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Section 1: 10-K (ANNUAL REPORT)

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2012

 

OR

 

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from    _________     to    ___________

 

Commission file number 0-16759

FIRST FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

INDIANA   35-1546989
(State of Incorporation)   (I.R.S. Employer Identification Number)

One First Financial Plaza

Terre Haute, Indiana

 

 

47807

(Address of Registrant’s Principal Executive Offices)   (Zip Code)

 

(812) 238-6000

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class   Name of Exchange on Which Registered
Common Stock, no par value  

The NASDAQ Stock Market LLC

(NASDAQ Global Select Market)

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

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 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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post 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 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, or a smaller reporting company. See definition of “accelerated filer”, “large accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act of 1934.

 

Large accelerated filer ¨       Accelerated filer x       Non-accelerated filer ¨       Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

 

As of June 30, 2012 the aggregate market value of the stock held by non-affiliates of the registrant based on the average bid and ask prices of such stock was $375,338,651. (For purposes of this calculation, the Corporation excluded the stock owned by certain beneficial owners and management and the Corporation’s Employee Stock Ownership Plan.)

 

Shares of Common Stock outstanding as of March 11, 2013—13,307,498 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Definitive Proxy Statement for the First Financial Corporation Annual Meeting of Shareholders to be held April 17, 2013 are incorporated by reference into Part III.

 

 

 

 
 

  

FIRST FINANCIAL CORPORATION
2012 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

 

  PAGE
   
PART I  
   
Item 1.    Business 3
   
Item 1A. Risk Factors 13
   
Item 1B. Unresolved Staff Comments 17
   
Item  2.  Properties 18
   
Item  3.   Legal Proceedings 19
   
Item  4.   Mine Safety Disclosures 19
   
PART II  
   
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 19
   
Item 6.    Selected Financial Data 21
   
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations 21
   
Item  7A. Quantitative and Qualitative Disclosures about Market Risk 31
   
Item 8.    Financial Statements and Supplementary Data 31
   
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 68
   
Item  9A. Controls and Procedures 68
   
Item 9B.  Other Information 68
   
PART III  
   
Item 10.    Directors, Executive Officers and Corporate Governance 69
   
Item 11.    Executive Compensation 69
   
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Shareholder    Matters 70
   
Item 13.   Certain Relationships and Related Transactions and Director Independence 70
   
Item 14.   Principal Accountant Fees and Services 70
   
PART IV  
   
Item 15.   Exhibits and Financial Statement Schedules 71
   
                Signatures 72
   
Exhibit 10.3  
Exhibit 10.4  
Exhibit 21  
Exhibit 31.1  
Exhibit 31.2  
Exhibit 32.1  
Exhibit 32.2  

 

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FIRST FINANCIAL CORPORATION
2012 ANNUAL REPORT ON FORM 10-K

 

PART I 

 

ITEM 1. BUSINESS

 

FORWARD-LOOKING STATEMENTS

 

A cautionary note about forward-looking statements: In its oral and written communication, First Financial Corporation from time to time includes forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements can include statements about estimated cost savings, plans and objectives for future operations and expectations about performance, as well as economic and market conditions and trends. They often can be identified by the use of words such as "expect," "may," "could," "intend," "project," "estimate," "believe" or "anticipate" or words of similar import. By their nature, forward-looking statements are based on assumptions and are subject to risks, uncertainties and other factors. Actual results may differ materially from those contained in the forward-looking statement. First Financial Corporation may include forward-looking statements in filings with the Securities and Exchange Commission, in other written materials such as this Annual Report and in oral statements made by senior management to analysts, investors, representatives of the media and others. It is intended that these forward-looking statements speak only as of the date they are made, and First Financial Corporation undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the forward-looking statement is made or to reflect the occurrence of unanticipated events.

 

The discussion in Item 1A (Risk Factors) and Item 7 (Management's Discussion and Analysis of Results of Operations and Financial Condition) of this Annual Report on Form 10-K, lists some of the factors which could cause actual results to vary materially from those in any forward-looking statements. Other uncertainties which could affect First Financial Corporation's future performance include the effects of competition, technological changes and regulatory developments; changes in fiscal, monetary and tax policies; market, economic, operational, liquidity, credit and interest rate risks associated with First Financial Corporation's business; inflation; competition in the financial services industry; changes in general economic conditions, either nationally or regionally, resulting in, among other things, credit quality deterioration; and changes in securities markets. Investors should consider these risks, uncertainties and other factors in addition to those mentioned by First Financial Corporation in its other filings from time to time when considering any forward-looking statement.

