivative positions as of March 31, 2013.
 
 
Notional
 
Consolidated Balance Sheet Presentation
 
Consolidated Income Statement
Presentation
 
Assets
 
Liabilities
 
Gains
 
Classification
 
Amount
 
Classification
 
Amount
 
Classification
 
Amount
Recognized
 
(in thousands)
Hedging Instrument:
 
 
 
 
 
 
 
 
 
 
 
 
 
Forward contracts
$
3,708

 
Other assets
 
N/A

 
Other liabilities
 
$

 
Noninterest income – other
 
$
(3
)
Hedged Items:
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans held for sale
N/A

 
Loans held for sale
 
$
3,708

 
N/A
 
N/A

 
Noninterest income – other
 
N/A


Derivatives expose us to credit risk from the counterparty when the derivatives are in an unrealized gain position. All counterparties must be approved by the Board of Directors and are monitored by ALCO on an ongoing basis. We minimize the credit risk exposure by requiring collateral when certain conditions are met. When the derivatives are at an unrealized loss position, our counterparty may require us to pledge collateral.

Off-Balance Sheet Arrangements
We are party to credit-related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.
Our exposure to credit loss is represented by the contractual amount of these commitments. We follow the same credit policies in making commitments as we do for on-balance sheet instruments.
The following table discloses our maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at the dates indicated.
 
 
As of
 
March 31, 2013
 
December 31, 2012
 
March 31, 2012
 
(in thousands)
Commitments to extend credit - fixed rate
$
17,319

 
$
16,312

 
$
10,481

Commitments to extend credit - variable rate
$
90,322

 
$
94,822

 
$
81,817

Total Commitments to extend credit
$
107,641

 
$
111,134

 
$
92,298

 
 
 
 
 
 
Standby letters of credit
$
2,761

 
$
5,023

 
$
7,916


Commitments to extend credit are agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

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Capital Resources
Banks and bank holding companies, as regulated institutions, must meet required levels of capital. The OCC and the Federal Reserve, the primary federal regulators for FSGBank and First Security, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are expected to maintain a level of capital commensurate with the risk profile assigned to their assets in accordance with the guidelines. As described in Note 2 to our consolidated financial statements, the Order requires FSGBank to achieve and maintain total capital to risk adjusted assets of at least 13% and a leverage ratio of at least 9%. The Order provided 120 days from April 28, 2010, the effective date of the Order, to achieve these ratios. As shown below, FSGBank is not currently in compliance with the capital requirements.
The following table compares the required capital ratios maintained by First Security and FSGBank:

CAPITAL RATIOS
 
 
 
 
 
 
 
 
March 31, 2013
FSGBank
Consent  Order1
 
Minimum
Capital Requirements under Prompt Corrective Action Provisions
 
First
Security
 
FSGBank
Tier 1 capital to risk adjusted assets
n/a

 
4.0
%
 
3.0
%
 
3.4
%
Total capital to risk adjusted assets
13.0
%
 
8.0
%
 
4.3
%
 
4.7
%
Leverage ratio
9.0
%
 
4.0
%
 
1.7
%
 
1.9
%
December 31, 2012
 
 
 
 
 
 
 
Tier 1 capital to risk adjusted assets
n/a

 
4.0
%
 
4.2
%
 
4.5
%
Total capital to risk adjusted assets
13.0
%
 
8.0
%
 
5.5
%
 
5.8
%
Leverage ratio
9.0
%
 
4.0
%
 
2.3
%
 
2.5
%
March 31, 2012
 
 
 
 
 
 
 
