|Closing Price ($)||Shares Out (MM)||Market Cap ($MM)|
|8-K||2019-02-06||Other Events, Exhibits|
|8-K||2019-01-21||Earnings, Other Events, Exhibits|
|8-K||2018-10-15||Earnings, Other Events, Exhibits|
|8-K||2018-07-31||Other Events, Exhibits|
|8-K||2018-07-16||Earnings, Other Events, Exhibits|
|8-K||2018-06-22||Amend Bylaw, Exhibits|
|8-K||2018-04-24||Shareholder Vote, Other Events|
|8-K||2018-04-16||Earnings, Officers, Other Events, Exhibits|
|8-K||2018-01-22||Earnings, Other Events, Exhibits|
|8-K||2018-01-04||Officers, Other Events, Exhibits|
|MUDS||Mudrick Capital Acquisition||263|
|AETI||American Electric Technologies||8|
|UEEC||United Health Products||0|
|PSCO||Public Service Co of Colorado||0|
|Item 1. Business|
|Item 1B. Unresolved Staff Comments|
|Item 2. Properties|
|Item 3.Legal Proceedings|
|Item 4. Mine Safety Disclosures|
|Item 5.Market for The Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities|
|Item 6.Selected Financial Data|
|Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations|
|Item 7A.Quantitative and Qualitative Disclosures About Market Risk|
|Item 8.Financial Statements and Supplementary Data|
|Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure|
|Item 9A.Controls and Procedures|
|Item 9B.Other Information|
|Item 10.Directors, Executive Officers and Corporate Governance|
|Item 11.Executive Compensation|
|Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters|
|Item 13.Certain Relationships and Related Transactions, and Director Independence|
|Item 14.Principal Accountant Fees and Services|
|Item 15.Exhibits, Financial Statement Schedules|
|Item 16.10-K Summary|
|Balance Sheet||Income Statement||Cash Flow|
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
|x||ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934|
|For the fiscal year ended December 31, 2018|
|¨||TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission File Number 0-26850
FIRST DEFIANCE FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
|(State or other jurisdiction of incorporation or organization)||(I.R.S. Employer Identification Number)|
|601 Clinton Street, Defiance, Ohio||43512|
|(Address of principal executive offices)||(Zip code)|
Registrant’s telephone number, including area code: (419) 782-5015
Securities registered pursuant to Section 12(b) of the Act:
|Common Stock, Par Value $0.01 Per Share||The NASDAQ Stock Market|
|(Title of Class)||(Name of each exchange on which registered)|
Securities registered pursuant to Section 12(g) of the Act:
(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes ¨ No x
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 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 x No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨ Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of the voting stock held by non-affiliates of the registrant computed by reference to the average bid and ask price of such stock as of June 30, 2018, was approximately $675.1 million.
As of January 31, 2019, there were issued and outstanding 20,067,268 shares of the registrant’s common stock.
Documents Incorporated by Reference
Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive Proxy Statement for the 2019 Annual Meeting of the registrant’s shareholders.
First Defiance Financial Corp.
Annual Report on Form 10-K
Table of Contents
|Item 1A.||Risk Factors||25|
|Item 1B.||Unresolved Staff Comments||33|
|Item 3.||Legal Proceedings||34|
|Item 4.||Mine Safety Disclosures||34|
|Item 5.||Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities||34|
|Item 6.||Selected Financial Data||36|
|Item 7.||Management’s Discussion and Analysis of Financial Condition and Results of Operations||37|
|Item 7A.||Quantitative and Qualitative Disclosures About Market Risk||56|
|Item 8.||Financial Statements and Supplementary Data||59|
|Item 9.||Changes in and Disagreements with Accountants on Accounting and Financial Disclosure||130|
|Item 9A.||Controls and Procedures||131|
|Item 9B.||Other Information||131|
|Item 10.||Directors, Executive Officers and Corporate Governance||131|
|Item 11.||Executive Compensation||131|
|Item 12.||Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters||132|
|Item 13.||Certain Relationships and Related Transactions, and Director Independence||132|
|Item 14.||Principal Accounting Fees and Services||132|
|Item 15.||Exhibits, Financial Statement Schedules||133|
|Item 16.||Form 10-K Summary||133|
First Defiance Financial Corp. (“First Defiance” or “the Company”) is a unitary thrift holding company that, through its subsidiaries, First Federal Bank of the Midwest (“First Federal” or “the Bank”), First Insurance Group of the Midwest, Inc. (“First Insurance”), and First Defiance Risk Management Inc. (collectively, “the Subsidiaries”), focuses on traditional banking and property, casualty, life and group health insurance products.
The Company’s philosophy is to grow and prosper, building long-term relationships based on top quality service, high ethical standards, and safe and sound assets. The Company operates as a locally- oriented, community-based financial services organization, augmented by experienced, centralized support in select critical areas. The Company’s local market orientation is reflected in its market area management and local advisory boards, which are comprised of local business persons, professionals and other community representatives that assist area management in responding to local banking needs.
The Company’s operating objectives include expansion, diversification within its markets, growth of its fee-based income, and growth organically and through acquisitions of financial institutions, branches and financial services businesses. The Company seeks merger or acquisition partners that are culturally similar, have experienced management and possess either significant market area presence or have the potential for improved profitability through financial management, economies of scale and expanded services. The Company regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur. Acquisitions typically involve the payment of premiums over book and market values and, therefore, some dilution of the Company’s tangible book value and net income per common share may occur in any future transaction.
At December 31, 2018, the Company had consolidated assets of $3.2 billion, consolidated deposits of $2.6 billion, and consolidated stockholders’ equity of $399.6 million. The Company was incorporated in Ohio in June of 1995. Its principal executive offices are located at 601 Clinton Street, Defiance, Ohio 43512, and its telephone number is (419) 782-5015.
On June 22, 2018, the Company announced a stock split in the form of a share distribution of two common shares for each outstanding common share. The stock split was distributed on July 12, 2018, to shareholders of record as of July 2, 2018. All share and per share data in this Form 10-K have been adjusted and are reflective of the stock split.
First Defiance's website, www.fdef.com, contains a hyperlink under the Investor Relations section to EDGAR, where the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge as soon as reasonably practicable after First Defiance has filed the report with the United States Securities and Exchange Commission (“SEC”).
The Company’s core business operations are conducted through its subsidiaries:
First Federal Bank of the Midwest: First Federal is a federally chartered stock savings bank headquartered in Defiance, Ohio. It conducts operations through thirty-six full-service banking center offices in Allen, Defiance, Fulton, Hancock, Henry, Lucas, Marion, Ottawa, Paulding, Putnam, Seneca, Williams, Wood, and Wyandot counties in northwest and central Ohio, three full-service banking center offices in Allen County in northeast Indiana, five full-service banking center offices in Lenawee County in southeast Michigan and one commercial loan production office in Ann Arbor, Michigan, that was opened late in the fourth quarter of 2017.
First Federal is primarily engaged in community banking. It attracts deposits from the general public through its offices and website, and uses those and other available sources of funds to originate residential real estate loans, commercial real estate loans, commercial loans, home improvement and home equity loans and consumer loans. In addition, First Federal invests in U.S. Treasury and federal government agency obligations, obligations of the State of Ohio and its political subdivisions, mortgage-backed securities that are issued by federal agencies, including real estate mortgage investment conduits (“REMICs”) and residential collateralized mortgage obligations (“CMOs”), and corporate bonds. First Federal’s deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”). First Federal is a member of the Federal Home Loan Bank (“FHLB”) System.
First Insurance Group of the Midwest: First Insurance is a wholly owned subsidiary of First Defiance. First Insurance is an insurance agency that conducts business throughout First Federal’s Markets. The Maumee and Oregon, Ohio, offices were consolidated into a new office in Sylvania, Ohio, in January 2018. First Insurance offers property and casualty insurance, life insurance and group health insurance.
First Defiance Risk Management: First Defiance Risk Management was incorporated on December 20, 2012, as a wholly-owned insurance company subsidiary of the Company to insure the Company and its subsidiaries against certain risks unique to the operations of the Company and for which insurance may not be currently available or economically feasible in today’s insurance marketplace. First Defiance Risk Management pools resources with several other similar insurance company subsidiaries of financial institutions to help minimize the risk allocable to each participating insurer.
First Defiance’s primary objective is to be a high-performing, community-focused financial institution, well regarded in its market areas. First Defiance accomplishes this through emphasis on local decision making and empowering its employees with tools and knowledge to serve its customers’ needs. First Defiance believes in a “Customer First” philosophy that is strengthened by its Mission & Vision and Core Values initiatives. First Defiance also has a tagline of “Better Together” as an indication of its commitment to local, responsive, personalized service. First Defiance believes this strategy results in greater customer loyalty and profitability through core relationships. First Defiance is focused on diversification of revenue sources and increased market penetration in areas where the growth potential exists for a balance between acquisition and organic growth. The primary elements of First Defiance’s business strategy are commercial banking, consumer banking, including the origination and sale of single-family residential loans, enhancement of fee income, wealth management and insurance sales, each united by a strong customer service culture throughout the organization. In the later part of 2017, the Company recognized the need to adapt its organization structure to meet certain future strategic objectives and to continue its past success. The Company believes that fully utilizing the strengths of its leadership team and a structure that supports strategic initiatives will enhance its ability to achieve even more objectives in the future. As such, the Company redefined its market areas to support strategies to enhance processes and efficiencies to support overall growth. The new structure includes three metro markets; Toledo, Ohio, Fort Wayne, Indiana, and Columbus, Ohio, and two legacy markets; Southern Market Area and Northern Market Area.
Commercial and Commercial Real Estate Lending - Commercial and commercial real estate lending have been an ongoing focus and a major component of First Federal’s success. First Federal provides primarily commercial real estate and commercial business loans with an emphasis on owner- occupied commercial real estate and commercial business lending, including a focus on the deposit balances that accompany these relationships. First Federal’s client base tends to be small to middle market customers with annual gross revenues generally between $1 million and $50 million. First Federal’s focus is also on securing multiple guarantors in addition to collateral where possible. These customers require First Federal to have a high degree of knowledge and understanding of their business in order to provide them with solutions to their financial needs. First Federal’s “Customer First” philosophy and culture complements this need of its clients. First Federal believes this personal service model differentiates First Federal from its competitors, particularly the larger regional institutions. First Federal offers a wide variety of products to support commercial clients including remote deposit capture and other cash management services. First Federal also believes that the small business customer is a strong market for First Federal. First Federal participates in many of the Small Business Administration lending programs. Maintaining a diversified portfolio with an emphasis on monitoring industry concentrations and reacting to changes in the credit characteristics of industries is an ongoing focus.
Consumer Banking - First Federal offers customers a full range of deposit and investment products including demand, checking, money market, certificates of deposits, Certificate of Deposit Account Registry Service (“CDARS”) and savings accounts. First Federal offers a full range of investment products through the wealth management department and a wide variety of consumer loan products, including residential mortgage loans, home equity loans, and installment loans. First Federal also offers online banking services, which include mobile banking, People Pay (“P2P”), online bill pay, and online account opening as well as the MoneyPass ATM Network offering access to our customers to over 32,000 ATMs nationwide without a surcharge fee.
Fee Income Development - Generation of fee income and the diversification of revenue sources are accomplished through the mortgage banking operation, First Insurance and the wealth management department as First Defiance seeks to reduce reliance on retail transaction fee income.
Deposit Growth - First Federal’s focus has been to grow core deposits with an emphasis on total relationship banking for both our retail and commercial customers. First Federal’s pricing strategy considers the whole relationship of the customer. First Federal continues to focus on increasing its market share in the communities it serves by providing quality products with extraordinary customer service, business development strategies and branch expansion. First Federal will look to grow its footprint in areas believed to further complement its overall market share and complement its strategy of being a high-performing community bank.
Asset Quality - Maintaining a strong credit culture is of the utmost importance to First Federal. First Federal has maintained a strong credit approval and review process that has allowed the Company to maintain a credit quality standard that balances the return with the risks of industry concentrations and loan types. First Federal is primarily a collateral lender with an emphasis on cash flow performance, while obtaining additional support from personal guarantees and secondary sources of repayment. First Federal has directed its attention to loan types and markets that it knows well and in which it has historically been successful. First Federal strives to have loan relationships that are well diversified in both size and industry, and monitors the overall trends in the portfolio to maintain its industry and loan type concentration targets. First Federal maintains a problem loan remediation process that focuses on detection and resolution. First Federal maintains a strong process of internal control that subjects the loan portfolio to periodic internal reviews as well as independent third-party loan review.
Expansion Opportunities - First Defiance believes it is well positioned to take advantage of acquisitions or other business opportunities in its market areas. First Defiance believes it has a track record of successfully accomplishing both acquisitions and de novo branching in its market area. This track record puts the Company in a solid position to enter or expand its business. First Defiance will continue to be disciplined as well as opportunistic in its approach to future acquisitions and de novo branching with a focus on its primary geographic market area, which it knows well, and has been competing in for a long period of time, as well as surrounding market areas.
First Defiance’s securities portfolio is managed in accordance with a written policy adopted by the Board of Directors and administered by the Investment Committee. The Chief Financial Officer, Controller, and the Chief Executive Officer can each approve transactions up to $3.0 million. Two of the three officers are required to approve transactions between $3.0 million and $5.0 million. All transactions in excess of $5.0 million must be approved by the Board of Directors.
First Defiance’s investment portfolio includes 86 CMO issues totaling $101.5 million, all of which are fully amortizing securities. Management does not believe the risks associated with any of its CMO investments are significantly different from risks associated with other pass-through mortgage-backed securities. First Defiance did not have any off-balance sheet derivative securities at December 31, 2018.
First Defiance’s securities portfolio is classified as either “available-for-sale” or “held-to-maturity.” Securities classified as “available-for-sale” may be sold prior to maturity due to changes in interest rates, prepayment risks, and availability of alternative investments, or to meet the Company’s liquidity needs.
The carrying value of securities at December 31, 2018, by contractual maturity is shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. For purposes of the maturity table, mortgage-backed securities, which are not due at a single maturity date, have been allocated over maturity groupings based on the weighted-average contractual maturities of underlying collateral. The mortgage-backed securities may mature earlier than their weighted-average contractual maturities because of principal prepayments.
|Under 1||Average||1 - 5||Average||6-10||Average||Over 10||Average|
|Year||Rate %||Years||Rate %||Years||Rate %||Years||Rate %||Amount||Yield|
|(Dollars in Thousands)|
|CMOs - residential||15,941||3.29||51,402||3.29||32,464||3.25||4,618||3.31||104,425||3.12|
|U.S. government and federal agency obligations||-||-||519||2.00||2,000||3.00||-||-||2,519||2.00|
|Obligations of states and political subdivisions (1)||802||4.07||9,528||3.31||32,689||3.61||56,805||3.38||99,824||3.55|
|Unamortized premiums/ (discounts)||1,312|
|Unrealized gain on securities available for sale and unrecognized gain on held to maturity||(2,605||)|
|(1)||Tax exempt yield based on effective tax rate of 21%. Actual coupon rate is approximately equal to the weighted average rate disclosed in the table times 79%.|
The carrying value of investment securities is as follows:
|Obligations of U.S. government corporations and agencies||$||2,503||$||508||$||3,915|
|Obligations of state and political subdivisions||99,887||92,828||88,043|
|CMOs - residential, REMICS and mortgage-backed securities||178,880||154,210||146,019|
|Trust preferred stock and preferred stock||-||1||2|
|Obligations of state and political subdivisions||475||580||93|
For additional information regarding First Defiance’s investment portfolio, refer to Note 5 – Investment Securities to the Consolidated Financial Statements.
The Company had $43.0 million and $55.0 million in overnight investments at the Federal Reserve at December 31, 2018 and 2017, respectively, which amount is included in interest-bearing deposits. First Defiance had interest-earning deposits at the FHLB of Cincinnati and other financial institutions amounting to $1.7 million and $2.0 million at December 31, 2018 and 2017, respectively.
Residential Loan Servicing Activities
Servicing mortgage loans for investors involves a contractual right to receive a fee for processing and administering loan payments on mortgage loans that are not owned by the Company and are not included on the Company’s balance sheet. This processing involves collecting monthly mortgage payments on behalf of investors, reporting information to those investors on a monthly basis and maintaining custodial escrow accounts for the payment of principal and interest to investors and property taxes and insurance premiums on behalf of borrowers. At December 31, 2018, First Federal serviced 14,606 loans totaling $1.41 billion of principal. The vast majority of the loans serviced for others are fixed rate conventional mortgage loans. The Company primarily sells its loans to, and then services for, Freddie Mac, Fannie Mae and FHLB. At December 31, 2018, 66.40%, 32.70% and 0.85% of the Company’s sold loans were to Freddie Mac, Fannie Mae and FHLB, respectively.
As compensation for its mortgage servicing activities, the Company receives servicing fees, usually approximating 0.25% per annum of the loan balances serviced, plus any late charges collected from delinquent borrowers and other fees incidental to the services provided. In the event of a default by the borrower, the Company receives no servicing fees until the default is cured.
The following table sets forth certain information regarding the number and aggregate principal balance of the mortgage loans serviced by the Company, including both fixed and adjustable rate loans, at various interest rates:
|Number||Aggregate||of Aggregate||Number||Aggregate||of Aggregate||Number||Aggregate||of Aggregate|
|(Dollars in Thousands)|
|Less than 3.00%||1,843||$||158,038||11.19||%||2,024||$||189,700||13.69||%||2,191||$||225,328||16.42||%|
|5.00% - 5.99%||1,096||77,154||5.46||1,122||68,423||4.94||1,405||83,775||6.11|
|6.00% - 6.99%||557||28,672||2.03||626||33,658||2.43||749||41,055||2.99|
|7.00% and over||146||5,570||0.39||158||6,382||0.46||175||7,680||0.56|
Loan servicing fees decrease as the principal balance on the outstanding loan decreases and as the remaining time to maturity of the loan shortens.
The following table sets forth certain information regarding the remaining maturity of the mortgage loans serviced by the Company as of the dates shown.
|(Dollars in Thousands)|
|More than 25 years||4,719||32.31||586,627||41.55||4,716||32.64||578,658||41.75||4,994||34.81||613,668||44.74|
General – A savings bank generally may not make loans to one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable collateral. Real estate is not considered “readily marketable collateral.” Certain types of loans are not subject to these limits. In applying these limits, loans to certain borrowers may be aggregated. Notwithstanding the specified limits, a savings bank may lend to one borrower up to $500,000 “for any purpose.” At December 31, 2018, First Federal’s limit on loans-to-one borrower was $52.6 million and its five largest loans (including available lines of credit) or groups of loans to one borrower, including related entities, were $30.5 million, $28.4 million, $28.2 million, $26.8 million and $26.6 million. All of these loans or groups of loans were performing in accordance with their terms at December 31, 2018.