 

GENERAL

 

First Financial Corporation (the “Corporation”) is a financial holding company. The Corporation was originally organized as an Indiana corporation in 1984 to operate as a bank holding company.

 

The Corporation, which is headquartered in Terre Haute, Ind., offers a wide variety of financial services including commercial, mortgage and consumer lending, lease financing, trust account services, depositor services and insurance services through its three subsidiaries. At the close of business in 2012 the Corporation and its subsidiaries had 928 full-time equivalent employees.

 

COMPANY PROFILE

 

First Financial Bank, N.A. (the “Bank”) is the largest bank in Vigo County, Ind. It operates 11 full-service banking branches within the county; five in Clay County, Ind.; one in Daviess County, Ind.; one in Gibson County, Ind.; one in Greene County, Ind.; four in Knox County, Ind.; five in Parke County, Ind.; one in Putnam County, Ind., five in Sullivan County, Ind.; one in Vanderburgh, County.; four in Vermillion County, Ind.; five in Champaign County, Illinois; one in Clark County, Ill.; one in Coles County, Ill.; three in Crawford County, Ill.; one in Jasper County, Ill.; one in Lawrence County, Ill.; three in Livingston County, Illinois; four in McLean County, Illinois; two in Richland County, Ill.; seven in Vermilion County, Ill.; and one in Wayne County, Ill. In addition to its branches, it has a main office in downtown Terre Haute and a 50,000-square-foot commercial building on South Third Street in Terre Haute, which serves as the Corporation's operations center and provides additional office space. The Morris Plan Company of Terre Haute, Inc. (“Morris Plan”) has one office and is located in Vigo County. Forrest Sherer Inc. is a premier regional supplier of insurance, surety and other financial products. The Forrest Sherer brand is well recognized in the Midwest, with more than 58 professionals and over 91 years of successful service to both businesses and households in their market area. The agency has representation agreements with more than 40 regional and national insurers to market their products of property and casualty insurance, surety bonds, employee benefit plans, life insurance and annuities. FFB Risk Management Co., Inc. located in Las Vegas, Nevada is a captive insurance subsidiary which insures various liability and property damage policies for First Financial Corporation subsidiaries. On December 30, 2011 the Bank completed its acquisition of 100% of the stock of Freestar Bank, National Association, of Pontiac, Illinois and merged Freestar Bank into the Bank. The Corporation paid PNB Holding Co., the former owner of the stock of Freestar Bank, $47 million and assumed liabilities of PNB equal to approximately $8.2 million.  As a result of the acquisition, the Bank added Illinois banking offices in the communities of Bloomington, Champaign, Urbana, Pontiac, Downs, Mahomet and Gridley, and acquired assets of approximately $400 million.

 

COMPETITION

 

First Financial Bank and Morris Plan face competition from other financial institutions. These competitors consist of commercial banks, a mutual savings bank and other financial institutions, including consumer finance companies, insurance companies, brokerage firms and credit unions.

 

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The Corporation's business activities are centered in west-central Indiana and east-central Illinois. The Corporation has no foreign activities other than periodically investing available funds in time deposits held in foreign branches of domestic banks.

 

Regulation And Supervision

 

The Corporation and its subsidiaries operate in highly regulated environments and are subject to supervision and regulation by several governmental regulatory agencies, including the Board of Governors of the Federal Reserve System (the "Federal Reserve"), the Office of the Comptroller of the Currency (the “OCC”), the Federal Deposit Insurance Corporation (the “FDIC”), and the Indiana Department of Financial Institutions (the “DFI”). The laws and regulations established by these agencies are generally intended to protect depositors, not shareholders. Changes in applicable laws, regulations, governmental policies, income tax laws and accounting principles may have a material effect on the Corporation’s business and prospects. The following summary is qualified by reference to the statutory and regulatory provisions discussed.