Tier 1 capital to risk adjusted assets
n/a

 
4.0
%
 
8.6
%
 
8.6
%
Total capital to risk adjusted assets
13.0
%
 
8.0
%
 
9.8
%
 
9.8
%
Leverage ratio
9.0
%
 
4.0
%
 
5.2
%
 
5.2
%
During 2012, we focused on operating under our strategic plan and executing on our capital plan. The execution of the capital plan, as described below, combined with the ongoing performance of the strategic plan should restore profitability and achieve compliance with all aspects of the regulatory agreements over the next twelve months.
On April 11, 2013, we completed a restructuring of the Company's Preferred Stock with the U.S. Treasury ("Treasury") by issuing $14.4 million of new common stock for $1.50 per share for the full satisfaction of the Treasury's 2009 investment in the Company. Pursuant to the exchange agreement ("Exchange Agreement"), as previously included in a Current Report on Form 8-K filed on February 26, 2013, we restructured the Company's Preferred Stock issued under the Capital Purchase Program ("CPP") by issuing new shares of common stock equal to 26.75% of the $33 million liquidation value of the Preferred Stock plus 100% of the accrued but unpaid dividends in exchange for the Preferred Stock, all accrued but unpaid dividends thereon, and the cancellation of stock warrants granted in connection with the CPP investment ("CPP Restructuring"). Immediately after the issuance of the common stock to the Treasury, the Treasury sold all of the Company's common stock to investors previously identified by the Company at the same $1.50 per share price.
On April 12, 2013, we completed the issuance of an additional $76.7 million of new common stock in a private placement to accredited investors. The private placement was previously announced on a Current Report on Form 8-K filed on February 26, 2013, in which we announced the execution of definitive stock purchase agreements with institutional investors as part of an approximately $90 million recapitalization ("Recapitalization"). In total, we issued $60,735,000 shares of common stock at $1.50 per share for gross proceeds of $91.1 million. See Note 2 to our Consolidated Financial Statements for a chart presenting pro-forma stockholders' equity based on the Recapitalization.
Pursuant to the Agreement, the Company is prohibited from declaring or paying dividends without the prior written consent of the Federal Reserve. Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our Board of Directors may deem relevant. Our ability to distribute cash dividends in the future may be limited by regulatory restrictions and the need to maintain sufficient consolidated capital.


75



EFFECTS OF GOVERNMENTAL POLICIES
We are affected by the policies of regulatory authorities, including the Federal Reserve Board and the OCC. An important function of the Federal Reserve Board is to regulate the national money supply.
Among the instruments of monetary policy used by the Federal Reserve Board are: purchases and sales of U.S. Government securities in the marketplace; changes in the discount rate, which is the rate any depository institution must pay to borrow from the Federal Reserve Board; and changes in the reserve requirements of depository institutions. These instruments are effective in influencing economic and monetary growth, interest rate levels and inflation.
The monetary policies of the Federal Reserve Board and other governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of changing conditions in the national and international economy and in the money market, as well as the result of actions by monetary and fiscal authorities, it is not possible to predict with certainty future changes in interest rates, deposit levels or loan demand or whether the changing economic conditions will have a positive or negative effect on operations and earnings.
Legislation from time to time is introduced in the United States Congress and the Tennessee General Assembly and other state legislatures, and regulations are proposed by the regulatory agencies that could affect our business. It cannot be predicted whether or in what form any of these proposals will be adopted or the extent to which our business may be affected thereby.
Dodd-Frank Act.
The bank regulatory landscape was dramatically changed by the Dodd-Frank Act, which was enacted on July 21, 2010 and which implements far-reaching regulatory reform. Among its many significant provisions, the Dodd-Frank Act
established the Financial Stability Oversight Counsel made up of the heads of the various bank regulatory and other agencies to identify and respond to risks to U.S. financial stability arising from ongoing activities of large financial companies
established centralized responsibility for consumer financial protection by creating a new Consumer Financial Protection Bureau which will be responsible for implementing, examining and enforcing compliance with federal consumer financial laws with respect to financial institutions with over $10 billion in assets
required that banking agencies establish for most bank holding companies the same leverage and risk-based capital requirements as apply to insured depository institutions, and that bank holding companies and banks be well-capitalized and well managed in order to acquire banks located outside their home states
prohibits bank holding companies from including new trust preferred securities in their Tier 1 capital and, beginning with a three-year phase-in period on January 1, 2013, requires bank holding companies with assets over $15 billion to deduct existing trust preferred securities from their Tier 1 capital;
required the FDIC to set a minimum DIF reserve ratio of 1.35% and that the DIF reserve ratio be increased to that level by September 30, 2020; that FDIC off-set the effect of the higher minimum ratio on insured depository institutions with assets of less than $10 billion; and that FDIC change the assessment base used for calculating insurance assessments from the amount of insured deposits to average consolidated total assets minus average tangible equity;
established a permanent $250,000 limit for federal deposit insurance; provided separate, unlimited federal deposit insurance until December 31, 2012 for noninterest-bearing demand transaction accounts; and repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts
amended the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that those fees be reasonable and proportional to the actual cost of a transaction to the issuer; an
required implementation of various corporate governance processes affecting areas such as executive compensation and proxy access by shareholders. Many provisions of the Dodd-Frank Act are subject to rulemaking by bank regulatory agencies and the SEC and will take effect over time, making it difficult to anticipate the overall financial impact on financial institutions and consumers. However, many provisions in the Dodd-Frank Act (including those permitting the payment of interest on demand deposits and restricting interchange fees) are likely to increase expenses and reduce revenues for all financial institutions.