Loan Portfolio Composition – The net increase in net loans receivable over the prior year was $189.7 million, $407.4 million (including $285.4 million acquired from CSB) and $137.8 million at December 31, 2018, 2017, and 2016, respectively. The loan portfolio contains no foreign loans. The Company’s loan portfolio is concentrated geographically in the northwest and central Ohio, northeast Indiana, and southeast Michigan market areas. Management has identified lending for income generating rental properties as an industry concentration. Total loans for income generating rental property totaled $982.5 million at December 31, 2018, which represents 37.9% of the Company’s loan portfolio.
The following table sets forth the composition of the Company’s loan portfolio by type of loan at the dates indicated.
|(Dollars in Thousands)|
|1-4 family residential||$||322,686||12.1||%||$||274,862||11.1||%||$||207,550||10.2||%||$||205,330||11.0||%||$||206,437||12.2||%|
|Commercial real estate||1,126,452||42.3||987,129||40.0||843,579||41.5||780,870||41.8||683,958||40.6|
|Total real estate loans||1,993,268||74.8||1,775,559||72.0||1,430,998||70.4||1,317,635||70.5||1,159,310||68.8|
|Home equity and improvement||128,152||4.8||135,457||5.5||118,429||5.8||116,962||6.2||111,813||6.6|
|Undisbursed loan funds||123,293||115,972||93,355||66,902||38,653|
|Net deferred loan origination fees||2,070||1,582||1,320||1,108||880|
|Allowance for loan losses||28,331||26,683||25,884||25,382||24,766|
In addition to the loans reported above, First Defiance had $6.6 million, $10.4 million, $9.6 million, $5.5 million, and $4.5 million in loans classified as held for sale at December 31, 2018, 2017, 2016, 2015 and 2014, respectively. The fair value of such loans, which are all single-family residential mortgage loans, approximated their carrying value for all years presented.
Contractual Principal, Repayments and Interest Rates – The following table sets forth certain information at December 31, 2018, regarding the dollar amount of gross loans maturing in First Defiance’s portfolio, based on the contractual terms to maturity. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less.
|Years After December 31, 2018|
|Due 1-2||Due 3-5||Due 5-10||Due 10-15||Due 15+||Total|
|Home equity and improvement||113,673||2,455||5,921||2,924||1,373||1,806||128,152|
The schedule above does not reflect the actual life of the Company’s loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which give First Defiance the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid.
The following table sets forth the dollar amount of gross loans due after one year from December 31, 2018, which has fixed interest rates or which have floating or adjustable interest rates.
Originations, Purchases and Sales of Loans – The lending activities of First Federal are subject to the written, non-discriminatory underwriting standards and loan origination procedures established by the Board of Directors and management. Loan originations are obtained from a variety of sources, including referrals from existing customers, real estate brokers, developers and builders, newspaper, internet and radio advertising and walk-in customers.
First Federal’s loan approval process for all types of loans is intended to assess the borrower’s ability to repay the loan, the viability of the loan and the adequacy of the value of the collateral that will secure the loan.
A commercial loan application is first reviewed by a commercial lender and underwritten by a commercial credit analyst. All loan requests must be presented for review or approval to a Regional Credit Officer. Loans which exceed $1,000,000 must then be presented to the Chief Credit Officer or Credit Administration Officer for approval. These two positions can also approve loans up to $2,000,000 individually or $4,000,000 when using their authority concurrently. Any loan in excess of these limits must be presented for approval to the Executive Loan Committee.
Residential mortgage applications are accepted by retail lenders or branch managers, who utilize an automated underwriting system to review the loan request. First Federal also receives mortgage applications via an online residential mortgage origination system. A final approval of all residential mortgage applications is made by a member of a centralized underwriting staff within their designated lending limits. Loan requests in excess or outside an individual underwriter’s limit are approved by a Regional or Chief Credit Officer and, if necessary, by the Executive Loan Committee.
Retail lenders and branch managers are authorized to originate and approve direct consumer loan requests that are within policy guidelines and within the lender’s approved lending limit. Loans in excess of the lender’s approved lending limit may be approved by retail lending managers up to their approved lending limit. Loans in excess of the retail lending manager’s authorized lending limit or outside of policy must be approved by a Regional or Chief Credit Officer and, if necessary, by the Executive Loan Committee.
First Federal offers adjustable-rate loans in order to decrease the vulnerability of its operations to changes in interest rates. The demand for adjustable-rate loans in First Federal’s primary market area has been a function of several factors, including customer preference, the level of interest rates, the expectations of changes in the level of interest rates and the difference between the interest rates offered for fixed-rate loans and adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate residential loans that can be originated at any time is largely determined by the demand for each in a competitive environment.
Adjustable-rate loans represented 22.0% of First Federal’s total originations of one-to-four family residential mortgage loans in 2018 compared to 9.9% and 10.8% during 2017 and 2016, respectively.
Adjustable-rate loans decrease the risks associated with changes in interest rates, but involve other risks, primarily because as interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, thereby increasing the potential for default. At the same time, the marketability of the underlying property may be adversely affected by higher interest rates.
The following table shows total loans originated, loan reductions, and the net increase in First Federal’s total loans and loans held for sale during the periods indicated:
|Years Ended December 31|
|1-4 family residential||$||282,109||$||240,921||$||294,307|
|Commercial real estate||279,251||181,289||166,437|
|Home equity and improvement||58,918||68,856||56,816|
|Total loans originated||1,084,777||1,005,269||1,115,533|
|Loans acquired in acquisitions:||-||285,448||-|
|Periodic principal repayments||317,128||288,215||432,445|
|Net increase in total loans and loans held for sale||$||195,313||$||431,934||$||169,019|
First Defiance’s credit policy establishes guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to ensure sound credit decisions. First Defiance’s credit policies and review procedures are meant to minimize the risk and uncertainties inherent in lending. In following the policies and procedures, management must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur because of changing economic conditions.
Delinquent Loans — The following table sets forth information concerning delinquent loans at December 31, 2018, in dollar amount and as a percentage of First Defiance’s total loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts that are past due.
|30 to 59 Days||60 to 89 Days||90 Days and Over||Total|
|(Dollars in Thousands)|
|1-4 family residential real estate||$||946||0.04||%||$||993||0.04||%||$||1,571||0.06||%||$||3,510||0.14||%|
|Multi- family residential||-||0.00||-||0.00||-||0.00||-||0.00|
|Commercial real estate||130||0.00||417||0.02||3,008||0.11||3,555||0.13|
|Home equity and improvement||1,427||0.05||144||0.01||90||0.00||1,661||0.06|
Overall, the level of delinquencies at December 31, 2018, declined slightly from the levels at December 31, 2017, when First Defiance reported that 0.53% of its outstanding loans were at least 30 days delinquent. The level of total loans 90 or more days delinquent has increased to 0.32% at December 31, 2018, from 0.20% at December 31, 2017. The level of total loans 60-89 days delinquent decreased to 0.07% at December 31, 2018, from 0.12% at December 31, 2017. The level of loans that were 30 to 59 days past due decreased to 0.10% at December 31, 2018, from 0.21% at December 31, 2017. Management has assessed the collectability of all loans that are 90 days or more delinquent as part of its procedures in establishing the allowance for loan losses.
Non-performing Assets – All loans are reviewed on a regular basis and are placed on non-accrual status when, in the opinion of management, the collectability of additional interest is not expected. Generally, First Defiance places all loans more than 90 days past due on non-accrual status. First Defiance also places loans on non-accrual status when the loan is paying as agreed but the Company believes the financial condition of the borrower is such that this classification is warranted. When a loan is placed on non-accrual status, total unpaid interest accrued to date is reversed. Subsequent payments are generally applied to the outstanding principal balance but may be recorded as interest income, depending on the assessment of the ultimate collectability of the loan. First Defiance considers that a loan is impaired when, based on current information and events, it is probable that it will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan agreement. First Defiance measures impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral, if collateral dependent. If the estimated recoverability of the impaired loan is less than the recorded investment, First Defiance will recognize impairment by allocating a portion of the allowance for loan losses on cash flow dependent loans and by charging off the deficiency on collateral dependent loans.
Loans originated by First Federal having principal balances of $45.8 million, $56.3 million and $27.4 million were considered impaired as of December 31, 2018, 2017 and 2016, respectively. These amounts of impaired loans exclude large groups of small-balance homogeneous loans that are collectively evaluated for impairment such as residential mortgage, consumer installment and credit card loans, except for those classified as troubled debt restructurings. There was $1.8 million of interest received and recorded in income during 2018 related to impaired loans. There was $1.4 million and $1.7 million recorded in 2017 and 2016, respectively. Unrecorded interest income based on the loan’s contractual terms on these impaired loans and all non-performing loans in 2018, 2017 and 2016 was $1.1 million, $1.1 million, and $1.2 million, respectively. The average recorded investment in impaired loans during 2018, 2017 and 2016 (excluding loans accounted for under FASB ASC Topic 310 Subtopic 30) was $49.2 million, $47.4 million and $32.8 million, respectively. The total allowance for loan losses related to these loans was $0.6 million, $0.8 million, and $0.8 million at December 31, 2018, 2017 and 2016, respectively.
Real estate acquired by foreclosure is classified as real estate owned until such time as it is sold. First Defiance also repossesses other assets securing loans, consisting primarily of automobiles. When such property is acquired it is recorded at fair value less cost to sell. Costs relating to development and improvement of property are capitalized, whereas costs relating to holding the property are expensed. Valuations are periodically performed by management and a write-down of the value is recorded with a corresponding charge to operations if it is determined that the carrying value of property exceeds its estimated net realizable value. During 2018, First Defiance recognized $552,000 of expense related to write-downs in value of real estate acquired by foreclosure or acquisition. The balance of real estate owned at December 31, 2018, was $1.2 million. During 2017, there was $20,000 of expense related to write-downs in fair value of real estate acquired by foreclosure or acquisition. The balance of real estate owned at December 31, 2017 was $1.5 million.
As of December 31, 2018, First Defiance’s total non-performing loans amounted to $19.0 million or 0.75% of total loans (net of undisbursed loan funds and deferred fees and costs), compared to $30.7 million or 1.31% of total loans, at December 31, 2017. Non-performing loans are loans which are more than 90 days past due or on non-accrual. The non-performing loan balance for 2018 includes $16.3 million of loans that were originated by First Federal and also considered impaired, compared to $25.5 million for 2017.
The following table sets forth the amounts and categories of First Defiance’s non-performing assets (excluding impaired loans not considered non-performing) and troubled debt restructurings at the dates indicated.
|(Dollars in Thousands)|
|1-4 family residential real estate||$||3,640||$||3,037||$||2,928||$||2,610||$||3,332|
|Multi-family residential real estate||102||128||2,639||2,419||2,539|
|Commercial real estate||10,255||18,091||6,953||7,429||12,635|
|Home equity and improvement||393||590||730||689||619|
|Total non-performing loans||19,016||30,715||14,348||16,261||24,130|
|Real estate owned||1,205||1,532||455||1,321||6,181|
|Total repossessed assets||1,205||1,532||455||1,321||6,181|
|Total non-performing assets||$||20,221||$||32,247||$||14,803||$||17,582||$||30,311|
|Restructured loans, accruing||$||11,573||$||13,770||$||10,544||$||11,178||$||24,686|
|Total non-performing assets as a percentage of total assets||0.64||%||1.08||%||0.60||%||0.77||%||1.39||%|
|Total non-performing loans as a percentage of total loans*||0.75||%||1.31||%||0.74||%||0.90||%||1.47||%|
|Total non-performing assets as a percentage of total loans plus OREO*||0.80||%||1.37||%||0.76||%||0.97||%||1.83||%|
|Allowance for loan losses as a percent of total non-performing assets||140.11||%||82.75||%||174.86||%||144.36||%||81.71||%|
* Total loans are net of undisbursed loan funds and deferred fees and costs.
Allowance for Loan Losses – First Defiance maintains an allowance for loan losses to absorb probable incurred credit losses in the loan portfolio. The allowance for loan loss is made up of two components. The first is a general reserve, which is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolio based on quantitative and qualitative factors.
The second component of the allowance for loan loss is the specific reserve in which the Company sets aside reserves based on the analysis of individual credits. In evaluating the adequacy of its allowance each quarter, management grades all loans in the commercial portfolio. See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations – Allowance for Loan Losses” for further discussion on management’s evaluation of the allowance for loan losses.
Loans are charged against the allowance when such loans meet the Company’s established policy on loan charge-offs and the allowance itself is adjusted quarterly by recording a provision for loan losses. As such, actual losses and losses provided for should be approximately the same if the overall quality, composition and size of the portfolio remained static along with a static loan environment. To the extent that the portfolio grows at a rapid rate or overall quality or the loan environment deteriorates, the provision generally will exceed charge-offs. However, in certain circumstances, net charge-offs may exceed the provision for loan losses when management determines that loans previously provided for in the allowance for loan losses are uncollectible and should be charged-off or as overall credit or the loan environment improves. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowances may be necessary, and net earnings could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations.
At December 31, 2018, First Defiance’s allowance for loan losses totaled $28.3 million compared to $26.7 million at December 31, 2017. The following table sets forth the activity in First Defiance’s allowance for loan losses during the periods indicated.
|Years Ended December 31|
|(Dollars in Thousands)|
|Allowance at beginning of year||$||26,683||$||25,884||$||25,382||$||24,766||$||24,950|
|Provision for credit losses||1,176||2,949||283||136||1,117|
|1-4 family residential real estate||(261||)||(279||)||(350||)||(282||)||(426||)|
|Commercial real estate and multi-family||(1,387||)||(429||)||(92||)||(468||)||(1,018||)|
|Home equity and improvement||(269||)||(301||)||(268||)||(350||)||(392||)|
|Net (charge-offs) recoveries||472||(2,150||)||219||480||(1,301||)|
|Ending allowance||$||28,331||$ 2 6,683||$||25,884||$||25,382||$||24,766|
|Allowance for loan losses to total non-performing loans at end of year||148.99||%||86.87||%||180.40||%||156.09||%||102.64||%|
|Allowance for loan losses to total loans at end of year*||1.12||%||1.14||%||1.33||%||1.41||%||1.50||%|
|Net charge-offs (recoveries) for the year to average loans||-0.02||%||0.10||%||-0.01||%||-0.03||%||0.08||%|
* Total loans are net of undisbursed loan funds and deferred fees and costs.
The provision for credit losses decreased in 2018 from the previous year despite growth in the loan portfolio due to a decrease in net charge-offs and improving credit quality. Management feels that the level of the allowance for loan losses at December 31, 2018, is sufficient to cover the estimated losses incurred but not yet recognized in the loan portfolio.
The following table sets forth information concerning the allocation of First Defiance’s allowance for loan losses by loan categories at the dates indicated. For information about the percent of total loans in each category to total loans, see “Lending Activities-Loan Portfolio Composition” above.
|Percent of||Percent of||Percent of||Percent of||Percent of|
|total loans||total loans||total loans||total loans||total loans|
|Amount||by category||Amount||by category||Amount||by category||Amount||by category||Amount||by category|
|(Dollars in Thousands)|
|1-4 family residential||$||2,881||12.1||%||$||2,532||11.1||%||$||2,627||10.2||%||$||3,212||11.0||%||$||2,494||12.2||%|
|Multi-family residential real estate||3,101||10.4||2,702||10.1||2,228||9.7||2,151||9.0||2,453||9.3|
|Commercial real estate||12,041||42.3||10,354||40.0||10,625||41.5||11,772||41.8||11,268||40.6|
|Home equity and improvement loans||2,026||4.8||2,255||5.5||2,386||5.8||2,270||6.2||1,704||6.6|
Sources of Funds
General – Deposits are the primary source of First Defiance’s funds for lending and other investment purposes. In addition to deposits, First Defiance derives funds from loan principal repayments. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings from the FHLB may be used on a short-term basis to compensate for reductions in the availability of funds from other sources. They may also be used on a longer-term basis for general business purposes. During 2007, First Defiance issued $15.0 million of trust preferred securities through an unconsolidated affiliated trust. Proceeds from the offering were used for general corporate purposes including funding of dividends and stock buybacks as well as bolstering regulatory capital at the First Federal level. First Defiance also issued $20.0 million of similar trust preferred securities in 2005.
Deposits – First Defiance’s deposits are attracted principally from within First Defiance’s primary market area through the offering of a broad selection of deposit instruments, including checking accounts, money market accounts, savings accounts, and term certificate accounts. Deposit account terms vary, with the principal differences being the minimum balance required, the time periods the funds must remain on deposit, and the interest rate.
To supplement its funding needs, First Defiance also has the ability to utilize the national market for certificates of deposit. First Defiance has used these deposits in the past and could in the future if necessary. First Defiance has no national market certificates of deposit as of December 31, 2018 or 2017.
Average balances and average rates paid on deposits are as follows:
|Years Ended December 31|
|(Dollars in Thousands)|
|Noninterest-bearing demand deposits||$||562,439||-||$||528,926||-||$||441,731||-|
|Interest-bearing demand deposits||1,026,383||0.27||%||955,248||0.18||%||798,266||0.17||%|
The following table sets forth the maturities of First Defiance’s retail certificates of deposit having principal amounts $250,000 or greater at December 31, 2018 (In Thousands):
|Retail certificates of deposit maturing in quarter ending:|
|March 31, 2019||$||24,347|
|June 30, 2019||20,481|
|September 30, 2019||8,791|
|December 31, 2019||6,865|
|After December 31, 2019||29,328|
|Total retail certificates of deposit with |
balances $250,000 or greater
The following table details the deposit accrued interest payable as of December 31:
|Interest-bearing demand deposits and |
money market accounts
|Certificates of deposit||314||68|
For additional information regarding First Defiance’s deposits see Note 11 to the Consolidated Financial Statements.
Borrowings – First Defiance may obtain advances from the FHLB of Cincinnati by pledging certain of its residential mortgage loans, commercial real estate loans, multi-family loans, home equity loans and investment securities provided certain standards related to creditworthiness have been met. Such advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities.