 

The Dodd-Frank Act

 

On July 21, 2010, financial regulatory reform legislation entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial industry, including provisions that, among other things, will:

 

·Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining, and enforcing compliance with federal consumer financial laws.
·Create the Financial Stability Oversight Council that will recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management, and other requirements as companies grow in size and complexity.
·Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies.
·Require financial holding companies to be well capitalized and well managed. Impose more stringent capital on bank holding companies and subject certain activities, including interstate mergers and acquisitions, to higher capital conditions.
·Restrict the preemption of state law by federal law and disallow subsidiaries and affiliates of national banks from availing themselves of such preemption.
·Provide mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring that the ability to repay variable-rate loans be determined by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans and new disclosures. In addition, certain compensation for mortgage brokers based on certain loan terms will be restricted.
·Require financial institutions to make a reasonable and good faith determination that borrowers have the ability to repay loans for which they apply. If a financial institution fails to make such a determination, a borrower can assert this failure as a defense to foreclosure.
·Require financial institutions to retain a specified percentage (5% or more) of certain non-traditional mortgage loans and other assets in the event that they seek to securitize such assets.
·Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund (“DIF”), and increase the floor on the size of the DIF, which generally will require an increase in the level of assessments for institutions with assets in excess of $10 billion.
·Make permanent the $250,000 limit for federal deposit insurance.
·Implement corporate governance revisions, including with regard to executive compensation, say on pay votes, proxy access by shareholders, and clawback policies which apply to all public companies, not just financial institutions.
·Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transactions and other accounts.
·Amend the Electronic Fund Transfer Act (“EFTA”) to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.
·Limit the hedging activities and private equity investments that may be made by various financial institutions.

 

The Consumer Financial Protection Bureau (the “CFPB”), created by the Dodd-Frank Act as discussed above, is responsible for administering federal consumer financial protection laws. The CFPB, which began operations on July 21, 2011, is an independent bureau within the Federal Reserve and has broad rule-making, supervisory and examination authority to set and enforce rules in the consumer protection area over financial institutions that have assets of $10 billion or more. The CFPB also has data collecting powers for fair lending purposes for both small business and mortgage loans, as well as authority to prevent unfair, deceptive and abusive practices.

 

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Although many aspects of the Dodd-Frank Act remain subject to rulemaking, several provisions of the Dodd-Frank Act have been implemented. In addition to the establishment of the CFPB, the Federal Reserve Board’s final rule implementing the Dodd-Frank Act’s “Durbin Amendment,” which limits debit card interchange fees, was issued on July 21, 2011 for transactions occurring after September 30, 2011. The final rule established a cap on the fees banks with more than $10 billion in assets can charge merchants for debit card transactions. The fee was set at $0.21 per transaction plus an additional 5 bps of the transaction amount and $0.01 to cover fraud losses. The Federal Reserve Board also repealed Regulation Q as mandated by the Dodd-Frank Act on July 21, 2011. Regulation Q was implemented as part of the Glass-Steagall Act in the 1930’s and provided a prohibition against the payment of interest on demand deposits.

 

Because full implementation of the Dodd-Frank Act will occur over several years, it is difficult to anticipate the overall financial impact on the Corporation, its customers or the financial industry generally. However, the impact is expected to be substantial and may have an adverse impact on the Corporation’s financial performance and growth opportunities. Provisions in the legislation that affect the payment of interest on demand deposits and interchange fees are likely to increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Provisions in the legislation that require revisions to the capital requirements of financial institutions could require the Corporation and its financial institution subsidiaries to seek other sources of capital in the future.

 

BASEL III

 

In December 2010 and January 2011, the Basel Committee published the final texts of reforms on capital and liquidity generally referred to as “Basel III.” Although Basel III is intended to be implemented by participating countries for large, internationally active banks, its provisions are likely to be considered by United States banking regulators in developing new regulations applicable to other banks in the United States, including the Bank.

 

For banks in the United States, among the most significant provisions of Basel III concerning capital are the following:

 

·a minimum ratio of common equity to risk-weighted assets reaching 4.5%, plus an additional 2.5% as a capital conservation buffer, by 2019 after a phase-in period;

 

·a minimum ratio of Tier 1 capital to risk-weighted assets reaching 6.0% by 2019 after a phase-in period;

 

·a minimum ratio of total capital to risk-weighted assets, plus the additional 2.5% capital conservation buffer, reaching 10.5% by 2019 after a phase-in period;

 

·an additional countercyclical capital buffer to be imposed by applicable national banking regulators periodically at their discretion, with advance notice;

 

·restrictions on capital distributions and discretionary bonuses applicable when capital ratios fall within the buffer zone;

 

·deduction from common equity of deferred tax assets that depend on future profitability to be realized; and

 

·increased capital requirements for counterparty credit risk relating to over the counter derivatives, repos and securities financing activities..