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Consumer Financial Protection Bureau (“CFPB”).
The Dodd-Frank Act created a new, independent federal agency, the CFPB, which was granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the laws referenced above, fair lending laws and certain other statutes
The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets, their service providers and certain non-depository entities such as debt collectors and consumer reporting agencies. Although FSGBank has less than $10 billion in assets, the impact of the formation of the CFPB has caused a ripple effect across all bank regulatory agencies, and placed a renewed focus on consumer protection and compliance efforts. For examples of this new authority, the CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower's ability to repay. In addition, the Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.
The CFPB has concentrated much of its rulemaking efforts on a variety of mortgage-related topics required under the Dodd-Frank Act, including mortgage origination disclosures, minimum underwriting standards and ability to repay, high-cost mortgage lending, and servicing practices. During 2012, the CFPB issued three proposed rulemakings covering loan origination and servicing requirements, which were finalized in January 2013, along with other rules on mortgages. The ability to repay and qualified mortgage standards rules, as well as the mortgage servicing rules, are scheduled to become effective in January 2014. The escrow and loan originator compensation rules are scheduled to become effective in June 2013. A final rule integrating disclosures required by the Truth in Lending Act and the Real Estate Settlement and Procedures Act is expected later this year. We continue to analyze the impact that such rules may have on our business model, particularly with respect to our mortgage banking business.
Basel III Capital Proposals.
In June 2012, federal regulators issued proposed rules to implement the capital adequacy recommendations of the Basel Committee on Bank Supervision first proposed in December 2010. These proposals, which are known as “Basel III,” propose significant changes to the minimum capital levels and asset risk-weights for all banks, regardless of size, and bank holding companies with greater than $500 million in assets. Among the many changes in these proposed rules, banks would be required to hold higher levels of capital, a significantly higher portion of which would be required to be Tier 1 capital. Further, beginning in 2016, the ability of a bank or bank holding company to declare and pay dividends or pay discretionary bonuses to certain executive officers would become limited should the bank or bank holding company fail to maintain a “capital conservation buffer” composed of Tier 1 common equity that is 2.5% greater than applicable minimum capital requirements. The proposed Basel III rules would also impose significant changes on the risk-weighting of many assets, including home mortgages with high loan to value ratios, certain acquisition, development and construction loans, and certain past due assets. Finally, the proposed rules would also prevent trust preferred securities from counting as Tier 1 capital for the issuer following a ten-year phase out ending in 2022. The comment period for the proposed rules closed in late October 2012, and federal regulators have indicated that implementation of the proposed Base III rules will be delayed.