The following table sets forth certain information as to First Defiance’s FHLB advances and other borrowings at the dates indicated.
|Years Ended December 31|
|(Dollars in Thousands)|
|Weighted average interest rate||1.68||%||1.55||%||1.42||%|
|Weighted average interest rate||2.45||%||-||-|
|Securities sold under agreement to repurchase||$||5,741||$||26,019||$||31,816|
|Weighted average interest rate||0.31||%||0.20||%||0.22||%|
The following table sets forth the maximum month-end balance and average balance of First Defiance’s long-term FHLB advances and other borrowings during the periods indicated.
|Years Ended December 31|
|(Dollars in Thousands)|
|Weighted average interest rate||1.75||%||1.44||%||1.42||%|
The following table sets forth the maximum month-end balance and average balance of First Defiance’s short-term FHLB advances and other borrowings during the periods indicated.
|Years Ended December 31|
|(Dollars in Thousands)|
|Weighted average interest rate||1.33||%||0.80||%||0.39||%|
|Securities sold under agreement to repurchase:|
|Weighted average interest rate||0.26||%||0.23||%||0.26||%|
First Defiance borrows funds under a variety of programs at the FHLB. As of December 31, 2018, there was $85.2 million outstanding under various FHLB advance programs. First Defiance utilizes short-term advances from the FHLB to meet cash flow needs and for short-term investment purposes. At December 31, 2018 and 2017, no outstanding balances existed under First Defiance’s short-term Cash Management Advance Line of Credit. The total available under the Cash Management Advance Line is $15.0 million. In addition, First Defiance has a $100.0 million REPO Advance line of credit available, under which $25.0 million was drawn at December 31, 2018. There were no borrowings against this line at December 31, 2017. Amounts are generally borrowed under these lines on an overnight basis. First Defiance’s total borrowing capacity at the FHLB is limited by various collateral requirements. Eligible collateral includes mortgage loans, home equity loans, non-mortgage loans, cash, and investment securities. At December 31, 2018, other than amounts available on the REPO and Cash Management line, First Defiance had additional borrowing capacity with the FHLB of $447.4 million as a result of these collateral requirements.
As a member of the FHLB of Cincinnati, First Federal must maintain a minimum investment in the capital stock of that FHLB in an amount defined in the FHLB’s regulations. First Federal is permitted to own stock in excess of the minimum requirement and was in compliance with the minimum requirement with an investment in stock of the FHLB of Cincinnati of $14.2 million at December 31, 2018, and $16.0 million at December 31, 2017. First Federal held stock of the FHLB of Indianapolis of $2,500 at December 31, 2018, and $5,000 at December 31, 2017.
Each FHLB is required to establish standards of community investment or service that its members must maintain for continued access to long-term advances from the FHLB. The standards take into account a member’s performance under the Community Reinvestment Act and its record of lending to first-time homebuyers.
For additional information regarding First Defiance’s FHLB advances and other debt see Notes 12 and 14 to the Consolidated Financial Statements.
Subordinated Debentures – In March 2007, the Company sponsored an affiliated trust, First Defiance Statutory Trust II (“Trust Affiliate II”) that issued $15.0 million of Guaranteed Capital Trust Securities (“Trust Preferred Securities”). In connection with the transaction, the Company issued $15.5 million of Junior Subordinated Deferrable Interest Debentures (“Subordinated Debentures”) to Trust Affiliate II. Trust Affiliate II was formed for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Subordinated Debentures held by Trust Affiliate II are the sole assets of the trust. Distributions on the Trust Preferred Securities issued by Trust Affiliate II are payable quarterly at a variable rate equal to the three-month LIBOR rate plus 1.5%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate II was 4.29% and 3.09% as of December 31, 2018 and 2017, respectively.
The Trust Preferred Securities are subject to mandatory redemption, in whole or in part, upon repayment of the Subordinated Debentures. The Company entered into an agreement that fully and unconditionally guarantees the Trust Preferred Securities subject to the terms of the guarantee. The Trust Preferred Securities and Subordinated Debentures mature on June 15, 2037, but can be redeemed at the Company’s option at any time now.
In October 2005, the Company formed an affiliated trust, First Defiance Statutory Trust I (“Trust Affiliate I”) that issued $20.0 million of Trust Preferred Securities. In connection with the transaction, the Company issued $20.6 million of Subordinated Debentures to Trust Affiliate I. Trust Affiliate I was formed for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Subordinated Debentures held by Trust Affiliate I are the sole assets of the trust. Distributions on the Trust Preferred Securities issued by Trust Affiliate I are payable quarterly at a variable rate equal to the three-month LIBOR rate plus 1.38%, or 4.17% and 2.97% as of December 31, 2018 and 2017, respectively.
The Trust Preferred Securities issued by Trust Affiliate I are subject to mandatory redemption, in whole or in part, upon repayment of the Subordinated Debentures. The Company entered into an agreement that fully and unconditionally guarantees the Trust Preferred Securities subject to the terms of the guarantee. The Trust Preferred Securities and Subordinated Debentures mature on December 15, 2035, but can be redeemed by the Company at any time now.
First Defiance had 696 employees at December 31, 2018. None of these employees are represented by a collective bargaining agent, and First Defiance believes that it maintains good relationships with its personnel.
Competition in originating commercial real estate and commercial loans comes mainly from commercial banks with banking center offices in the Company’s market area. Competition for the origination of mortgage loans arises mainly from savings associations, commercial banks, and mortgage companies. The distinction among market participants is based on a combination of price, the quality of customer service and name recognition. The Company competes for loans by offering competitive interest rates and product types and by seeking to provide a higher level of personal service to borrowers than is furnished by competitors. First Federal has a significant market share of the lending markets in which it conducts operations, except for central Ohio.
Management believes that First Federal’s most direct competition for deposits comes from local financial institutions. The distinction among market participants is based on price and the quality of customer service and name recognition. First Federal’s cost of funds fluctuates with general market interest rates. During certain interest rate environments, additional significant competition for deposits may be expected from corporate and governmental debt securities, as well as from money market mutual funds. First Federal competes for conventional deposits by emphasizing quality of service, extensive product lines and competitive pricing.
General – First Defiance is subject to regulation examination and oversight by the Federal Reserve Board (“Federal Reserve”). First Federal is subject to regulation, examination and oversight by the Office of the Comptroller of the Currency (“OCC”). Because the FDIC insures First Federal’s deposits, First Federal is also subject to examination and regulation by the FDIC. In addition, First Federal is subject to regulations of the Consumer Financial Protection Bureau (the “CFPB”) which was established by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and has broad powers to adopt and enforce consumer protection regulations. First Defiance and First Federal must file periodic reports with the Federal Reserve and the OCC and examinations are conducted periodically by the Federal Reserve, the OCC and the FDIC to determine whether First Defiance and First Federal are in compliance with various regulatory requirements and are operating in a safe and sound manner.
First Defiance is also subject to various Ohio laws which restrict takeover bids, tender offers and control-share acquisitions involving public companies which have significant ties to Ohio.
Economic Growth, Regulatory Relief and Consumer Protection Act
On May 25, 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Regulatory Relief Act”) was signed into law. The Regulatory Relief Act was designed to provide regulatory relief for banking organizations, particularly for all but the very largest, those with assets in excess of $250 billion. Bank holding companies with assets of less than $100 billion are no longer subject to enhanced prudential standards, and those with assets between $100 billion and $250 billion will be relieved of those requirements in 18 months, unless the Federal Reserve Board takes action to maintain those standards. Certain regulatory requirements applied only to banks with assets in excess of $50 billion and so did not apply to First Federal even before the enactment of the Regulatory Relief Act.
The Regulatory Relief Act also provides that the banking regulators must adopt regulations implementing the provision that banking organizations with assets of less than $10 billion are permitted to satisfy capital standards and be considered “well capitalized” under the prompt corrective action framework if their leverage ratios of tangible assets to average consolidated assets is between 8% and 10%, unless the bank’s federal banking agency determines that the organization’s risk profile warrants a more stringent leverage ratio. The Office of the Comptroller of the Currency (“OCC”), the Federal Reserve Board and the FDIC have proposed for comment the leverage ratio framework for any banking organization with total consolidated assets of less than $10 billion, limited amounts of certain types of assets and off-balance sheet exposures, and a community bank leverage ratio greater than 9%. The community bank leverage ratio would be calculated as the ratio of tangible equity capital divided by average total consolidated assets. Tangible equity capital would be defined as total bank equity capital or total holding company equity capital, as applicable, prior to including minority interests, and excluding accumulated other comprehensive income, deferred tax assets arising from net operating loss and tax credit carry forwards, goodwill and other intangible assets (other than mortgage servicing assets). Average total assets would be calculated in a manner similar to the current tier 1 leverage ratio denominator in that amounts deducted from the community bank leverage ratio numerator would also be excluded from the community bank leverage ratio denominator.
The OCC, the Federal Reserve Board and the FDIC also adopted a rule providing banking organizations the option to phase in over a three-year period the day-one adverse effects on regulatory capital that may result from the adoption of new current expected credit loss methodology accounting under U. S. generally accepted accounting principles (“GAAP”).
The Regulatory Relief Act also relieves bank holding companies and banks with assets of less than $100 billion in assets from certain record-keeping, reporting and disclosure requirements.
Holding Company Regulation – First Defiance is a unitary thrift holding company and is subject to the Federal Reserve regulations, examination, supervision and reporting requirements. Federal law generally prohibits a thrift holding company from controlling any other savings association or thrift holding company, without prior approval of the Federal Reserve, or from acquiring or retaining more than 5% of the voting shares of a savings association or holding company thereof, which is not a subsidiary.
Regulatory Capital Requirements and Prompt Corrective Action – The federal banking regulators have adopted risk-based capital guidelines for financial institutions and their holding companies, designed to absorb losses. The guidelines provide a systematic analytical framework, which makes regulatory capital requirements sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures expressly into account in evaluating capital adequacy and minimizes disincentives to holding liquid, low-risk assets. Capital levels as measured by these standards are also used to categorize financial institutions for purposes of certain prompt corrective action regulatory provisions.
In July 2013, the federal banking regulators issued final new capital rules applicable to smaller banking organizations which also implement certain provisions of the Dodd-Frank Act. The new minimum capital requirements became effective on January 1, 2015, whereas a new capital conservation buffer and deductions from common equity capital phased in from January 1, 2016, through January 1, 2019.
The rules include (a) a minimum common equity Tier 1 (“CET1”) capital ratio of 4.5%, (b) a minimum Tier 1 capital ratio of 6.0%, (c) a minimum total capital ratio of 8.0%, and (d) a minimum leverage ratio of 4%.
Common equity for the CET1 capital ratio includes common stock (plus related surplus) and retained earnings, plus limited amounts of minority interests in the form of common stock, less the majority of certain regulatory deductions.
Tier 1 capital includes common equity as defined for the CET1 capital ratio, plus certain non-cumulative preferred stock and related surplus, cumulative preferred stock and related surplus and trust preferred securities that have been grandfathered (but which are not permitted going forward), and limited amounts of minority interests in the form of additional Tier 1 capital instruments, less certain deductions.
Tier 2 capital, which can be included in the total capital ratio, includes certain capital instruments (such as subordinated debt) and limited amounts of the allowance for loan and lease losses (“ALLL”), subject to new eligibility criteria, less applicable deductions.
The deductions from CET1 capital include goodwill and other intangibles, certain deferred tax assets, mortgage-servicing assets above certain levels, gains on sale in connection with a securitization, investments in a banking organization’s own capital instruments and investments in the capital of unconsolidated financial institutions (above certain levels).
Under the guidelines, capital is compared to the relative risk related to the balance sheet. To derive the risk included in the balance sheet, one of several risk weights is applied to different balance sheet and off-balance sheet assets, primarily based on the relative credit risk of the counterparty. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
The rules also place restrictions on the payment of capital distributions, including dividends, and certain discretionary bonus payments to executive officers if the company does not hold a capital conservation buffer of greater than 2.5% composed of CET1 capital above its minimum risk-based capital requirements, or if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter. The capital conservation buffer was fully phased in effective January 1, 2019 at 2.5%.
The federal banking agencies have established a system of “prompt corrective action” to resolve certain problems of undercapitalized banks. This system is based on five capital level categories for insured depository institutions: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” The federal banking agencies may (or in some cases must) take certain supervisory actions depending upon a bank's capital level. For example, the banking agencies must appoint a receiver or conservator for a bank within 90 days after it becomes "critically undercapitalized" unless the bank's primary regulator determines, with the concurrence of the FDIC, that other action would better achieve regulatory purposes. Banking operations otherwise may be significantly affected depending on a bank's capital category. For example, a bank that is not "well capitalized" generally is prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market, and the holding company of any undercapitalized depository institution must guarantee, in part, specific aspects of the bank's capital plan for the plan to be acceptable.
Effective January 1, 2015, in order to be “well-capitalized,” a financial institution must have a CET1 capital ratio of 6.5%, a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital of at least 8% and a leverage ratio of at least 5%, and the institution must not be subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. As of December 31, 2018, First Federal met the ratio requirements in effect to be deemed "well-capitalized." See Note 17 of the Notes to the Consolidated Financial Statements which is incorporated herein by reference.
The following table sets forth the amounts and percentage levels of regulatory capital of First Defiance and First Federal, the minimum amounts required for each of First Defiance and First Federal, and the amounts required for First Federal to be deemed well capitalized under the prompt corrective action system, all as of December 21, 2018. (Dollars in Thousands):
|Actual||Minimum Required for |
|Minimum Required to be Well |
Capitalized for Prompt
|CET1 Capital (to Risk-Weighted Assets) (2)|
|Tier 1 Capital (2)|
|Tier 1 Capital (to Risk Weighted Assets) (2)|
|Total Capital (to Risk Weighted Assets) (2)|
|(1)||Excludes capital conservation buffer of 1.875% as of December 31, 2018.|
|(2)||Core capital is computed as a percentage of adjusted total assets of $3.04 billion for consolidated and for the Bank. Risk-based capital is computed as a percentage of total risk-weighted assets of $2.76 billion for consolidated and for the Bank.|
In September 2017, the Federal Reserve, along with other bank regulatory agencies, proposed amendments to its capital requirements to simplify various aspects of the capital rules for community banks, including First Federal, in an attempt to reduce the regulatory burden for such smaller financial institutions. In November 2017, the federal banking agencies extended, for the community banks, the existing capital requirements for certain items that were scheduled to change effective January 1, 2018, in light of the simplification amendments being considered. As described above, the bank regulatory agencies have proposed revised capital requirements under the Regulatory Relief Act.
Dividends – Dividends paid by First Federal to First Defiance are subject to various regulatory restrictions. First Federal paid $22.0 million in dividends to First Defiance in 2018 and $13.0 million in 2017. Generally, First Federal may not pay dividends to First Defiance in excess of its net profits (as defined by statute) for the last two fiscal years, plus any year-to-date net profits without the approval of the OCC. First Insurance paid $1.6 million in dividends to First Defiance in 2018 and $1.8 million in dividends in 2017. First Defiance Risk Management paid $950,000 in dividends to First Defiance in 2018 and $1.0 million in dividends in 2017.
First Defiance’s ability to pay dividends to its shareholders is primarily dependent on its receipt of dividends from the Subsidiaries. The Federal Reserve expects First Defiance to serve as a source of strength for First Federal and may require First Defiance to retain capital for further investment in First Federal, rather than pay dividends to First Defiance shareholders. Payment of dividends by First Defiance or First Federal may be restricted at any time at the discretion of its applicable regulatory authorities if they deem such dividends to constitute an unsafe or unsound practice. These provisions could have the effect of limiting First Defiance's ability to pay dividends on its common shares.
Transactions with Insiders and Affiliates – Loans to executive officers, directors and principal shareholders and their related interests must conform to the lending limits. Most loans to directors, executive officers and principal shareholders must be approved in advance by a majority of the “disinterested” members of board of directors of the association with any “interested” director not participating. All loans to directors, executive officers and principal shareholders must be made on terms substantially the same as offered in comparable transactions with the general public or as offered to all employees in a company-wide benefit program. Loans to executive officers are subject to additional restrictions. All transactions between savings associations and their affiliates must comply with Sections 23A and 23B of the Federal Reserve Act (“FRA”) and the Federal Reserve’s Regulation W. An affiliate of a savings association is any company or entity that controls, is controlled by, or is under common control with the savings association. First Defiance, First Defiance Risk Management and First Insurance are affiliates of First Federal.
Deposit Insurance – The FDIC maintains the Deposit Insurance Fund (“DIF’), which insures the deposit accounts of First Federal to the maximum amount provided by law. The general insurance limit is $250,000 per separately insured depositor. This insurance is backed by the full faith and credit of the United States government.
The FDIC assesses deposit insurance premiums on each insured institution quarterly based on risk characteristics of the institution. The FDIC may also impose a special assessment in an emergency situation.
Pursuant to the Dodd-Frank Act, the FDIC has established 2.0% as the designated reserve ratio (“DRR”), which is the ratio of the DIF to insured deposits of the total industry. In March 2016, the FDIC adopted final rules designed to meet the statutory minimum DRR of 1.35% by September 30, 2020, the deadline imposed by the Dodd-Frank Act. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets of less than $10 billion of the increase in the statutory minimum DRR to 1.35% from the former statutory minimum of 1.15%. The FDIC’s rules reduced assessment rates on all banks but imposed a surcharge on banks with assets of $10 billion or more until the DRR reaches 1.35% and provide assessment credits to banks with assets of less than $10 billion for the portion of their assessments that contribute to the increase of the DRR to 1.35%. The DRR reached 1.36% at September 30, 2018. The credits will be applied when the reserve ratio is at least 1.38%. The rules also changed the method to determine risk-based assessment rates for established banks with less than $10 billion in assets to better ensure that banks taking on greater risks pay more for deposit insurance than less risky banks.
In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation, a mixed-ownership government corporation established to recapitalize a predecessor to the DIF. These assessments will continue until the Financing Corporation bonds mature in September 2019. The Financing Corporation has projected that the last assessment will be collected on the March 29, 2019 FDIC invoice.
As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, federally-insured institutions. It also may prohibit any federally-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the DIF. The FDIC also has the authority to take enforcement actions against insured institutions. Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged or is engaging in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or written agreement entered into with the FDIC.
Consumer Protection Laws and Regulations – Banks are subject to regular examination to ensure compliance with federal statutes and regulations applicable to their business, including consumer protection statutes and implementing regulations. Potential penalties under these laws include, but are not limited to, fines. The Dodd-Frank Act established the CFPB, which has extensive regulatory and enforcement powers over consumer financial products and services. The CFPB has adopted numerous rules with respect to consumer protection laws, amending some existing regulations and adopting new ones, and has commenced enforcement actions. The following are just some of the consumer protection laws applicable to First Federal:
• Community Reinvestment Act of 1977 (“CRA”): imposes a continuing and affirmative obligation to fulfill the credit needs of its entire community, including low- and moderate-income neighborhoods.