 

The Basel III provisions on liquidity include complex criteria establishing the liquidity coverage ratio (“LCR”) and the net stable funding ratio (“NSFR”). The purpose of the LCR is to ensure that a bank maintains adequate unencumbered, high quality liquid assets to meet its liquidity needs for 30 days under a severe liquidity stress scenario. The purpose of the NSFR is to promote more medium and long-term funding of assets and activities, using a one-year horizon. Although Basel III is described as a “final text,” it is subject to the resolution of certain issues and to further guidance and modification, as well as to adoption by United States banking regulators, including decisions as to whether and to what extent it will apply to United States banks that are not large, internationally active banks.

 

On June 7, 2012, the federal bank regulatory agencies issued a series of proposed rules that would revise their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to make them consistent with Basel III and certain provisions of the Dodd-Frank Act. The three separate but related proposals are: (i) the “Basel III Proposal,” which applies the Basel III capital framework to almost all U.S. banking organizations; (ii) the “Standardized Approach Proposal,” which applies certain elements of the Basel II standardized approach for credit risk weightings to almost all U.S. banking organizations; and (iii) the “Advanced Approaches Proposal,” which applies changes made to Basel II and Basel III in the past few years to large U.S. banking organizations subject to the advanced Basel II capital framework. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies (“banking organizations”). The comment period for these notices of proposed rulemaking ended October 22, 2012.

 

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Among other things, the proposed rules establish a new Common Equity Tier 1 minimum capital requirement of 4.5% and a higher minimum Tier 1 capital requirement of 6.0%. The proposed rules limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of Common Equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements.

 

The Basel III implementation proposal provides for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Proposal, the effects of certain accumulated other comprehensive items are not excluded, which could result in significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of the Corporation’s securities portfolio. The Basel III Proposal also requires the phase-out of certain hybrid securities, such as trust preferred securities, as Tier 1 capital of bank holding companies in equal installments between 2013 and 2016. Trust preferred securities no longer included in Tier 1 capital may nonetheless be included as a component of Tier 2 capital.

 

Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2014 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

 

The Basel III implementation proposal would also revise the “prompt corrective action” regulations described below by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The Basel III proposal does not change the total risk-based capital requirement for any category.

 

In addition to the changes in capital requirements included within the Basel III Proposal, the Standardized Approach Proposal revises a large number of the risk weights (or their methodologies) for bank assets that are used to determine the capital ratios. For nearly every class of assets, the proposal requires a more complex, detailed and calibrated assessment of credit risk and calculation of risk weightings. For example, under the current risk-weighting rules, residential mortgages have a risk weighting of 50%. Under the proposed new rules, two categories of residential mortgage lending would be created: (i) traditional lending would be category 1, where the risk weights range from 35 to 100%; and (ii) nontraditional loans would fall within category 2, where the risk weights would range from 50 to 150%.

 

Because of the number of comments received by the regulatory agencies on the proposals discussed above, the regulatory agencies have indicated that the date for the implementation of the proposed Basel III rules has been delayed . At this time it is unclear when the Basel III regime will become effective in the United States, no guarantee that the proposals will be adopted in their current form, what changes may be made before adoption, or when ultimate adoption will occur. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Corporation’s net income and return on equity.

 

The Corporation

 

The Bank Holding Company Act. Because the Corporation owns all of the outstanding capital stock of the Bank, it is registered as a bank holding company under the federal Bank Holding Company Act of 1956 (“Act”) and is subject to periodic examination by the Federal Reserve and required to file periodic reports of its operations and any additional information that the Federal Reserve may require.

 

Investments, Control, and Activities. With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before acquiring another bank holding company or acquiring more than five percent of the voting shares of a bank (unless it already owns or controls the majority of such shares).

 

Bank holding companies are prohibited, with certain limited exceptions, from engaging in activities other than those of banking or of managing or controlling banks. They are also prohibited from acquiring or retaining direct or indirect ownership or control of voting shares or assets of any company which is not a bank or bank holding company, other than subsidiary companies furnishing services to or performing services for their subsidiaries, and other subsidiaries engaged in activities which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be incidental to these operations. The Bank Holding Company Act does not place territorial restrictions on the activities of such nonbanking-related activities.

 

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Bank holding companies which meet certain management, capital, and Community Reinvestment Act of 1977 (“CRA”) standards may elect to become a financial holding company, which would allow them to engage in a substantially broader range of nonbanking activities than is permitted for a bank holding company, including insurance underwriting and making merchant banking investments in commercial and financial companies.

 

The Corporation does not currently plan to engage in any activity other than owning the stock of the Bank.