RECENT ACCOUNTING PRONOUNCEMENTS
In February 2013, the FASB issued Accounting Standards Update ("ASU") No. 2013-02, "Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income." The amendments in this Update supersede the presentation requirements for reclassification out of accumulated other comprehensive income in ASU No. 2011-05 and ASU No. 2011-12. The amendments require the Company to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, the Company is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. The ASU is effective during the interim and annual periods beginning after December 15, 2012. The Company adopted the standard as of January 1, 2013. The adoption did not have an impact on the Company's financial position, results of operations or earnings per share.


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ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk, with respect to us, is the risk of loss arising from adverse changes in interest rates and prices. The risk of loss can result in either lower fair market values or reduced net interest income. We manage several types of risk, such as credit, liquidity and interest rate. We consider interest rate risk to be a significant risk that could potentially have a large material effect on our financial condition. Further, we process hypothetical scenarios whereby we shock our balance sheet up and down for possible interest rate changes, we analyze the potential change (positive or negative) to net interest income, as well as the effect of changes in fair market values of assets and liabilities. We do not deal in international instruments, and therefore are not exposed to risks inherent to foreign currency. Additionally, as of March 31, 2013, we had no trading assets that exposed us to the risks in market changes.
Oversight of our interest rate risk management is the responsibility of the Asset/Liability Committee (ALCO). ALCO has established policies and limits to monitor, measure and coordinate our sources, uses and pricing of funds. In addition, as a result of the changes in executive management, an executive risk committee consisting of the Chief Executive Officer, Chief Financial Officer, Chief Credit Officer and Chief Administrative Officer has been established to monitor the various risks of First Security, including interest rate risk, and will report directly to the Audit and Enterprise Risk Management Committee of the Board of Directors.
Interest rate risk represents the sensitivity of earnings to changes in interest rates. As interest rates change, the interest income and expense associated with our interest sensitive assets and liabilities also change, thereby impacting net interest income, the primary component of our earnings. ALCO utilizes the results of both static gap and income simulation reports to quantify the estimated exposure of net interest income to a sustained change in interest rates.
Our income simulation analysis projected net interest income based on a decline in interest rates of 100 basis points (i.e. 1.00%) and an increase of 100 basis points and 200 basis points (1.00% and 2.00%, respectively) over a twelve-month period. Given this scenario, as of March 31, 2013, we had an exposure to falling rates and a benefit from rising rates. More specifically, our model forecasts a decline in net interest income of $29.3 million, or 14.0%, as a result of a 100 basis point decline in rates based on annualizing our financial results through March 31, 2013. The model predicts a $26.4 million increase in net interest income resulting from a 100 basis point increase in rates. Finally, the model also forecasts an $48.3 million increase in net interest income, or 23.1%, as a result of a 200 basis point increase in rates.
The following chart reflects our sensitivity to changes in interest rates as indicated as of March 31, 2013. The numbers are based on a static balance sheet, and the chart assumes that pay downs and maturities of both assets and liabilities are reinvested in like instruments at current interest rates,.
INTEREST RATE RISK
INCOME SENSITIVITY SUMMARY
 
 
Down
100 BP
 
Current
 
Up 100
BP
 
Up 200
BP
 
(in thousands, except percentages)
Annualized net interest income1
$
180,084

 
$
209,347

 
$
235,767

 
$
257,643

Dollar change net interest income
(29,263
)
 

 
26,420

 
48,296

Percentage change net interest income
(13.98
)%
 
0.00
%
 
16.77
%
 
23.07
%
 __________________
1. 
Annualized net interest income is a twelve month projection based on year-to-date results.
The preceding sensitivity analysis is a modeling analysis, which changes periodically and consists of hypothetical estimates based upon numerous assumptions including interest rate levels, shape of the yield curve, prepayments on loans and securities, rates on loans and deposits, reinvestments of paydowns and maturities of loans, investments and deposits, and other assumptions. In addition, there is no input for growth or a change in asset mix. While assumptions are developed based on the current economic and market conditions, we cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.
As market conditions vary from those assumed in the sensitivity analysis, actual results will differ. Also, the sensitivity analysis does not reflect actions that we might take in responding to or anticipating changes in interest rates.
We use the Sendero Vision Asset/Liability system, which is a comprehensive interest rate risk measurement tool that is widely used in the banking industry. Generally, it provides the user with the ability to more accurately model both static and

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dynamic gap, economic value of equity, duration and income simulations using a wide range of scenarios including interest rate shocks and rate ramps. The system also models derivative instruments.