• Equal Credit Opportunity Act: prohibits discrimination in any credit transaction on the basis of any of various criteria.
• Truth in Lending Act: requires that credit terms are disclosed in a manner that permits a consumer to understand and compare credit terms more readily and knowledgeably.
• Fair Housing Act: makes it unlawful for a lender to discriminate in its housing-related lending activities against any person on the basis of any of certain criteria.
• Home Mortgage Disclosure Act: requires financial institutions to collect data that enables regulatory agencies to determine whether the financial institutions are serving the housing credit needs of the communities in which they are located.
• Real Estate Settlement Procedures Act: requires that lenders provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibits abusive practices that increase borrowers’ costs.
• Privacy provisions of the Gramm-Leach-Bliley Act: requires financial institutions to establish policies and procedures to restrict the sharing of non-public customer data with non-affiliated parties and to protect customer information from unauthorized access.
The banking regulators also use their authority under the Federal Trade Commission Act to take supervisory or enforcement action with respect to unfair or deceptive acts or practices by banks that may not necessarily fall within the scope of specific banking or consumer finance law.
In October 2017, the CFPB issued a final rule (the “Payday Rule”) with respect to certain consumer loans to be effective on January 16, 2018, although compliance with most sections is required starting on August 19, 2019. The first major part of the rule makes it an unfair and abusive practice for a lender to make short-term and longer-term loans with balloon payments (with certain exceptions) without reasonably determining that the borrower has the ability to repay the loan. The second major part of the rule applies to the same types of loans as well as certain other longer-term loans that are repaid directly from the borrower's account. The rule states that it is an unfair and abusive practice for the lender to withdraw payment from the borrower's account after two consecutive payment attempts have failed, unless the lender obtains the consumer's new and specific authorization to make further withdrawals from the account. The rule also requires lenders to provide certain notices to the borrower before attempting to withdraw payment on a covered loan from the borrower’s account.
On February 6, 2019, the CFPB issued two proposals with respect to the Payday Rule. First, the CFPB proposed to delay the compliance date for the mandatory underwriting provisions of the Payday Rule to November 19, 2020. It has requested comments on the proposed delay to be made within 30 days. Second, the CFPB proposed to rescind provisions of the Payday Rule that (1) provide that it is an unfair and abusive practice for a lender to make a covered short-term or longer-term balloon-payment loan without reasonably determining that the consumer has the ability to repay the loan according to its terms; (2) prescribe mandatory underwriting requirements for making the ability-to-repay determination; (3) provide exemptions of certain loans from the mandatory underwriting requirements; and (4) provide related definitions, reporting and recordkeeping requirements. The CFPB has requested comments to be made within 90 days on this proposal. These proposals do not change the provisions of the Payday Rule that address lender payment practices with respect to covered loans. The CFPB also stated that it will be considering other changes to the Payday Rule in response to requests received for exemptions of certain types of lenders or loan products and may commence separate additional rulemaking initiatives.
CRA - Under the CRA, every FDIC-insured institution is obligated, consistent with safe and sound banking practices, to help meet the credit needs of its entire community, including low- and moderate-income neighborhoods. The CRA requires the appropriate federal banking regulator, in connection with the examination of an insured institution, to assess the institution’s record of meeting the credit needs of its community and to consider this record in its evaluation of certain applications to banking regulators, such as an application for approval of a merger or the establishment of a branch. An unsatisfactory rating may be used as the basis for the denial of an application to acquire another financial institution or open a new branch. As of its last examination, First Federal received a CRA rating of “satisfactory.”
In June 2010, the Federal Reserve, the OCC and the FDIC issued joint interagency guidance on incentive compensation policies (the Joint Guidance) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. This principles-based guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should: (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks; (ii) be compatible with effective internal controls and risk management; and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. The Joint Guidance made incentive compensation part of the regulatory agencies’ examination process, with the findings of the supervisory initiatives included in reports of examination and enforcement actions possible.
In May 2016, the federal bank regulatory agencies approved a joint notice of proposed rules (the “Proposed Joint Rules”) designed to prohibit incentive-based compensation arrangements that encourage inappropriate risks at financial institutions. The Proposed Joint Rules would apply to covered financial institutions with total assets of $1 billion or more. For all covered institutions, including Level 3 institutions like First Defiance, the proposed rule would:
• prohibit incentive-based compensation arrangements that are “excessive” or “could lead to material financial loss;”
• require incentive based compensation that is consistent with a balance of risk and reward, effective management and control of risk, and effective governance; and
• require board oversight, recordkeeping and disclosure to the appropriate regulatory agency.
Further, as stock exchanges impose additional listing requirements under the Dodd-Frank Act, public companies will be required to implement “clawback” procedures for incentive compensation payments and to disclose the details of the procedures, which allow recovery of incentive compensation that was paid on the basis of erroneous financial information necessitating a restatement due to material noncompliance with financial reporting requirements. This clawback policy is intended to apply to compensation paid within a three-year look-back window of the restatement and would cover all executives who received incentive awards.
Patriot Act – In response to the terrorist events of September 11, 2001, the Uniting and Strengthening of America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the Patriot Act) was signed into law in October 2001. The Patriot Act gives the United States government powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and broadened anti-money laundering requirements. Title III of the Patriot Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions. Among other requirements, Title III and related regulations require regulated financial institutions to establish a program specifying procedures for obtaining identifying information from customers seeking to open new accounts and establish enhanced due diligence policies, procedures and controls designed to detect and report suspicious activity. First Federal has established policies and procedures that it considers to be in compliance with the requirements of the Patriot Act.
Volcker Rule – The Volcker Rule under the Dodd-Frank Act prohibits banks and their affiliates from engaging in proprietary trading and investing in and sponsoring hedge funds and private equity funds. The Volcker Rule, which became effective in July 2015, does not impact the operations of First Defiance or its subsidiaries, as the Company does not engage in the businesses prohibited by the Volcker Rule and banks under $10.0 billion in assets are exempted from the Volcker Rule provisions.
|Item||1A. Risk Factors|
The risks listed below present risks that could have a material impact on the Company’s financial condition, results of operations, or business. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or that management currently deems immaterial may also impair the Company’s business operations.
Economic, political and financial market conditions may adversely affect First Defiance’s operations and financial condition.
First Defiance’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services First Defiance offers, is highly dependent upon the business environment in the markets where the Company operates, mainly in the State of Ohio, Northeast Indiana and Southeast Michigan. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability of or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters; or a combination of these or other factors. Conditions such as inflation, recession, unemployment, changes in interest rates, fiscal and monetary policy and other factors beyond First Defiance’s control may adversely affect its deposit levels and cost/composition, demand for loans, the ability of its borrowers to repay their loans and the value of the collateral securing the loans it makes. Because First Defiance has a significant amount of real estate loans, decreases in real estate values could adversely affect the value of property used as collateral and First Defiance’s ability to sell the collateral upon foreclosure.
The election of a new United States President in 2016 has resulted in substantial changes in economic and political conditions for the United States and the remainder of the world. Economic turmoil in Europe and Asia and changes in oil production in the Middle East affect the economy and stock prices in the United States. The timing and circumstances of the United Kingdom leaving the European Union (Brexit) and their effects on the United States are unknown. While these changes do not have a direct, immediate impact on First Defiance’s financial performance, we cannot predict how the change in the political climate will affect the economy and First Defiance’s performance in the future.
First Defiance’s loan portfolio includes a concentration of commercial real estate loans and commercial loans, which involve risks specific to real estate value and the successful operations of these businesses.
At December 31, 2018, First Federal’s portfolio of commercial real estate loans totaled $1.4 billion, or approximately 52.2% of total loans. First Federal’s commercial real estate loans typically have higher principal amounts than residential real estate loans, and many of our commercial real estate borrowers have more than one loan outstanding. As a result, an adverse development on one loan can expose First Defiance to greater risk of loss on other loans. Additionally, repayment of the loans is generally dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic conditions and events outside of the control of the borrower or lender could negatively impact the future cash flows and market values of the affected properties.
At December 31, 2018, First Federal’s portfolio of commercial loans totaled $509.6 million, or approximately 19.1% of total loans. Commercial loans generally expose First Defiance to a greater risk of nonpayment and loss than commercial real estate or residential real estate loans since repayment of such loans often depends on the successful operations and income stream of the borrowers. First Federal’s commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower such as accounts receivable, inventory, machinery or real estate. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The collateral securing other loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists.
First Defiance targets its business lending towards small- and medium-sized businesses, many of which have fewer financial resources than larger companies and may be more susceptible to economic downturns. If general economic conditions negatively impact these businesses, First Defiance’s results of operations and financial condition may be adversely affected.
If First Defiance's actual loan losses exceed its allowance for loan losses, First Defiance's net income will decrease.
In accordance with GAAP, First Defiance must maintain an allowance for loan losses to provide for loan defaults and non-performance, which when combined, are referred to as the allowance for loan losses. First Defiance's allowance for loan losses is based upon a number of relevant factors, including, but not limited to, trends in the level of nonperforming assets and classified loans, current economic conditions in the primary lending area, prior experience, possible losses arising from specific problem loans, and management's evaluation of the risks in the current portfolio. However, there are many factors that can result in actual loan losses exceeding the allowance.
For instance, in deciding whether to extend credit or enter into other transactions with customers and counterparties, First Defiance may rely on information provided to us by customers and counterparties, including financial statements and other financial information. First Defiance may also rely on representations of customers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. Such information may not turn out to be accurate. Further, First Defiance's loan customers may not repay their loans according to their terms, and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. As a result, First Defiance may experience significant loan losses, which could have a material adverse effect on its operating results.
The amount of future losses also is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond management's control, and these losses may exceed current estimates. Further, federal regulatory agencies, as an integral part of their examination process, review First Defiance's loans and allowance for loan losses and may require that First Defiance increase its allowance. Moreover, the Financial Accounting Standards Board (“FASB”) has changed its requirements for establishing the allowance, which will be effective for First Defiance in the first quarter of 2020. That accounting change exposes First Defiance to increased risk of failure to establish a sufficient allowance and the possibility that First Defiance will need to increase its allowance substantially through an increase to the provision for loan losses, which will adversely affect First Defiance's net income.
As a result of any of the above factors, First Defiance's allowance for loan losses may not be adequate to cover actual credit losses, and future provisions for credit losses could have a material adverse effect on First Defiance's operating results. There is no assurance that First Defiance will not further increase the allowance for loan losses. Either of these occurrences could have a material adverse effect on First Defiance's financial condition and results of operations.
Changes in interest rates can adversely affect First Defiance’s profitability.
First Defiance’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities, and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond First Defiance’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Open Market Committee. Changes in monetary policy, including changes in interest rates, could influence not only the interest First Defiance receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) First Defiance’s ability to originate loans and obtain deposits, (ii) the fair value of First Defiance’s financial assets and liabilities, and (iii) the average duration of certain assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, First Defiance’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. While we generally invest in securities with limited credit risk, certain investment securities we hold possess higher credit risk since they represent beneficial interests in structured investments collateralized by residential mortgages. All investment securities are subject to changes in market value due to changing interest rates and implied credit spreads. Any substantial, unexpected, or prolonged change in market interest rates could have a material adverse effect on First Defiance’s results of operations and financial condition.
First Federal originates a significant amount of residential mortgage loans that it sells in the secondary market. The origination of residential mortgage loans is highly dependent on the local real estate market and the current interest rates. Increasing interest rates tend to reduce the origination of loans for sale and consequently fee income, which First Defiance reports as mortgage banking income. Conversely, decreasing interest rates have the effect of causing clients to refinance mortgage loans faster than anticipated. This causes the value of mortgage servicing rights on the loans sold to be lower than originally anticipated. If this happens, First Defiance may be required to write down the value of its mortgage servicing rights faster than anticipated, which will increase expense and lower earnings. Accelerated repayments on loans and mortgage backed securities could result in the reinvestment of funds at lower rates than the loans or securities were paying.
Laws, regulations and periodic regulatory reviews may affect First Defiance’s results of operations.
The earnings of financial institutions are affected by the regulations and policies of various regulatory authorities, including the Federal Reserve, the OCC, the FDIC and the CFPB. The Federal Reserve has extensive supervisory authority over the Company, affecting a comprehensive range of matters relating to ownership and control of First Defiance’s shares, First Defiance’s acquisition of other companies and businesses, permissible activities for the Company to engage in, maintenance of adequate capital levels and other aspects of operations. These supervisory and regulatory powers are intended primarily for the protection of First Defiance’s depositors and borrowers and the DIF, rather than First Defiance’s shareholders.
As discussed above, in October 2017, the CFPB issued the Payday Rule with respect to certain consumer loans to be effective on January 16, 2018, although compliance with most sections is required starting on August 19, 2019. Then, on February 6, 2019, the CFPB issued two proposals with respect to the Payday Rule regarding the underwriting provisions. These proposals do not change the provisions of the Payday Rule that address lender payment practices with respect to covered loans. The CFPB also stated that it will be considering other changes to the Payday Rule in response to requests received for exemptions of certain types of lenders or loan products and may commence separate additional rulemaking initiatives. First Defiance is currently assessing the expected effect of this new rule on First Defiance's lending businesses and on First Defiance’s financial condition and results of operations. The costs of complying with this regulation or a determination to discontinue certain types of consumer lending in light of the expense of compliance could have an adverse effect on the financial conditions and results of operations of the Company.
Changes in tax laws could adversely affect First Defiance's financial condition and results of operations.
First Defiance is subject to extensive federal, state and local taxes, including income, excise, sales/use, payroll, franchise, withholding and ad valorem taxes. Changes to the tax laws could have a material adverse effect on First Defiance's results of operations. In addition, First Defiance's customers are subject to a wide variety of federal, state and local taxes. Changes in taxes paid by customers, including changes in the deductibility of mortgage loan related expenses, may adversely affect their ability to purchase homes or consumer products, which could adversely affect their demand for First Defiance's loans and deposit products. In addition, such negative effects on First Defiance's customers could result in defaults on the loans already made and decrease the value of mortgage-backed securities in which First Defiance has invested.
On December 22, 2017, H.R.1, formally known as the “Tax Cuts and Jobs Act,” was enacted into law. This new tax legislation, among other changes, limits the amount of state, federal and local taxes that taxpayers are permitted to deduct on their individual tax returns and eliminates other deductions in their entirety. Such limits and eliminations may result in customer defaults on loans already made and decrease the value of mortgage-backed securities in which First Defiance has invested.
The laws and regulations applicable to the banking industry could change at any time. The potential exists for new laws and regulations, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations. Increased regulation could increase First Defiance’s cost of compliance and reduce its income to the extent that they limit the manner in which First Defiance may conduct business, including its ability to offer new products, charge fees for specific products and services, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads.
First Defiance’s ability to meet cash flow needs on a timely basis at a reasonable cost may adversely affect net income.
First Defiance’s principal sources of liquidity are local deposits and wholesale funding sources such as FHLB advances, Federal Funds purchased, securities sold under repurchase agreements, and brokered or other out-of-market certificate of deposit purchases. Also, First Defiance maintains a portfolio of securities that can be used as a secondary source of liquidity. First Defiance’s access to funding sources in amounts adequate to finance or capitalize its activities or on terms that are acceptable could be impaired by factors that affect First Defiance directly or the financial services industry or economy in general, such as further disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry.
Other possible sources of liquidity include the sale or securitization of loans, the issuance of additional collateralized borrowings beyond those currently utilized with the FHLB, the issuance of debt securities and the issuance of preferred or common securities in public or private transactions, or borrowings from a commercial bank. First Defiance does not currently have any borrowings from a commercial bank, but it has used them in the past.
Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, pay dividends to First Defiance’s shareholders, or fulfill obligations such as repaying First Defiance’s borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, results of operations and financial condition.
Competition affects First Defiance’s earnings.
First Defiance’s continued profitability depends on its ability to continue to effectively compete to originate loans and attract and retain deposits. Competition for both loans and deposits is intense in the financial services industry. The Company competes in its market area by offering superior service and competitive rates and products. The type of institutions First Defiance competes with include large regional commercial banks, smaller community banks, savings institutions, mortgage banking firms, credit unions, finance companies, brokerage firms, insurance agencies and mutual funds. As a result of their size and ability to achieve economies of scale, certain of First Defiance’s competitors can offer a broader range of products and services than the Company can offer. In addition, the OCC has recently announced that it will start accepting applications for bank charters from nondepository financial technology companies engaged in banking activities, which will add to the number of parties with whom the Company competes. Further, technological advances allow consumers to pay bills and transfer funds electronically without banks. Consumers can also shop for higher deposit interest rates at banks across the country, which may offer higher rates because they have few or no physical branches. To stay competitive in its market area, First Defiance may need to adjust the interest rates on its products to match rates of its competition, which could have a negative impact on net interest margin.
The increasing complexity of First Defiance’s operations presents varied risks that could affect its earnings and financial condition.
First Defiance processes a large volume of transactions on a daily basis and is exposed to numerous types of risks related to internal processes, people and systems. These risks include, but are not limited to, the risk of fraud by persons inside or outside the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, breaches of data security and our internal control system and compliance with a complex array of consumer and safety and soundness regulations. First Defiance could also experience additional loss as a result of potential legal actions that could arise as a result of operational deficiencies or as a result of noncompliance with applicable laws and regulations.
First Defiance has established and maintains a system of internal controls that provides management with information on a timely basis and allows for the monitoring of compliance with operational standards. These systems have been designed to manage operational risks at an appropriate, cost effective level. Procedures exist that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. Losses from operational risks may still occur, however, including losses from the effects of operational errors.
Unauthorized disclosure of sensitive or confidential client or customer information or confidential trade secrets, whether through a breach of the Company’s computer systems or otherwise, could severely harm its business.
Potential misuse of funds or information by First Defiance’s employees or by third parties could result in damage to First Defiance’s customers for which First Defiance could be held liable, subject First Defiance to regulatory sanctions and otherwise adversely affect First Defiance’s financial condition and results of operations.