 

Gramm-Leach-Bliley Financial Modernization Act. The Corporation is a financial holding company (“FHC”) within the meaning of the Act. This Act restricts the business of FHC’s to financial and related activities. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (“GLB Act”), which amended the , provides the following:

 

·it allows bank holding companies that qualify as “financial holding companies” to engage in a broad range of financial and related activities;
·it allows insurers and other financial services companies to acquire banks;
·it removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and
·it establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.

 

As a qualified FHC, the Corporation is eligible to engage in, or acquire companies engaged in, the broader range of activities that are permitted by the GLB Act. These activities include those that are determined to be “financial in nature,” including insurance underwriting, securities underwriting and dealing, and making merchant banking investments in commercial and financial companies. If any of the Corporation’s banking subsidiaries ceases to be “well capitalized” or “well managed” under applicable regulatory standards, the Federal Reserve Board may, among other things, place limitations on the Corporation’s ability to conduct these broader financial activities or, if the deficiencies persist, require the divestiture of the banking subsidiary. In addition, if any of the Corporation’s banking subsidiaries receives a rating of less than satisfactory under the Community Reinvestment Act of 1977 (“CRA”), the Corporation would be prohibited from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies. The Corporation’s banking subsidiaries currently meet these capital, management and CRA requirements.

 

Capital Adequacy Guidelines for Bank Holding Companies. The Federal Reserve, as the regulatory authority for bank holding companies, has adopted capital adequacy guidelines for bank holding companies. Bank holding companies with assets in excess of $500 million must comply with the Federal Reserve's risk-based capital guidelines which require a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities such as standby letters of credit) of 8%. At least half of the total required capital must be "Tier 1 capital", consisting principally of common stockholders' equity, non-cumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder ("Tier 2 capital") may consist of a limited amount of subordinated debt and intermediate-term preferred stock, certain hybrid capital instruments and other debt securities, cumulative perpetual preferred stock, and a limited amount of the general loan loss allowance. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a Tier 1 (leverage) capital ratio under which the bank holding company must maintain a minimum level of Tier 1 capital to average total consolidated assets of 3% in the case of bank holding companies which have the highest regulatory examination ratings and are not contemplating significant growth or expansion. All other bank holding companies are expected to maintain a ratio of at least 1% to 2% above the stated minimum.

 

Certain regulatory capital ratios for the Corporation as of December 31, 2012, are shown below:

 

Tier 1 Capital to Risk-Weighted Assets   15.38%
Total Risk Based Capital to Risk-Weighted Asset   16.37%
Tier 1 Leverage Ratio   11.43%

 

Dividends. The Federal Reserve's policy is that a bank holding company experiencing earnings weakness should not pay cash dividends exceeding its net income or which could only be funded in ways that weaken the bank holding company's financial health, such as by borrowing. Additionally, the Federal Reserve possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.

 

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Source of Strength. In accordance with Federal Reserve policy, the Corporation is expected to act as a source of financial strength to the Bank and Morris Plan and to commit resources to support the Bank and Morris Plan in circumstances in which the Corporation might not otherwise do so.

 

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. Among other requirements, the Sarbanes-Oxley Act established: (i) requirements for audit committees of public companies, including independence and expertise standards; (ii) additional responsibilities regarding financial statements for the chief executive officers and chief financial officers of reporting companies; (iii) standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for reporting companies regarding various matters relating to corporate governance, and (v) new and increased civil and criminal penalties for violation of the securities laws.

 

The Bank and Morris Plan

 

General Regulatory Supervision. The Bank is a national bank organized under the laws of the United States of America and is subject to the supervision of the OCC, whose examiners conduct periodic examinations of the Bank. The Bank must undergo regular on-site examinations by the OCC and must submit quarterly and annual reports to the OCC concerning its activities and financial condition.

 

Morris Plan is an Indiana-chartered institution and is subject to the supervision of the FDIC and the DFI, whose examiners conduct periodic examinations of Morris Plan. Morris Plan must undergo regular on-site examinations by the FDIC and the DFI and must submit quarterly and annual reports to the FDIC and the DFI concerning its activities and financial condition.

 

The deposits of the Bank and Morris Plan are insured by the FDIC and are subject to the FDIC's rules and regulations respecting the insurance of deposits. See "Deposit Insurance".

 

Lending Limits. The total loans and extensions of credit to a borrower outstanding at one time and not fully secured may not exceed 15 percent of the bank's capital and unimpaired surplus. In addition, the total amount of outstanding loans and extensions of credit to any borrower outstanding at one time and fully secured by readily marketable collateral may not exceed 10 percent of the unimpaired capital and unimpaired surplus of the bank (this limitation is separate from and in addition to the above limitation). If a loan is secured by United States obligations, such as treasury bills, it is not subject to the legal lending limit.