ITEM 4.
CONTROLS AND PROCEDURES
As of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer have evaluated the effectiveness of our “disclosure controls and procedures” (“Disclosure Controls”).
Disclosure Controls, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.
Our management, including the CEO and CFO, does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Our CEO and CFO have concluded that our Disclosure Controls were effective at a reasonable assurance level as of March 31, 2013.
Changes in Internal Controls
There have been no changes in our internal controls over financial reporting during the fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II - OTHER INFORMATION
 
ITEM 1.
LEGAL PROCEEDINGS
In the normal course of business, we are at times subject to pending and threatened legal actions. Although we are not able to predict the outcome of such actions, after reviewing pending and threatened actions with counsel, we believe that the outcome of any or all such actions will not have a material adverse effect on our business, financial condition and/or operating results.

ITEM 1A.
RISK FACTORS
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
 


ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND THE USE OF PROCEEDS
Not applicable.

ITEM 3.
DEFAULTS UPON SENIOR SECURITIES
As previously disclosed, since January 2010, First Security has elected to defer quarterly cash dividend payments on its Series A Preferred Stock. Cash dividends on the Series A Preferred Stock are cumulative and accrue and compound on each subsequent payment date. At March 31, 2013, First Security had unpaid preferred stock dividends in arrears of $5.6 million. (This suspension of dividends does not constitute a default under the terms of the Series A Preferred Stock.)


ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.

ITEM 5.
OTHER INFORMATION

Not applicable.

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ITEM 6.
EXHIBITS
 
 
 
EXHIBIT
NUMBER
DESCRIPTION
 
 
3.1
Articles of Amendment to the Charter of Incorporation, incorporated by reference to Exhibit 3.1 of First Security's Registration Statement on Form S-1 dated April 25, 2013, as filed with the SEC on April 25, 2013.
 
 
3.2
Articles to the bylaws of the Company, incorporated by reference to Exhibit 3.1 of First Security's Current Report on Form 8-K dated March 19, 2013, as filed with the SEC on March 22, 2013.
 
 
10.1
Exchange Agreement by and between First Security Group, Inc. and The United States Department of the Treasury, dated February 25, 2013, incorporated by reference to the Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on February 26, 2013.
 
 
10.2
Stock Purchase Agreement by and between First Security Group, Inc. and certain Named Investors, dated February 25, 2013, incorporated by reference to the Exhibit 10.2 to the Current Report on Form 8-K filed with the SEC on February 26, 2013.
 
 
10.3
Form of Securities Purchase Agreement by and between the United States Department of The Treasury and First Security Group, Inc., dated February 25, 2013, incorporated by reference to the Exhibit 10.3 to the Current Report on Form 8-K filed with the SEC on February 26, 2013.
 
 
31.1
Certification of Principal Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934
 
 
31.2
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934
 
 
32.1
Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934
 
 
32.2
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934
 
 
101
Interactive Data Files providing financial information from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013 in XBRL (eXtensible Business Reporting Language). Pursuant to Regulation 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.


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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed by the undersigned, thereunto duly authorized.
 
 
FIRST SECURITY GROUP, INC.
 
(Registrant)
 
 
May 15, 2013
/s/ D. MICHAEL KRAMER
 
D. Michael Kramer
 
Chief Executive Officer
 
 
May 15, 2013
/s/ JOHN R. HADDOCK
 
John R. Haddock
 
Chief Financial Officer

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