First Defiance’s employees handle a significant amount of funds, as well as financial and personal information. First Defiance also depends upon third-party vendors who have access to funds and personal information about customers. Cybersecurity breaches of other companies, such as the breach of the systems of a credit bureau, may result in criminals using personal information obtained from such other source to impersonate a customer of First Defiance and obtain funds from customer accounts. Further, First Defiance may be affected by data breaches at retailers and other third parties who participate in data interchanges with First Defiance’s customers that involve the theft of customer credit and debit card data, which may include the theft of debit card personal identification numbers (“PIN”) and commercial card information used to make purchases at such retailers and other third parties. Such data breaches could result in First Defiance incurring significant expenses to reissue debit cards and cover losses, which could result in a material adverse effect on First Defiance’s results of operations.
Although First Defiance has implemented systems to minimize the risk of fraudulent taking or misuse of funds or information, there can be no assurance that such systems will be adequate or that a taking or misuse of funds or information by employees, by third parties who have authorized access to funds or information, or by third parties who are able to access funds or information without authorization will never occur. First Defiance could be held liable for such an event and could also be subject to regulatory sanctions. First Defiance could also incur the expense of developing additional controls and investing in additional equipment or contracts to prevent future such occurrences. Although First Defiance has insurance to cover such potential losses, First Defiance cannot provide assurance that such insurance will be adequate to meet any liability, and insurance premiums may rise substantially if First Defiance suffers such an event. In addition, any loss of trust or confidence placed in First Defiance by our customers could result in a loss of business, which could adversely affect our financial condition and results of operations, or result in a loss of investor confidence, hurting First Defiance’s stock price and ability to acquire capital in the future. First Defiance could also lose revenue by the wrongful appropriation of confidential information about its business operations by competitors who use the information to compete with First Defiance.
First Defiance could suffer a material adverse impact from interruptions in the effective operation of, or security breaches affecting, First Defiance’s computer systems.
First Defiance relies heavily on its own information systems and those of vendors to conduct business and to process, record, and monitor transactions. Risks to the system could result from a variety of factors, including the potential for bad acts on the part of hackers, criminals, employees and others. As one example, some banks have experienced denial of service attacks in which individuals or organizations flood the bank’s website with extraordinarily high volumes of traffic, with the goal and effect of disrupting the ability of the bank to process transactions. Other businesses have been victims of a ransomware attack in which a business becomes unable to access its own information and is presented with a demand to pay a ransom in order to once again have access to its information. First Defiance is also at risk for the impact of natural disasters, terrorism and international hostilities on its systems or for the effects of outages or other failures involving power or communications systems operated by others. These risks also arise from the same types of threats to businesses with which First Defiance deals.
Potential adverse consequences of attacks on First Defiance’s computer systems or other threats include damage to First Defiance’s reputation, loss of customer business, costs of incentives to customers or business partners in order to maintain their relationships, loss of investor confidence and a reduction in First Defiance’s stock price, litigation, increased regulatory scrutiny and potential enforcement actions, repairs of system damage, increased investments in cybersecurity (such as obtaining additional technology, making organizational changes, deploying additional personnel, training personnel and engaging consultants), and increased insurance premiums, all of which could result in financial loss and material adverse effects on First Defiance’s results of operations and financial condition.
If First Defiance forecloses on collateral property resulting in First Defiance’s ownership of the underlying real estate, First Defiance may be subject to the increased costs associated with the ownership of real property, resulting in reduced income.
A significant portion of First Defiance’s loan portfolio is secured by real property. During the ordinary course of business, First Defiance may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, First Defiance may be liable for remediation costs, as well as for personal injury and property damage.
In addition, when First Defiance forecloses on real property, the amount First Defiance realizes after a default is dependent upon factors outside of First Defiance’s control, including, but not limited to, economic conditions, neighborhood real estate values, interest rates, real estate taxes, operating expenses of the mortgaged properties, zoning laws, governmental rules, regulations and fiscal policies, and acts of God. Certain expenditures associated with the ownership of real estate, principally real estate taxes and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the rental income earned from such property, and First Defiance may have to sell the property at a loss. The foregoing expenditures could adversely affect First Defiance’s financial condition and results of operations.
First Defiance’s business strategy focuses on planned growth, including strategic acquisitions, and its financial condition and results of operations could be negatively affected if First Defiance fails to grow or fails to manage its growth effectively.
First Defiance’s ability to grow successfully will depend on a variety of factors, including the continued availability of desirable business opportunities, its ability to integrate mergers and other acquisitions and manage growth and First Defiance’s ability to raise capital. There can be no assurance that growth opportunities will be available.
First Defiance may acquire other financial institutions or parts of institutions in the future, open new branches, and consider new lines of business and new products or services. Expansions of its business would involve a number of expenses and risks, including:
|·||the time and costs associated with identifying and evaluating potential acquisitions or expansions into new markets;|
|·||the potential inaccuracy of estimates and judgments used to evaluate the business and risks with respect to target institutions;|
|·||the time and costs of hiring local management and opening new offices;|
|·||the delay between commencing making acquisitions or engaging in new activities and the generation of profits from the expansion;|
|·||First Defiance’s ability to finance an expansion and the possible dilution to existing shareholders;|
|·||the diversion of management’s attention to the expansion;|
|·||management’s lack of familiarity with new market areas;|
|·||the integration of new products and services and new personnel into First Defiance’s existing business;|
|·||the incurrence and possible impairment of goodwill associated with an acquisition and effects on First Defiance’s results of operations; and|
|·||the risk of loss of key employees and customers.|
If First Defiance’s growth involves the acquisition of companies through mergers or other acquisitions, the success of such acquisitions will depend on, among other things, First Defiance’s ability to combine the businesses in a manner that permits growth opportunities and cost efficiencies, and does not cause inconsistencies in standards, controls, procedures and policies that adversely affect the ability of First Defiance to maintain relationships with customers and employees or to achieve the anticipated benefits of the acquisitions.
Failure to manage First Defiance’s growth effectively could have a material adverse effect on its business, future prospects, financial condition or results of operations and could adversely affect First Defiance’s ability to successfully implement its business strategy.
First Defiance’s ability to pay dividends is subject to regulatory limitations which, to the extent First Defiance requires such dividends in the future, may affect its ability to pay dividends or repurchase its stock.
As a unitary thrift holding company, First Defiance is a separate legal entity from First Federal and does not have significant operations of its own. Dividends from First Federal provide a significant source of capital for First Defiance. The availability of dividends from First Federal is limited by various statutes and regulations. The federal banking regulators require that insured financial institutions and their holding companies should generally only pay dividends out of current operating earnings. It is possible, depending upon the financial condition of First Federal and other factors, that the OCC, as First Federal’s primary regulator, could assert that the payment of dividends or other payments by First Federal are an unsafe or unsound practice. In the event First Federal is unable to pay dividends to First Defiance, First Defiance may not be able to pay its obligations as they become due, repurchase its stock, or pay dividends on its common stock. Consequently, the potential inability to receive dividends from First Federal could adversely affect First Defiance’s business, financial condition, results of operations or prospects.
Failure to integrate or adopt new technology may undermine First Defiance’s ability to meet customer demands, leading to adverse effects on First Defiance’s financial condition and results of operations.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. First Defiance’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in operations. First Defiance may not be able to effectively implement or have the resources to implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could adversely affect First Defiance’s business, financial condition, or results of operations.
A transition away from LIBOR as a reference rate for financial contracts could negatively affect First Defiance’s income and expenses and the value of various financial contracts.
LIBOR is used extensively in the U.S. and globally as a benchmark for various commercial and financial contracts, including adjustable rate mortgages, corporate debt, interest rate swaps and other derivatives. LIBOR is set based on interest rate information reported by certain banks, which may stop reporting such information after 2021. It is uncertain at this time whether LIBOR will change or cease to exist or the extent to which those entering into financial contracts will transition to any other particular benchmark. Other benchmarks may perform differently than LIBOR or alternative benchmarks have performed in the past or have other consequences that cannot currently be anticipated. It is also uncertain what will happen with instruments that rely on LIBOR for future interest rate adjustments and which remain outstanding if LIBOR ceases to exist.
First Defiance may be the subject of litigation, which would result in legal liability and damage to its business and reputation.
From time to time, First Defiance may be subject to claims or legal action from customers, employees or others. Financial institutions like First Defiance are facing a growing number of significant class actions, including those based on the manner of calculation of interest on loans and the assessment of overdraft fees. Future litigation could include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. First Defiance is also involved from time to time in other reviews, investigations and proceedings (both formal and informal) by governmental and other agencies regarding its businesses. These matters also could result in adverse judgments, settlements, fines, penalties, injunctions or other relief. Like other financial institutions, First Defiance is also subject to risk from potential employee misconduct, including non-compliance with policies and improper use or disclosure of confidential information. Substantial legal liability or significant regulatory action against First Defiance could materially adversely affect its business, financial condition or results of operations and/or cause significant reputational harm to its business.
At December 31, 2018, First Federal conducted its business from its main office at 601 Clinton St., Defiance, Ohio, and 43 other full-service banking centers in northwest and central Ohio, northeast Indiana and southeast Michigan as well as a loan production office in southeast Michigan. First Insurance conducted its business primarily from nine offices in northwest Ohio.
In October 2018, First Federal opened a branch located at 203 E. Berry St., Fort Wayne, Indiana. This office is leased.
First Defiance maintains its headquarters in the main office of First Federal at 601 Clinton St., Defiance, Ohio. Back-office operation departments, including information technology, loan processing and underwriting, deposit processing, accounting and risk management are headquartered in an operations center located at 25600 Elliott Rd., Defiance, Ohio.
The following table sets forth certain information with respect to the offices and other properties of the Company at December 31, 2018. See Note 9 to the Consolidated Financial Statements.
|Leased/||Net Book Value|
|Main Office - 601 Clinton St., Defiance, OH||Owned||$||2,908||$||268,657|
|Operations Center - 25600 Elliott Rd., Defiance, OH||Owned||4,495||N/A|
|Branch Offices, First Federal|
|204 E. High St., Bryan, OH||Owned||490||160,615|
|211 S. Fulton St., Wauseon, OH||Owned||282||75,492|
|625 Scott St., Napoleon, OH||Owned||778||97,500|
|1050 E. Main St., Montpelier, OH||Owned||216||52,327|
|1800 Scott St., Napoleon, OH||Owned||1,030||42,728|
|1177 N. Clinton St., Defiance, OH||Owned, Land Lease Leased||634||45,905|
|905 N. Williams St., Paulding, OH||Owned||593||92,873|
|201 E. High St., Hicksville, OH||Owned||250||36,928|
|3900 N. Main St., Findlay, OH||Owned||731||64,763|
|1694 N. Countyline St., Fostoria, OH||Owned||510||61,838|
|1226 W. Wooster St., Bowling Green, OH||Owned||810||129,991|
|301 S. Main St., Findlay, OH||Owned||669||107,898|
|405 E. Main St., Ottawa, OH||Owned||250||97,812|
|124 E. Main St., McComb, OH||Owned||142||22,156|
|7591 Patriot Dr., Findlay, OH||Owned||972||55,377|
|417 W. Dussel Dr., Maumee, OH||Owned, Land Lease||624||101,954|
|230 E. Second St., Delphos, OH||Owned||777||108,086|
|105 S. Greenlawn Ave., Elida, OH||Owned||276||44,050|
|2600 Allentown Rd., Lima, OH||Owned||866||51,231|
|22020 W. State Rt. 51, Genoa, OH||Owned||674||37,187|
|3426 Navarre Ave., Oregon, OH||Owned||744||42,202|
|1077 Louisiana Ave., Perrysburg, OH||Owned||477||50,288|
|2565 Shawnee Rd., Lima, OH||Owned||1,151||44,475|
|1595 W. Dupont Rd., Fort Wayne, IN||Leased||-||33,692|
|135 S. Main St., Glandorf, OH||Leased||-||19,395|
|300 N. Main St., Adrian, MI||Owned||646||85,995|
|1701 W. Maumee St., Adrian, MI||Owned||178||50,110|
|211 W. Main St., Morenci, MI||Owned||150||36,192|
|539 S. Meridian Hwy., Hudson, MI||Owned||453||49,559|
|1449 W. Chicago Blvd., Tecumseh, MI||Owned||1,325||64,201|
|1200 N. Main St., Bowling Green OH||Owned||1,508||14,884|
|9909 Illinois Rd, Fort Wayne, IN||Owned||1,859||56,102|
|4501 Cemetery Rd, Hilliard, OH||Owned||928||9,970|
|2920 W. Central Ave., Toledo, OH||Owned||158||2,073|
|118 S. Sandusky Ave., Upper Sandusky, OH||Owned||1,106||121,574|
|112 E. Liberty St., Arlington, OH||Owned||83||20,610|
|128 S. Vance St., Carey, OH||Owned||167||54,926|
|17480 Cherokee St., Harpster, OH||Owned||132||12,662|
|279 Jamesway Dr., Marion, OH||Owned||686||36,909|
|195 Barks Rd. West, Marion, OH||Owned||613||41,947|
|1707 Cherry St., Toledo, OH||Owned||56||9,145|
|1995 Highland Dr., Suite A, Ann Arbor, MI||Leased||-||-|
|5520 Monroe St., Sylvania, OH||Leased||16||7,669|
|203 E. Berry St., Fort Wayne, IN||Leased||26||934|
|First Insurance Group|
|511 Fifth St., Defiance, OH||Leased||409||N/A|
|209 W. Poe Rd., Bowling Green, OH||Leased||-||N/A|
|204 E. High St., Bryan, OH||Leased||-||N/A|
|2600 Allentown Rd., Lima, OH||Leased||-||N/A|
|107 Ditto St., Suite 400, Archbold, OH||Leased||-||N/A|
|101 W. Sandusky St., Suite 306, Findlay, OH||Leased||-||N/A|
|1650 N. Countyline St., Suite 200, Fostoria, OH||Leased||-||N/A|
|643 Miami St., Suite 5, Tiffin, OH||Leased||-||N/A|
|5520 Monroe St., Suite A, Sylvania, OH||Leased||-||N/A|
|Item 3.||Legal Proceedings|
First Defiance is involved in routine legal proceedings that are incidental to and occur in the ordinary course of business which, in the aggregate, are believed by management to be immaterial to the financial condition of First Defiance.
|Item 4.||Mine Safety Disclosures|
|Item 5.||Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities|
The Company’s common shares trade on The NASDAQ Global Select Market under the symbol “FDEF.” As of January 31, 2019, the Company had approximately 2,347 shareholders of record.
The line graph below compares the yearly percentage change in cumulative total shareholder return on First Defiance common shares and the cumulative total return of the NASDAQ Composite Index, the SNL NASDAQ Bank Index and the SNL Midwest Thrift Index. An investment of $100 on December 31, 2013, and the reinvestment of all dividends are assumed. The performance graph represents past performance and should not be considered to be an indication of future performance.
|First Defiance Financial Corp.||100.00||134.08||151.90||208.51||217.83||210.01|
|SNL Bank NASDAQ||100.00||103.57||111.80||155.02||163.20||137.56|
|SNL Midwest Thrift||100.00||114.29||139.95||168.52||160.27||146.29|
The following table provides information regarding First Defiance’s purchases of its common shares during the fourth quarter period ended December 31, 2018:
|Total Number of|
as Part of
|Maximum Number of|
Shares (or Approximate
Dollar Value) that May
Yet Be Purchased Under
the Plans or Programs (1)
|October 1 – October 31, 2018||-||$||-||-||755,000|
|November 1 – November 30, 2018||145,422||27.63||145,422||609,578|
|December 1 – December 31, 2018||85,738||26.96||85,738||523,840|
|(1)||On January 29, 2016, the Company announced that its Board of Directors authorized a program for the repurchase of up to 5% of the outstanding common shares or 900,000 shares. There is no expiration date for the new repurchase program.|
The information set forth under the caption “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters - Equity Compensation Plans” of this Form 10-K is incorporated herein by reference.
|Item 6.||Selected Financial Data|
The following table is derived from the Company’s audited financial statements as of and for the five years ended December 31, 2018. The following consolidated selected financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes included elsewhere in this Form 10-K. The operating results of acquired companies are included with the Company’s results of operations since their respective dates of acquisition.
|As of and For the Year Ended December 31|
|(Dollars and Shares in Thousands, Except Per Share Data)|
|Loans receivable, net||2,511,708||2,322,030||1,914,603||1,776,835||1,622,020|
|Allowance for loan losses||28,331||26,683||25,884||25,382||24,766|
|Non-performing assets (1)||20,221||32,247||14,803||17,582||30,311|
|Deposits and borrowers’ escrow balances||2,624,534||2,440,581||1,984,278||1,838,811||1,763,122|
|Basic earnings per share||$||2.27||$||1.62||$||1.61||$||1.44||$||1.28|
|Diluted earnings per share||2.26||1.61||1.60||1.41||1.22|
|Book value per common share||19.81||18.38||16.31||15.39||15.09|
|Tangible book value per common share (2)||14.71||13.24||12.80||11.89||11.62|
|Cash dividends per common share||0.64||0.50||0.44||0.39||0.31|
|Dividend payout ratio||28.19||%||30.96||%||27.41||%||27.00||%||24.51||%|
|Weighted average diluted shares outstanding||20,468||20,056||18,070||18,742||19,938|
|Shares outstanding end of period||20,171||20,312||17,966||18,204||18,470|
|Net interest income||108,255||96,671||78,943||74,055||69,689|
|Provision for loan losses||1,176||2,949||283||136||1,117|
|Income before tax||56,875||48,452||41,597||37,833||33,455|
|Federal income tax||10,626||16,184||12,754||11,410||9,163|
|Return on average assets||1.52||%||1.13||%||1.20||%||1.19||%||1.12||%|
|Return on average equity||12.03||%||9.19||%||10.10||%||9.52||%||8.78||%|
|Interest rate spread (2)||3.79||%||3.74||%||3.61||%||3.71||%||3.57||%|
|Net interest margin (2)||3.98||%||3.88||%||3.74||%||3.81||%||3.68||%|
|Ratio of operating expense to average total assets||2.93||%||2.99||%||2.97||%||3.05||%||3.09||%|
|Efficiency ratio (2)||60.29||%||61.81||%||62.20||%||63.01||%||65.32||%|
|Equity to total assets at end of period||12.56||%||12.47||%||11.83||%||12.19||%||12.83||%|
|Average equity to average assets||12.61||%||12.32||%||11.91||%||12.49||%||12.79||%|
|Asset Quality Ratios:|
|Non-performing assets to total assets at end of period (1)||0.64||%||1.08||%||0.60||%||0.77||%||1.39||%|
|Allowance for loan losses to total loans*||1.12||%||1.14||%||1.33||%||1.41||%||1.50||%|
|Net charge-offs (recoveries) to average loans||-0.02||%||0.10||%||-0.01||%||-0.03||%||0.08||%|
|(1)||Non-performing assets include non-accrual loans that are contractually past due 90 days or more and real estate, mobile homes and other assets acquired by foreclosure or deed-in-lieu thereof.|
|(2)||Refer to Non-GAAP Financial Measures in Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations.|
* Total loans are net of undisbursed loan funds and deferred fees and costs.
|Item 7.||Management’s Discussion and Analysis of Financial Condition and Results of Operations|
Forward-Looking Statements and Factors that Could Affect Future Results
Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (“Act”), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Company’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Corporation that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per common share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of First Defiance or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as “believes”, “anticipates”, “expects”, “intends”, “targeted”, “continue”, “remain”, “will”, “should”, “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:
|·||Local, regional, national and international economic conditions and the impact they may have on the Company and its customers and the Company’s assessment of that impact.|
|·||Volatility and disruption in national and international financial markets.|
|·||Government intervention in the U.S. financial system.|
|·||Changes in the level of non-performing assets and charge-offs.|
|·||Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.|
|·||The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve.|
|·||Inflation, interest rate, securities market and monetary fluctuations.|
|·||Acts of God or of war or terrorism.|
|·||The timely development and acceptance of new products and services and perceived overall value of these products and services by users.|
|·||Changes in consumer spending, borrowing and saving habits.|
|·||Changes in the financial performance and/or condition of the Company’s borrowers or customers.|
|·||Technological changes including core system conversions.|
|·||Acquisitions and integration of acquired businesses.|
|·||The ability to increase market share and control expenses.|
|·||Changes in the competitive environment among financial holding companies and other financial service providers.|
|·||The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Company and its subsidiaries must comply.|
|·||The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board (“PCAOB”), the Financial Accounting Standards Board (“FASB”) and other accounting standard setters.|
|·||The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews.|
|·||Greater than expected costs or difficulties related to the integration of new products and lines of business.|
|·||The Company’s success at managing the risks involved in the foregoing items.|
Forward-looking statements speak only as of the date on which such statements are made. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.
This Item 7 presents information to assess the financial condition and results of operations of First Defiance. This item should be read in conjunction with the Consolidated Financial Statements and the supplemental financial data contained elsewhere in this Annual Report on Form 10-K.
Non-GAAP Financial Measures
This Annual Report on Form 10-K contains GAAP financial measures and certain non-GAAP financial measures. Management believes that these measures are helpful in understanding the Company’s results of operations or financial position. Fully taxable-equivalent (“FTE”) is an adjustment to net interest income to reflect tax-exempt income on an equivalent before-tax basis. The following tables present a reconciliation of non-GAAP measures to their respective GAAP measures at December 31, 2018 and 2017.
Non-GAAP Financial Measures – Net Interest Income on an
FTE basis, Net Interest Margin and Efficiency Ratio
|(In Thousands)||December 31,|
|Net interest income (GAAP)||$||108,255||$||96,671|
|Add: FTE adjustment||1,004||1,914|
|Net interest income on a FTE basis (1)||$||109,259||$||98,585|
|Noninterest income – less securities gains/(losses) (2)||$||39,035||$||39,497|
|Noninterest expense (3)||89,412||85,351|
|Average interest-earning assets less average unrealized gains/(losses) on securities(4)||2,744,752||2,542,129|
|Average interest-earning assets||2,741,215||2,545,261|
|Average unrealized gains/losses on securities||(3,537||)||3,132|
|Net interest margin (1) / (4)||3.98||%||3.88||%|
|Efficiency ratio (3) / (1) + (2)||60.29||%||61.81||%|
Non-GAAP Financial Measures – Tangible Book Value
|(In Thousands, except per share data)||December 31,|
|Total Shareholders’ Equity (GAAP)||$||399,589||$||373,286|
|Tangible common equity (1)||$||296,629||$||269,014|
|Common shares outstanding (2)||20,171||20,312|
|Tangible book value per share (1) / (2)||$||14.71||$||13.24|
First Defiance is a unitary thrift holding company that conducts business through its wholly-owned subsidiaries, First Federal, First Insurance and First Defiance Risk Management.
First Federal is a federally chartered stock savings bank that provides financial services to communities based in northwest Ohio, northeast Indiana, and southeastern Michigan where it operates 44 full service banking centers in fourteen northwest and central Ohio counties, one northeast Indiana county, and one southeastern Michigan county. First Federal operates one loan production office in Ann Arbor, Michigan, which is located in Washtenaw County.
First Federal provides a broad range of financial services including checking accounts, savings accounts, certificates of deposit, real estate mortgage loans, commercial loans, consumer loans, home equity loans and trust and wealth management services through its extensive branch network.
First Insurance sells a variety of property and casualty, group health and life and individual health and life insurance products. First Insurance is an insurance agency that conducts business throughout First Federal’s Markets. The previous Maumee and Oregon, Ohio offices were consolidated into a new office in Sylvania, Ohio, in January 2018.
First Defiance Risk Management is a wholly owned insurance company subsidiary of the Company to insure the Company and its subsidiaries against certain risks unique to the operations of the Company and for which insurance may not be currently available or economically feasible in today’s insurance marketplace. First Defiance Risk Management pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. First Defiance Risk Management was incorporated on December 20, 2012.
On June 22, 2018, the Company announced a stock split in the form of a share distribution of two common shares for each outstanding common share. The stock split was distributed on July 12, 2018, to shareholders of record as of July 2, 2018. All share and per share data in this Form 10-K have been adjusted and are reflective of the stock split.
Assets at December 31, 2018, totaled $3.18 billion compared to $2.99 billion at December 31, 2017, an increase of $188.3 million or 6.3%. The increase in assets was primarily due to an increase in loans receivable, net of undisbursed loan funds and deferred fees and costs, of $191.3 million, and an increase in securities of $33.3 million. These increases were funded primarily by an increase in total deposits of $183.2 million.
The securities portfolio increased $33.3 million to $294.6 million at December 31, 2018. The 2018 activity in the portfolio included $76.6 million of purchases, which were partially offset by $1.2 million of amortization, $32.7 million of principal pay-downs and maturities, and $5.5 million of securities being sold. There was a net loss of $3.5 million in the market value of available-for-sale securities. For additional information regarding First Defiance’s investment securities see Note 5 to the Consolidated Financial Statements.
Loans receivable, net of undisbursed loan funds and deferred fees and costs, increased $191.3 million to $2.54 billion at December 31, 2018. For more details on the loan balances, see Note 7 – Loans Receivable to the Consolidated Financial Statements.
The majority of First Defiance’s commercial real estate and commercial loans are to small- and mid-sized businesses. The combined commercial, commercial real estate and multi-family real estate loan portfolios totaled $1.85 billion and $1.76 billion at December 31, 2018 and 2017, respectively, and accounted for approximately 71.8% and 71.4% of First Defiance’s loan portfolio at the end of those respective periods. First Defiance believes it has been able to establish itself as a leader in its market area in the commercial and commercial real estate lending area by hiring experienced lenders and providing a high level of customer service to its commercial lending clients.
The 1-4 family residential portfolio totaled $322.7 million at December 31, 2018, compared with $274.9 million at the end of 2017. At the end of 2018, those loans comprised 12.1% of the total loan portfolio, up from 11.1% at December 31, 2017.
Construction loans, which include one-to-four family and commercial real estate properties, increased to $265.8 million at December 31, 2018, compared to $265.5 million at December 31, 2017. These loans accounted for approximately 10.0% and 10.8% of the total loan portfolio at December 31, 2018 and 2017, respectively.
Home equity and home improvement loans decreased to $128.2 million at December 31, 2018, from $135.5 million at the end of 2017. At the end of 2018, those loans comprised 4.8% of the total loan portfolio, down from 5.5% at December 31, 2017.
Consumer finance and mobile home loans were $34.4 million at December 31, 2018 up from $29.1 million at the end of 2017. These loans accounted for approximately 1.3% and 1.2% of the total loan portfolio at December 31, 2018 and 2017, respectively.
In order to properly assess the collateral dependent loans included in its loan portfolio, the Company has established policies regarding the monitoring of the collateral underlying such loans. The Company requires an appraisal that is less than one year old for all new collateral dependent real estate loans, and all renewed collateral dependent real estate loans where significant new money is extended. The appraisal process is handled by the Credit Department, which selects the appraiser and orders the appraisal. First Defiance’s loan policy prohibits the account officer from talking or communicating with the appraiser to insure that the appraiser is not influenced by the account officer in any way in making a determination of value.
First Federal generally does not require updated appraisals for performing loans unless significant new money is requested by the borrower.
When a collateral dependent loan is downgraded to classified status, First Federal reviews the most current appraisal on file and if appropriate, based on First Federal’s assessment of the appraisal, such as age, market, etc. First Federal will discount the appraisal amount to a more appropriate current value based on inputs from lenders and realtors. This amount may then be discounted further by First Federal’s estimation of the selling costs. In most instances, if the appraisal is more than twelve to fifteen months old, a new appraisal may be required. Finally, First Federal assesses whether there is any collateral short fall, taking into consideration guarantor support and liquidity, and determines if a charge-off is necessary.
All loans over 90 days past due and/or on non-accrual are classified as non-performing loans. Non-performing status automatically occurs in the month in which the 90-day delinquency occurs. When a collateral dependent loan moves to non-performing status, First Federal generally gets a new third party appraisal and charges the loan down appropriately based upon the new appraisal and an estimate of costs to liquidate the collateral. All properties that are moved into the Other Real Estate Owned (“OREO”) category are supported by current appraisals, and the OREO is carried at the lower of cost or fair value, which is determined based on appraised value less First Federal’s estimate of the liquidation costs.
First Federal does not adjust any appraisals upward without written documentation of this valuation change from the appraiser. When setting reserves and charge-offs on classified loans, appraisal values may be discounted downward based upon First Federal’s experience with liquidating similar properties.
Appraisals are received within approximately 60 days after they are requested. The First Federal Loan Loss Reserve Committee reviews the amount of each new appraisal and makes any necessary charge-off decisions at its meeting prior to the end of each quarter.
Any partially charged-off collateral dependent loans are considered non-performing, and as such, would need to show an extended period of time with satisfactory payment performance as well as cash flow coverage capability supported by current financial statements before First Federal will consider an upgrade to performing status. First Federal may consider moving the loan to accruing status after approximately six months of satisfactory payment performance.
First Federal monitors and tracks its loan to value quarterly to determine accuracy and any necessary charge-offs. Based on these results, changes may occur in the processes used.
Loan modifications constitute a troubled debt restructuring (“TDR”) if First Federal, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. For loans that are considered TDRs and the balance is over $250,000, First Federal either computes the present value of expected future cash flows discounted at the original loan’s effective interest rate or it may measure impairment based on the fair value of the collateral. For those loans measured for impairment utilizing the present value of future cash flows method, any discount is carried as a specific reserve in the allowance for loan and lease losses. For those loans measured for impairment utilizing the fair value of the collateral, any shortfall is charged-off. For loans that are considered TDRs and the balance is under $250,000 a specific reserve is carried in the allowance for loan and lease losses based on a general reserve analysis. As of December 31, 2018, and December 31, 2017, First Federal had $11.6 million and $13.8 million, respectively, of loans that were still performing and which were classified as TDRs.
Allowance for Loan Losses
The allowance for loan losses represents management’s assessment of the estimated probable incurred credit losses in the loan portfolio at each balance sheet date. Management analyzes the adequacy of the allowance for loan losses regularly through reviews of the loan portfolio. Consideration is given to economic conditions, changes in interest rates and the effect of such changes on collateral values and borrower’s ability to pay, changes in the composition of the loan portfolio and trends in past due and non-performing loan balances. The allowance for loan losses is a material estimate that is susceptible to significant fluctuation and is established through a provision for loan losses based on management’s evaluation of the inherent risk in the loan portfolio. In addition to extensive in-house loan monitoring procedures, the Company utilizes an outside party to conduct an independent loan review of commercial loan and commercial real estate loan relationships. The goal is to have approximately 55% to 60% of the portfolio reviewed annually. This includes all relationships over $5.0 million with new exposure greater than $2.0 million and a sample of other relationships greater than $5.0 million; loan relationships between $1.0 million and $5.0 million with new exposure greater than $750,000 and a sample of other relationships between $1.0 million and $5.0 million; and a sample of relationships less than $1.0 million. Management utilizes the results of this outside loan review to assess the effectiveness of its internal loan grading system as well as to assist in the assessment of the overall adequacy of the allowance for loan losses associated with these types of loans.
The allowance for loan loss is made up of two basic components. The first component of the allowance for loan loss is the specific reserve in which the Company sets aside reserves based on the analysis of individual impaired credits. In establishing specific reserves, the Company analyzes all substandard, doubtful and loss graded loans quarterly and makes judgments about the risk of loss based on the cash flow of the borrower, the value of any collateral and the financial strength of any guarantors. For loans that are considered impaired and the balance is over $250,000, First Federal either computes the present value of expected future cash flows discounted at the original loan’s effective interest rate or it may measure impairment based on the fair value of the collateral. For those loans measured for impairment utilizing the present value of future cash flows method, any discount is carried as a specific reserve in the allowance for loan and lease losses. For those loans measured for impairment utilizing the fair value of the collateral, any shortfall is usually charged-off. For loans that are considered impaired and the balance is under $250,000 a specific reserve is carried in the allowance for loan and lease losses based on a general reserve analysis. The Company also considers the impacts of any Small Business Association or Farm Service Agency guarantees. The specific reserve was $595,000 at December 31, 2018, and $758,000 at December 31, 2017.
The second component is a general reserve, which is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolio based on quantitative and qualitative factors. For purposes of the general reserve analysis, the loan portfolio is stratified into nine different loan pools based on loan type to allocate historic loss experience. The loss experience factor is then applied to the non-impaired loan portfolio. The Company utilizes loss migration measurement for each loan portfolio segment with differentiation between loan risk grades in calculating the general reserve component for non-impaired loans. Beginning December 31, 2016, the historical loss calculation was changed from using a an average of four (4) four-year loss migration periods to using an average of all four-year loss migration periods to the present beginning with data from the second quarter 2011. Management believes this enhancement is consistent with the rationale of the previous measurement but provides a more precise calculation of historical losses by incorporating more data points for the average loss ratio and including periods that provide a more complete coverage of the full business cycle. Management believes that capturing the risk grade changes and cumulative losses over the life cycle of a loan more accurately depicts management’s estimate of historical losses as well as being more reflective of the ongoing risks in the loan portfolio.
The quantitative general allowance remained steady at $5.9 million at December 31, 2018, from $6.0 million at December 31, 2017, due to relatively small changes in the historical loss rates from the migration analysis.
In addition to the quantitative analysis, a qualitative analysis is performed each quarter to provide additional general reserves on the non-impaired loan portfolio for various factors. The overall qualitative factors are based on nine sub-factors. The nine sub-factors have been aggregated into three qualitative factors: economic, environment and risk.
|1)||Changes in international, national and local economic business conditions and developments, including the condition of various market segments.|
|2)||Changes in the value of underlying collateral for collateral dependent loans.|
|3)||Changes in the nature and volume in the loan portfolio.|
|4)||The existence and effect of any concentrations of credit and changes in the level of such concentrations.|
|5)||Changes in lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices.|
|6)||Changes in the quality and breadth of the loan review process.|
|7)||Changes in the experience, ability and depth of lending management and staff.|
|8)||Changes in the trends of the volume and severity of delinquent and classified loans, and changes in the volume of non-accrual loans, trouble debt restructuring, and other loan modifications.|
|9)||Changes in the political and regulatory environment.|
The qualitative analysis at December 31, 2018, indicated a general reserve of $21.8 million compared with $20.0 million at December 31, 2017, an increase of $1.8 million. Management reviews the overall economic, environmental and risk factors quarterly and determines appropriate adjustments to these sub-factors based on that review.
The economic factors for all loan segments decreased in 2018 primarily due to strengthening trends in the U.S. economy, particularly unemployment rates, which decreased in all markets.
The environmental factors increased in 2018 for all loan segments. This is principally due to an increase in credit concentrations and an increase in the mix of lending in First Federal’s defined metro markets.
The risk factors decreased in 2018 in most loan segments with the largest decrease being in commercial. This is due to favorable trends in the levels of non-performing loans and classified assets.
First Defiance’s general reserve percentages for main loan segments not otherwise classified ranged from 0.48% for construction loans to 1.50% for home equity and improvement loans.
As a result of the quantitative and qualitative analysis, along with the change in specific reserves, the Company’s provision for loan losses for 2018 was $1.2 million compared to $2.9 million for 2017. The allowance for loan losses was $28.3 million at December 31, 2018, and $26.7 million at December 31, 2017, and represented 1.12% and 1.14% of loans, net of undisbursed loan funds and deferred fees and costs, respectively. The provision was offset by charge-offs of $2.9 million and recoveries of $3.3 million resulting in an increase to the overall allowance for loan loss of $1.6 million. In management’s opinion, the overall allowance for loan losses of $28.3 million as of December 31, 2018, is adequate.
Management also assesses the value of OREO as of the end of each accounting period and recognizes write-downs to the value of that real estate in the income statement if conditions dictate. In 2018, First Defiance recorded OREO write-downs that totaled $552,000. These amounts were included in other noninterest expense. Management believes that the values recorded at December 31, 2018, for OREO and repossessed assets represent the realizable value of such assets.
Total classified loans decreased from $59.4 million at December 31, 2017 to $50.8 million at December 31, 2018, a reduction of $8.6 million, due to payoffs and an upgrade of a large classified relationship during 2018.
First Defiance’s ratio of allowance for loan losses to non-performing loans was 149.0% at December 31, 2018, compared with 86.9% at December 31, 2017. Management monitors collateral values of all loans included on the watch list that are collateral dependent and believes that allowances for those loans at December 31, 2018, are appropriate.
At December 31, 2018, First Defiance had total non-performing assets of $20.2 million, compared to $32.2 million at December 31, 2017. Non-performing assets include loans that are 90 days past due, OREO and other assets held for sale.
The decrease in non-performing assets between December 31, 2018, and December 31, 2017, is primarily in commercial loans and commercial real estate loans. The balance of commercial non-performing loans was $4.3 million lower at December 31, 2018, compared to December 31, 2017. The balance of commercial real estate loans was $7.9 million lower at December 31, 2018, compared to December 31, 2017.
Non-performing loans in the 1-4 family residential, commercial real estate and commercial loan categories represent 1.13%, 0.74% and 0.88% of the total loans in those categories respectively at December 31, 2018, compared to 1.10%, 1.47% and 1.68% respectively for the same categories at December 31, 2017. Management believes that the current allowance for loan losses is appropriate and that the provision for loan losses recorded in 2018 is consistent with both charge-off experience and the risk inherent in the overall credits in the portfolio.
First Federal’s Asset Review Committee meets monthly to review the status of work-out strategies for all criticized relationships, which include all non-accrual loans. Based on such factors as anticipated collateral values in liquidation scenarios, cash flow projections, assessment of net worth of guarantors and all other factors which may mitigate risk of loss, the Asset Review Committee makes recommendations regarding proposed charge-offs which are approved by the Loan Loss Reserve Committee.
The net charge-offs and non-accrual loan balances as a percentage of total are presented in the table below at December 31, 2018 and 2017.
Table 1 – Net Charge-offs and Non-accruals by Loan Type
|For the Twelve Months Ended December 31, 2018||As of December 31, 2018|
|Net||% of Total Net|
|Charge-offs||Charge-offs||Non-accrual||% of Total Non-|
|(In Thousands)||(In Thousands)|
|Commercial real estate||610||129.24||%||10,357||54.47||%|
|Home equity and improvement||78||16.53||%||393||2.07||%|
|For the Twelve Months Ended December 31, 2017||As of December 31, 2017|
|Net||% of Total Net|
|Charge-offs||Charge-offs||Non-accrual||% of Total Non-|
|(In Thousands)||(In Thousands)|
|Commercial real estate||(260||)||(12.09||)%||18,219||59.32||%|
|Home equity and improvement||134||6.23||%||590||1.92||%|
The following table sets forth information concerning the allocation of First Defiance’s allowance for loan losses by loan categories at December 31, 2018 and 2017.
Table 2 – Allowance for Loan Loss Allocation by Loan Category
|December 31, 2018||December 31, 2017|
|Percent of||Percent of|
|total loans||total loans|
|Amount||by category||Amount||by category|
|(Dollars in Thousands)|
|1-4 family residential||$||2,881||12.1||%||$||2,532||11.1||%|
|Multi-family residential real estate||3,101||10.4||2,702||10.1|
|Commercial real estate||12,041||42.3||10,354||40.0|
|Home equity and improvement loans||2,026||4.8||2,255||5.5|
Loans Acquired with Impairment
The Company has purchased loans, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.
As of December 31, 2018, the total contractual receivable for those loans was $2.5 million and the recorded value was $2.3 million.
High Loan-to-Value Mortgage Loans
The majority of First Defiance’s mortgage loans are collateralized by one-to-four-family residential real estate, have loan-to-value ratios of 80% or less, and are made to borrowers in good credit standing. First Federal usually requires residential mortgage loan borrowers whose loan-to-value is greater than 80% to purchase private mortgage insurance (“PMI”). Management also periodically reviews and monitors the financial viability of its PMI providers.
First Federal originates and retains a limited number of residential mortgage loans with loan-to-value ratios that exceed 80% where PMI is not required if the borrower possesses other demonstrable strengths. The loan-to-value ratios on these loans are generally limited to 85% and exceptions must be approved by First Federal’s Chief Credit Officer. Management monitors the balance of one-to-four family residential loans, including home equity loans and committed lines of credit that exceed certain loan to value standards (90% for owner occupied residences, 85% for non-owner occupied residences and one-to-four family construction loans, 75% for developed land and 65% for raw land). Total loans that exceed those standards described above at December 31, 2018, totaled $53.0 million, compared to $50.8 million at December 31, 2017. These loans are generally paying as agreed.
First Defiance does not make interest-only, first-mortgage residential loans, nor does it have residential mortgage loan products or other consumer products that allow negative amortization.
Goodwill and Intangible Assets
Goodwill was $98.6 million at December 31, 2018, and December 31, 2017. Core deposit intangibles and other intangible assets decreased to $4.4 million at December 31, 2018, compared to $5.7 million at December 31, 2017. During 2018, changes to the core deposit intangibles and other intangibles were due to the recognition of $1.3 million of amortization expense. No impairment of goodwill was recorded in 2018 or 2017.
Total deposits at December 31, 2018, were $2.62 billion compared to $2.44 billion at December 31, 2017, an increase of $183.2 million or 7.5%. Noninterest-bearing checking accounts grew by $35.8 million, interest-bearing checking accounts and money markets grew by $35.0 million, savings decreased by $9.2 million and retail certificates of deposit grew by $121.6 million. Management can utilize the national market for certificates of deposit to supplement its funding needs if necessary. For more details on the deposit balances in general see Note 11 – Deposits to the Consolidated Financial Statements.
FHLB advances totaled $85.2 million at December 31, 2018, compared to $84.3 million at December 31, 2017. The balance at the end of 2018 includes thirteen fixed-rate advances totaling $59.0 million with rates ranging from 1.14% to 2.50%, one amortizing advance of $1.2 million with a rate of 2.14% and one overnight advance of $25.0 million with a rate of 2.45%.
At December 31, 2018, First Defiance also had $5.7 million of securities that were sold with agreements to repurchase, compared to $26.0 million at December 31, 2017.
Total stockholders’ equity increased $26.3 million to $399.6 million at December 31, 2018, compared to $373.3 million at December 31, 2017. The increase in stockholders’ equity was the result of recording net income of $46.2 million. This was partially offset by the payment of $13.0 million of common stock dividends, the repurchase of 231,160 shares of common stock totaling $6.3 million and other comprehensive loss of $2.4 million.
Results of Operations
First Defiance reported net income of $46.2 million for the year ended December 31, 2018, compared to $32.3 million and $28.8 million for the years ended December 31, 2017 and 2016, respectively. On a diluted per common share basis, First Defiance earned $2.26 in 2018, $1.61 in 2017 and $1.60 in 2016.
Net Interest Income
First Defiance’s net interest income is determined by its interest rate spread (i.e. the difference between the yields on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.
Net interest income was $108.3 million for the year ended December 31, 2018, compared to $96.7 million and $78.9 million for the years ended December 31, 2017 and 2016, respectively. The tax-equivalent net interest margin was 3.98%, 3.88% and 3.74% for the years ended December 31, 2018, 2017 and 2016, respectively. The margin increased 10 basis points between 2017 and 2018. The increase in margin in 2018 was primarily due to the increase in interest rates as the federal rate hikes impacted asset yields more favorably than deposit costs as well as the mix of our noninterest-bearing balances. Interest-earning asset yields increased 26 basis points (to 4.59% in 2018 from 4.33% in 2017) and the cost of interest- bearing liabilities between the two periods increased 21 basis points (to 0.80% in 2018 from 0.59% in 2017).
Total interest income increased by $16.6 million or 15.4% to $124.7 million for the year ended December 31, 2018, from $108.1 million for the year ended December 31, 2017. This is due to solid loan growth, the increase in interest rates and a more profitable earning asset mix. Interest income from loans increased to $114.4 million for 2018 compared to $99.5 million in 2017, which represents an increase of 14.9%. The average balance of loans receivable increased $184.3 million to $2.4 billion at December 31, 2018, from $2.2 billion at December 31, 2017.
During the same period, the average balance of investment securities increased to $280.0 million in 2018 from $258.8 million for the year ended December 31, 2017. Interest income from investment securities increased to $8.1 million in 2018 compared to $6.9 million in 2017, which represents an increase of 17.1%. The overall duration of investments increased to 4.29 years at December 31, 2018, from 3.40 years at December 31, 2017.
Interest expense increased by $5.0 million in 2018 compared to 2017, to $16.5 million from $11.4 million. This increase was mainly due to a 21 basis point increase in the average cost of interest-bearing liabilities in 2018 and a $127.5 million increase in the average balance of interest-bearing liabilities. The average balance of interest-bearing deposits increased $175.3 million to $1.95 billion at December 31, 2018, from $1.77 billion at December 31, 2017. Interest expense related to interest-bearing deposits was $13.9 million in 2018 compared to $8.8 million in 2017.
Interest expenses on FHLB advances and other interest-bearing funding sources were $1.3 million and $23,000 respectively, in 2018 and $1.5 million and $208,000 respectively in 2017. The decrease in FHLB advance expense was due to a $28.7 million decrease in the average balance of FHLB advances to $73.4 million at December 31, 2018, compared to $102.2 million at December 31, 2017. The decrease in average balances of FHLB advances offset an increase in the rate paid on FHLB advances as it increased to 1.72% at December 31, 2018, from 1.44% at December 31, 2017. Interest expense recognized by the Company related to subordinated debentures was $1.3 million in 2018 and $935,000 in 2017 due to rising rates.
Total interest income increased by $20.7 million or 23.7% to $108.1 million for the year ended December 31, 2017, from $87.4 million for the year ended December 31, 2016. This is primarily due to continued loan growth, the CSB acquisition, the increase in interest rates and a more profitable earning asset mix. Interest income from loans increased to $99.5 million for 2017 compared to $80.2 million in 2016, which represents an increase of 24.1%. The average balance of loans receivable increased $345.2 million to $2.2 billion at December 31, 2017, from $1.9 billion at December 31, 2016, due primarily to the CSB acquisition.
During the same period, the average balance of investment securities increased to $258.8 million in 2017 from $233.4 million for the year ended December 31, 2016. Interest income from investment securities increased to $6.9 million in 2017 compared to $6.2 million in 2016, which represents an increase of 11.1%. The overall duration of investments increased to 3.40 years at December 31, 2017, from 3.38 years at December 31, 2016.
Interest expense increased by $3.0 million in 2017 compared to 2016, to $11.4 million from $8.4 million. This increase was mainly due to a seven basis point increase in the average cost of interest-bearing liabilities in 2017 and a $297.3 million increase in the average balance of interest-bearing liabilities. The average balance of interest-bearing deposits increased $305.9 million to $1.77 billion at December 31, 2017, from $1.46 billion at December 31, 2016, primarily due to the CSB acquisition. Interest expense related to interest-bearing deposits was $8.8 million in 2017 compared to $6.3 million in 2016.
Interest expenses on FHLB advances and other interest-bearing funding sources were $1.5 million and $208,000 respectively, in 2017 and $1.3 million and $138,000 respectively in 2016. The increase in FHLB advance expense was primarily due to rising interest rates and a $16.3 million increase in the average balance of FHLB advances to $102.2 million at December 31, 2017, compared to $85.9 million at December 31, 2016. Interest expense recognized by the Company related to subordinated debentures was $935,000 in 2017 and $753,000 in 2016 due to rising rates.
The following table shows an analysis of net interest margin on a tax equivalent basis for the years ended December 31, 2018, 2017 and 2016:
Table 3 – Net Interest Margin
|Year Ended December 31|
|Loans receivable (5)||$||2,382,941||$||114,500||4.80||%||$||2,198,639||$||99,742||4.54||%||$||1,853,419||$||80,423||4.34||%|
|Total interest-earning assets||2,741,215||125,721||4.59||%||2,545,261||110,016||4.33||%||2,168,046||89,213||4.13||%|
|Total interest-bearing liabilities||2,063,565||16,462||0.80||%||1,936,026||11,431||0.59||%||1,638,713||8,440||0.52||%|
|Noninterest-bearing demand deposits||562,439||-||528,926||-||441,731||-|
|Total including non- interest- bearing demand deposits||2,626,004||16,462||0.63||%||2,464,952||11,431||0.46||%||2,080,444||8,440||0.41||%|
|Other noninterest liabilities||38,216||35,343||31,361|
|Total liabilities and stockholders’ equity||$||3,048,525||$||2,851,531||$||2,397,439|
|Net interest income; interest rate spread (3)||$||109,259||3.79||%||$||98,585||3.74||%||$||80,773||3.61||%|
|Net interest margin (4)||3.98||%||3.88||%||3.74||%|
|Average interest-earning assets to average interest-bearing liabilities||132.8||%||131.5||%||132.3||%|
|(1)||Interest on certain tax exempt loans (amounting to $380,000, $375,000 and $383,000 in 2018, 2017 and 2016, respectively) and tax-exempt securities ($3.4 million, $3.2 million and $3.0 million in 2018, 2017, and 2016, respectively) is not taxable for Federal income tax purposes. The average balance of such loans was $10.5 million, $11.5 million and $11.8 million in 2018, 2017, and 2016, respectively, while the average balance of such securities was $98.2 million, $91.2 million and $83.4 million in 2018, 2017, and 2016, respectively. In order to compare the tax-exempt yields on these assets to taxable yields, the interest earned on these assets is adjusted to a pre-tax equivalent amount based on the marginal corporate federal income tax rate of 21% for 2018 and 35% for 2017 and 2016.|
|(2)||At December 31, 2018, the yields earned and rates paid were as follows: loans receivable, 4.80%; securities, 3.32%; FHLB stock, 6.00%; total interest-earning assets, 4.66%; deposits, 0.57%; FHLB advances, 1.88%; other borrowings, 0.26%, subordinated debentures, 4.22%; total including non- interest-bearing liabilities, 0.66%; and interest rate spread, 3.99%.|
|(3)||Interest rate spread is the difference in the yield on interest-earning assets and the cost of interest-bearing liabilities.|
|(4)||Net interest margin is net interest income divided by average interest-earning assets excluding average unrealized gains/losses. See Non-GAAP Financial Measure discussion for further details.|
|(5)||For the purpose of the computation for loans, non-accrual loans are included in the average loans outstanding.|
(6) Securities yield = annualized interest income divided by the average balance of securities, excluding average unrealized gains/losses.
See Non-GAAP Financial Measure discussion for further details.
The following table describes the extent to which changes in interest rates and changes in volume of interest-related assets and liabilities have affected First Defiance’s tax-equivalent interest income and interest expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) change in rate (change in rate multiplied by prior year volume), and (iii) total change in rate and volume. The combined effect of changes in both rate and volume has been allocated proportionately to the change due to rate and the change due to volume.
Table 4 – Changes in Interest Rates and Volumes (1)
|Year Ended December 31|
|2018 vs. 2017||2017 vs. 2016|
|Total interest-earning assets||$||6,506||$||9,199||$||15,705||$||4,319||$||16,484||$||20,803|
|Total interest- bearing liabilities||$||4,644||$||387||$||5,031||$||1,415||$||1,576||$||2,991|
|Increase in net interest income||$||10,674||$||17,812|
|(1)||The change in interest rates due to both rate and volume has been allocated between the factors in proportion to the relationship of the absolute dollar amounts of the change in each.|
Provision for Loan Losses – First Defiance’s provision for loan losses was $1.2 million for the year ended December 31, 2018, compared to $2.9 million for December 31, 2017, and $283,000 for December 31, 2016.
Provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level deemed appropriate by management to absorb probable losses incurred in the loan portfolio. Factors considered by management include identifiable risk in the portfolios, historical experience, the volume and type of lending conducted by First Defiance, the amount of non-performing loans (including loans which meet the FASB ASC Topic 310 definition of impaired), the amount of loans graded by management as substandard, doubtful, or loss, general economic conditions (particularly as they relate to First Defiance’s market areas) and other factors related to the collectability of First Defiance’s loan portfolio. See also Allowance for Loan Losses in this Management’s Discussion and Analysis and Note 7 to the Consolidated Financial Statements.
Noninterest Income – Noninterest income decreased by $873,000 or (2.2%) in 2018 to $39.2 million from $40.1 million for the year ended December 31, 2017. That followed an increase of $6.1 million or 17.8% in 2017 from $34.0 million in 2016.
Service fees and other charges increased to $13.1 million for the year ended December 31, 2018, from $12.1 million for 2017 and increased from $10.9 million for 2016. The increase in service fees and other charges in 2018 and 2017 from 2016 is primarily due to increased number of deposit accounts and the CSB acquisition in 2017.
First Federal’s overdraft privilege program generally provides for the automatic payment of modest overdraft limits on all accounts deemed to be in good standing when the account is accessed using paper-based check processing, a teller withdrawal, a point-of-sale terminal, an automated clearing house (“ACH”) transaction, an online banking or voice-response transfer, or an automated teller machine (“ATM”). To be in good standing, an account must be brought to a positive balance within a 30-day period and have not excessively used the overdraft privilege program. Overdraft limits are established for all customers without discrimination using a risk assessment approach for each account classification. The approach includes a systematic review and evaluation of the normal deposit flows made to each account classification to establish reasonable and prudent negative balance limits that would be routinely repaid by normal, expected and reoccurring deposits. The risk assessment by portfolio approach assumes a minimal degree of undetermined credit risk associated with unidentified individual accounts that are overdrawn for 30 or more days. Consumer accounts overdrawn for more than 60 days are automatically charged off. Fees are charged as a one-time fee per occurrence, up to five charges per day, and the fee charged for an item that is paid is equal to the fee charged for a non-sufficient fund item that is returned.
Overdrawn balances, net of allowance for losses, are reflected as loans on First Defiance’s balance sheet. The fees charged for this service are established based both on the return of processing costs plus a profit, and on the level of fees charged by competitors in the Company’s market area for similar services. These fees are considered to be compensation for providing a service to the customer and therefore deemed to be noninterest income rather than interest income. Fee income recorded for the years ending December 31, 2018 and 2017, related to the overdraft privilege product, net of adjustments to the allowance for uncollectible overdrafts, were both $2.8 million, respectively. Accounts charged-off are included in noninterest expense. The allowance for uncollectible overdrafts was $34,000 at December 31, 2018, and $24,000 at December 31, 2017.
Noninterest income also includes gains, losses and impairment on investment securities. In 2018, First Defiance realized a $173,000 gain on sale of securities. In 2017, a $584,000 gain was recognized compared to a $509,000 gain in 2016.
Mortgage banking income includes gains from the sale of mortgage loans, fees for servicing mortgage loans for others, an offset for amortization of mortgage servicing rights, and adjustments for impairment in the value of mortgage servicing rights. Mortgage banking income totaled $7.1 million, $7.0 million and $7.3 million in 2018, 2017 and 2016, respectively. The $73,000 increase in 2018 from 2017 is attributable to a decrease of $123,000 in mortgage servicing rights amortization expense along with a $70,000 increase in servicing revenue and a $42,000 positive change in the valuation adjustments on mortgage servicing rights. This was partially offset by a $162,000 decrease in the gain on sale of loans. First Defiance originated $205.9 million of residential mortgages for sale into the secondary market in 2018 compared with $213.5 million in 2017. The balance of the mortgage servicing right valuation allowance was $300,000 at the end of 2018.
The $266,000 decrease in 2017 from 2016 is attributable to a $647,000 decrease in the gain on sale of loans, along with a $33,000 negative change in the valuation adjustments on mortgage servicing rights. These were partially offset by a decrease of $260,000 in mortgage servicing rights amortization expense along with a $154,000 increase in servicing revenue. First Defiance originated $213.5 million of residential mortgages for sale into the secondary market in 2017 compared with $263.7 million in 2016. The balance of the mortgage servicing right valuation allowance was $432,000 at the end of 2017. See Note 8 to the Consolidated Financial Statements.
Gains on the sale of non-mortgage loans, which include SBA and FSA loans, totaled $317,000 in 2018 compared to $217,000 in 2017 and $753,000 in 2016. The volume of eligible SBA loans decreased in 2018 and 2017 from levels in 2016.
Insurance commission income increased $1.2 million or 9.5% to $14.1 million in 2018 from $12.9 million in 2017 mainly due to having a full year results of the Corporate One acquisition and an increase in general production in the property and casualty and group employee benefits lines of business. Insurance commission income increased $2.4 million or 23.2% to $12.9 million in 2017 from $10.4 million in 2016 mainly due to the acquisition of Corporate One.
Income from bank owned life insurance decreased $1.3 million in 2018 to $1.8 million from $3.1 million in 2017. In 2017, the Company surrendered an underperforming BOLI policy and recorded a tax penalty of $1.7 million (recorded in income tax expense) and purchased a new BOLI policy receiving a $1.5 million enhancement value gain. The increase to $3.1 million in 2017 from $909,000 in 2016 is also due to the enhancement value gain.
Trust income decreased $241,000 to $2.1 million in 2018 from $2.3 million in 2017 and $1.7 million. The decrease in 2018 is due to a $428,000 positive accrual adjustment recorded in 2017 to bring trust fees to an accrual basis of accounting.
Other income decreased $1.3 million to $598,000 in 2018 compared to $1.9 million in 2017 and $1.5 million in 2016. The $1.3 million decrease in 2018 included a $388,000 decrease in deferred compensation plan assets compared to a $377,000 increase for the same period in 2017 due to stock market performance in 2018. The $316,000 increase in 2017 is due mainly to group benefit referral fees.
Noninterest Expense – Total noninterest expense for 2018 was $89.4 million compared to $85.4 million for the year ended December 31, 2017, and $71.1 million for the year ended December 31, 2016.
Compensation and benefits increased $2.8 million or 5.5% to $52.6 million from $49.8 million in 2017. The increase is mainly related to merit increases and investing some of the benefits of lower tax rates in support of our metro market growth strategies. Occupancy expense increased $934,000, to $8.6 million in 2018 compared to $7.7 million in 2017 and data processing expense increased $818,000 to $8.6 million in 2018 from $7.7 million in 2017 both increases primarily related to our metro market growth initiatives. Other noninterest expenses decreased $181,000 to $18.6 million in 2018 from $18.8 million in 2017. This decrease is due to an $806,000 benefit from the deferred compensation accounting correction as well as a $1.2 million reduction year over year due to the decline in the liabilities of the deferred compensation plan as a result of the stock market performance in the fourth quarter of 2018. See Note 19 to the Consolidation Financial Statements for further details.
Compensation and benefits increased $9.7 million or 24.0% to $49.8 million from $40.2 million in 2016. The increase is mainly related to personnel expenses both from certain benefit payouts associated with the CSB merger as well as operating the new CSB and Corporate One locations, merit increases and other new staff for growth strategies. Other noninterest expenses increased $2.8 million or 17.5% to $18.8 million in 2017 from $16.0 million in 2016. This is due mainly to $2.1 million increase in expenses associated with the acquisition of CSB and Corporate One, as well as an increase in the amortization of intangibles of $754,000. Occupancy expense increased $289,000, to $7.7 million in 2017 compared to $7.4 million in 2016 and data processing expense increased $1.4 million to $7.7 million in 2017 from $6.4 million in 2016.
Income Taxes – Income taxes totaled $10.6 million in 2018 compared to $16.2 million in 2017 and $12.8 million in 2016. The effective tax rates for those years were 18.7%, 33.4%, and 30.7%, respectively. The tax rate is lower than the statutory 21% and 35% tax rate for the Company mainly because of investments in tax-exempt securities. The increase in the effective tax rate in 2017 primarily relates to the surrender of a bank-owned life insurance policy which added $1.7 million to income tax expense. The earnings on tax-exempt securities are not subject to federal income tax. See Note 18 – Income Taxes to the Consolidated Financial Statements for further details.
Concentrations of Credit Risk
Financial institutions such as First Defiance generate income primarily through lending and investing activities. The risk of loss from lending and investing activities includes the possibility that losses may occur from the failure of another party to perform according to the terms of the loan or investment agreement. This possibility is known as credit risk.
Lending or investing activities that concentrate assets in a way that exposes the Company to a material loss from any single occurrence or group of occurrences increases credit risk. Diversifying loans and investments to prevent concentrations of risks is one way a financial institution can reduce potential losses due to credit risk. Examples of asset concentrations would include multiple loans made to a single borrower and loans of inappropriate size relative to the total capitalization of the institution. Management believes adherence to its loan and investment policies allows it to control its exposure to concentrations of credit risk at acceptable levels. First Defiance’s loan portfolio is concentrated geographically in its northwest and central Ohio, northeast Indiana, and southeast Michigan market areas. Management has also identified lending for income-generating rental properties as an industry concentration. Total loans for income-generating rental property totaled $982.5 million at December 31, 2018, which represents 37.9% of the Company’s loan portfolio. Management believes it has the skill and experience to manage any risks associated with this type of lending. Loans in this category are generally paying as agreed without any unusual or unexpected levels of delinquency. The delinquency rate in this category, which is any loan 30 days or more past due, was 0.03% at December 31, 2018. There are no other industry concentrations that exceed 10% of the Company’s loan portfolio.
Liquidity and Capital Resources
The Company’s primary source of liquidity is its core deposit base, raised through First Federal’s branch network, along with wholesale sources of funding and its capital base. These funds, along with investment securities, provide the ability to meet the needs of depositors while funding new loan demand and existing commitments.
Cash generated from operating activities was $53.1 million, $36.0 million and $27.0 million in 2018, 2017 and 2016, respectively. The adjustments to reconcile net income to cash provided by or used in operations during the periods presented consist primarily of proceeds from the sale of loans (less the origination of loans held for sale), the provision for loan losses, depreciation expense, the origination, amortization and impairment of mortgage servicing rights and increases and decreases in other assets and liabilities.
The primary investing activity of First Defiance is lending, which is funded with cash provided from operating and financing activities, as well as proceeds from payment on existing loans and proceeds from maturities of investment securities. In 2017 and 2016, the Company purchased $11.5 million and $822,000, respectively, in portfolio residential home loans. There were no purchases in 2018.
In considering the more typical investing activities, during 2018, $32.6 million and $5.5 million was generated from the combination of maturity or pay-downs and the sale or call of available-for-sale investment securities, respectively, and $220.0 million was used by an increase in loans while $76.6 million was used to purchase available-for-sale investment securities. During 2017, $32.7 million and $34.2 million was generated from the combination of maturity or pay-downs and the sale or call of available-for-sale investment securities, respectively, and $133.4 million was used by an increase in loans while $73.0 million was used to purchase available-for-sale investment securities. During 2016, $36.4 million and $14.9 million was generated from the combination of maturity or pay-downs and the sale or call of available-for-sale investment securities, respectively, and $158.1 million was used by an increase in loans while $71.3 million was used to purchase available-for-sale investment securities.
Principal financing activities include the gathering of deposits, the utilization of FHLB advances, and the sale of securities under agreements to repurchase such securities and borrowings from other banks. In 2018, total deposits increased by $183.2 million. Securities sold under repurchase arrangements decreased by $20.3 million in 2018. Also in 2018, the Company paid $13.0 million in common stock dividends and $6.3 million in common stock purchases. In 2017, total deposits increased by $148.1 million. Securities sold under repurchase arrangements decreased by $5.8 million in 2017. Also in 2017, the Company paid $9.9 million in common stock dividends. In 2016, total deposits increased by $145.5 million. Securities sold under repurchase arrangements decreased by $25.4 million in 2016. Also in 2016, the Company paid $7.9 million in common stock dividends and $6.3 million in common stock repurchases. For additional information about cash flows from First Defiance’s operating, investing and financing activities, see the Consolidated Statements of Cash Flows included in the Consolidated Financial Statements.
At December 31, 2018, First Defiance had the following commitments to fund deposit, advance, borrowing obligations and post-retirement benefits:
Table 5 – Contractual Obligations
|Maturity Dates by Period at December 31, 2018|
|Contractual Obligations||Total||Less than|
|1-3 years||3-5 years||More than|
|Certificates of deposit||$||680,384||$||417,562||$||216,319||$||46,503||-|
|FHLB fixed advances including interest (1)||86,747||45,926||36,870||3,388||563|
|Securities sold under repurchase agreements||5,741||5,741||-||-||-|
|Total contractual obligations||$||823,137||$||470,364||$||255,292||$||51,788||$||45,693|
(1) Includes principal payments of $85,189, interest payments of $1,534 and fair value adj. on acquired balances of $24.
At December 31, 2018, First Defiance had the following commitments to fund loan or line of credit obligations:
Table 6 – Commitments
|Total||Amount of Commitment Expiration by Period|
|1-3 years||3-5 years||More than|
|Fixed commitments to make loans||$||44,352||$||15,811||$||5,228||$||8,465||$||14,848|
|Variable commitments to make loans||114,308||8,876||14,914||31,197||59,321|
|Fixed unused lines of credit||7,523||4,150||1,777||1,164||432|
|Variable unused lines of credit||382,189||162,724||4,349||7,018||208,098|
|Total loan commitments||548,372||191,561||26,268||47,844||282,699|
|Standby letters of credit||7,239||7,209||30||-||-|
In addition to the above commitments, at December 31, 2018, First Defiance had commitments to sell $8.6 million of loans to Freddie Mac, Fannie Mae, or FHLB of Cincinnati.
To meet its obligations management can adjust the rate of savings certificates to retain deposits in changing interest rate environments; it can sell or securitize mortgage and non-mortgage loans; and it can turn to other sources of financing including FHLB advances, the Federal Reserve, and brokered certificates of deposit. At December 31, 2018, First Defiance had additional borrowing capacity of $447.4 million under its agreements with the FHLB.
First Federal is subject to various capital requirements of the OCC. At December 31, 2018, First Federal had capital ratios that exceeded the standard to be considered “well capitalized.” For additional information about First Defiance and First Federal’s capital requirements, see Note 17 – Regulatory Matters to the Consolidated Financial Statements.
Critical Accounting Policies and Estimates
First Defiance has established various accounting policies that govern the application of accounting principles generally accepted in the United States (“GAAP”) in the preparation of its Consolidated Financial Statements. The significant accounting policies of First Defiance are described in the footnotes to the Consolidated Financial Statements. Certain accounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of certain assets and liabilities; Management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and estimates, which could have a material impact on the carrying value of assets and liabilities and the results of operations of First Defiance.
Allowance for Loan Losses - First Defiance believes the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in preparation of its Consolidated Financial Statements. In determining the appropriate estimate for the allowance for loan losses, management considers a number of factors relative to both specific credits in the loan portfolio and macro-economic factors relative to the economy of the United States as a whole and the economy of the northwest and central Ohio, northeast Indiana and southeast Michigan regions in which the Company does business.
Factors relative to specific credits that are considered include a customer’s payment history, a customer’s recent financial performance, an assessment of the value of collateral held, knowledge of the customer’s character, the financial strength and commitment of any guarantors, the existence of any customer or industry concentrations, changes in a customer’s competitive environment and any other issues that may impact a customer’s ability to meet his obligations.
Economic factors that are considered include levels of unemployment and inflation, specific plant or business closings in the Company’s market area, the impact of strikes or other work stoppages, the impact of weather or environmental conditions, especially relative to agricultural borrowers, and other matters that may have an impact on the economy as a whole.
In addition to the identification of specific customers who may be potential credit problems, management considers its historical losses, the results of independent loan reviews, an assessment of the adherence to underwriting standards, and other factors in providing for loan losses that have not been specifically classified. Management believes that the level of its allowance for loan loss is sufficient to cover the estimates loss incurred but not yet recognized on the loan portfolio. Refer to Allowance for Loan Losses in this Management’s Discussion and Analysis and Note 2 - Statement of Accounting Policies for a further description of the Company’s estimation process and methodology related to the allowance for loan losses.
Valuation of Mortgage Servicing Rights - First Defiance believes the valuation of mortgage servicing rights is a critical accounting policy that requires significant estimates in preparation of its Consolidated Financial Statements. First Defiance recognizes as separate assets the value of mortgage servicing rights, which are acquired through loan origination activities. First Defiance does not purchase any mortgage servicing rights.
Key assumptions made by management relative to the valuation of mortgage servicing rights include the stratification policy used in valuing servicing, assumptions relative to future prepayments of mortgages, the potential value of any escrow deposits maintained or ancillary income received as a result of the servicing activity and discount rates used to value the present value of a future cash flow stream. In assessing the value of the mortgage servicing rights portfolio, management utilizes a third party that specializes in valuing servicing portfolios. That third party reviews key assumptions with management prior to completing the valuation. Prepayment speeds are determined based on projected median prepayment speeds for 15 and 30 year mortgage backed securities. Those speeds are then adjusted up or down based on the size of the loan. The discount rate used in this analysis is the pretax yield generally required by purchasers of bulk servicing rights as of the valuation date. The value of mortgage servicing rights is especially vulnerable in a falling interest rate environment. Refer also to the section entitled Mortgage Servicing Rights in this Management’s Discussion and Analysis and Note 2 - Statement of Accounting Policies and Note 8 - Mortgage Banking to the Consolidated Financial Statements, for a further description of First Defiance’s valuation process, methodology and assumptions along with sensitivity analyses.
Goodwill and Intangibles - First Defiance has two reporting units: First Federal and First Insurance. At December 31, 2018, First Defiance had goodwill of $98.6 million, including $80.0 million in First Federal, representing 81% of total goodwill and $18.6 million in First Insurance, representing 19% of total goodwill. The carrying value of goodwill is tested annually for impairment or more frequently if it is determined appropriate. The evaluation for impairment involves comparing the current estimated fair value of each reporting unit to its carrying value, including goodwill. If the current estimated fair value of a reporting unit exceeds its carrying value, no additional testing is required and impairment loss is not recorded. If the estimated fair value of a reporting unit is less than the carrying value, further valuation procedures are performed and could result in impairment of goodwill being recorded. Further valuation procedures would include allocating the estimated fair value to all assets and liabilities of the reporting unit to determine an implied goodwill value. If the implied value of goodwill of a reporting unit is less than the carrying amount of that goodwill, an impairment loss is recognized in an amount equal to that excess.
If, for any future period First Defiance determines that there has been impairment in the carrying value of goodwill balances, First Defiance will record a charge to earnings, which could have a material adverse effect on net income, but not risk-based capital ratios.
First Defiance has core deposit and other intangible assets resulting from acquisitions which are subject to amortization. First Defiance determines the amount of identifiable intangible assets based upon independent core deposit and customer relationship analyses at the time of the acquisition. Intangible assets with finite useful lives are evaluated for impairment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. No events or changes in circumstances that would indicate that the carrying amount of any identifiable intangible assets may not be recoverable had occurred during the years ended December 31, 2018 and 2017.
|Item 7A.||Quantitative and Qualitative Disclosures About Market Risk|
A significant portion of the Company’s revenues and net income is derived from net interest income and, accordingly, the Company strives to manage its interest-earning assets and interest-bearing liabilities to generate an appropriate contribution from net interest income. Asset and liability management seeks to control the volatility of the Company’s performance due to changes in interest rates. The Company attempts to achieve an appropriate relationship between rate sensitive assets and rate sensitive liabilities. First Defiance does not presently use off-balance sheet derivatives for risk management.
First Defiance monitors interest rate risk on a monthly basis through simulation analysis that measures the impact changes in interest rates can have on net interest income. The simulation technique analyzes the effect of a presumed 100 basis point shift in interest rates (which is consistent with management’s estimate of the range of potential interest rate fluctuations) and takes into account prepayment speeds on amortizing financial instruments, loan and deposit volumes and rates, non-maturity deposit assumptions and capital requirements. At December 31, 2018, the results of the simulation indicate that in an environment where interest rates rise 100 basis points over a 24 month period, First Defiance’s net interest income would increase by 2.88% over the base case scenario. It should be noted that other areas of First Defiance’s income statement, such as gains from sales of mortgage loans and amortization of mortgage servicing rights are also impacted by fluctuations in interest rates, but are not considered in the simulation of net interest income.
The majority of First Federal’s lending activities are in commercial real estate and commercial loan areas. In addition to carrying higher credit risk than residential mortgage lending, such loans tend to be more rate sensitive than residential mortgage loans. The balance of First Federal’s commercial real estate and multi-family real estate loan portfolio was $1.40 billion, which was split between $181.7 million of fixed-rate loans and $1.22 billion of adjustable-rate loans, at December 31, 2018. The commercial loan portfolio decreased to $509.6 million, which was split between $165.8 million of fixed-rate loans and $343.8 million of adjustable-rate loans, at December 31, 2018. Certain loans classified as adjustable have fixed rates for an initial term that may be as long as five years. The maturities on fixed-rate loans are generally less than seven years. First Federal also has $128.2 million of home equity and improvement loans at December 31, 2018, of which $116.8 million fluctuate with changes in the prime lending rate and $11.3 million have fixed rates. First Federal also has $34.4 million of consumer loans at December 31, 2018, which tend to have a shorter duration than residential mortgage loans. Also, to limit its interest rate risk, as well as to provide liquidity, First Federal sells a majority of its fixed-rate mortgage originations into the secondary market.
The table below presents, for the twelve months subsequent to December 31, 2018, and December 31, 2017, an estimate of the change in net interest income that would result from a gradual (ramp) and immediate (shock) change in interest rates, moving in a parallel fashion over the entire yield curve, relative to the measured base case scenario. Based on our net interest income simulation as of December 31, 2018, net interest income sensitivity to changes in interest rates for the twelve months subsequent to December 31, 2018, was slightly less liability sensitive for the ramp and shock compared to the sensitivity profile for the twelve months subsequent to December 31, 2017. The Company did not complete an earnings at risk analysis for the down 200 basis point change in rates as of December 31, 2017. Management noted the likelihood of a decrease beyond 100 basis points as of December 31, 2017, was considered to be unlikely given the interest rate levels at that time and therefore was not included in this analysis.