 

Deposit Insurance. The Dodd-Frank Act has permanently increased the maximum amount of deposit insurance for financial institutions per insured depositor to $250,000.

 

The deposits of the Bank and Morris Plan are insured up to the applicable limits under the DIF. The FDIC maintains the DIF by assessing depository institutions an insurance premium. Pursuant to the Dodd-Frank Act, the FDIC is required to set a DIF reserve ratio of 1.35% of estimated insured deposits and is required to achieve this ratio by September 30, 2020. Also, the Dodd-Frank Act has eliminated the 1.50% ceiling on the reserve ratio and provides that the FDIC is no longer required to refund amounts in the DIF that exceed 1.50% of insured deposits.

 

In connection with the Dodd-Frank Act’s requirement that insurance assessments be based on assets, the FDIC bases assessments on an institution’s average consolidated assets (less average tangible equity) as opposed to its deposit level. This may shift the burden of deposit premiums toward larger depository institutions which rely on funding sources other than U.S. deposits.

 

Under the FDIC’s risk-based assessment system, insured institutions are required to pay deposit insurance premiums based on the risk that each institution poses to the DIF. An institution’s risk to the DIF is measured by its regulatory capital levels, supervisory evaluations, and certain other factors. An institution’s assessment rate depends upon the risk category to which it is assigned. As noted above, pursuant to the Dodd-Frank Act, the FDIC will calculate an institution’s assessment level based on its total average consolidated assets during the assessment period less average tangible equity (i.e., Tier 1 capital) as opposed to an institution’s deposit level which was the previous basis for calculating insurance assessments. Pursuant to the Dodd-Frank Act, institutions will be placed into one of four risk categories for purposes of determining the institution’s actual assessment rate. The FDIC will determine the risk category based on the institution’s capital position (well capitalized, adequately capitalized, or undercapitalized) and supervisory condition (based on exam reports and related information provided by the institution’s primary federal regulator). The Bank paid a total FDIC assessment of $1.88 million and Morris Plan paid a total FDIC assessment of $34 thousand in 2012.

 

During 2009, the FDIC adopted a rule requiring each insured institution to prepay on December 30, 2009 the estimated amount of its quarterly assessments for the fourth quarter of 2009 and all quarters through the end of 2012 (in addition to the regular quarterly assessment for the third quarter which was due on December 30, 2009). The prepaid amount is recorded as an asset with a zero risk weight and the institution will continue to record quarterly expenses for FDIC deposit insurance. Collection of the prepayment amount does not preclude the FDIC from changing assessment rates or revising the risk-based assessment system in the future. If events cause actual assessments during the prepayment period to vary from the prepaid amount, institutions will pay excess assessments or receive a rebate of prepaid amounts not fully utilized after the collection of assessments due in June 2013. The amount of the Bank’s prepayment was $8.96 million and the amount of Morris Plan’s prepayment was $249 thousand.

 

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In addition to the FDIC insurance premiums, the Bank and the Morris Plan are required to make quarterly payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize a predecessor deposit insurance fund. These assessments will continue until the FICO bonds are repaid.

 

Transactions with Affiliates and Insiders. Pursuant to Sections 23A and 23B of the Federal Reserve Act and Regulation W, the Bank and Morris Plan are subject to limitations on the amount of loans or extensions of credit to, or investments in, or certain other transactions with, affiliates (including the Corporation) and insiders and on the amount of advances to third parties collateralized by the securities or obligations of affiliates. Furthermore, within the foregoing limitations as to amount, each covered transaction must meet specified collateral requirements. Compliance is also required with certain provisions designed to avoid the taking of low quality assets. The Bank and Morris Plan are also prohibited from engaging in certain transactions with certain affiliates and insiders unless the transactions are on terms substantially the same, or at least as favorable to such institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

 

Extensions of credit by the Bank or Morris Plan to their executive officers, directors, certain principal shareholders, and their related interests must:

 

·be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties; and
·not involve more than the normal risk of repayment or present other unfavorable features.

 

The Dodd-Frank Act also included specific changes to the law related to the definition of a “covered transaction” in Sections 23A and 23B and limitations on asset purchases from insiders. With respect to the definition of a “covered transaction,” the Dodd-Frank Act now defines that term to include the acceptance of debt obligations issued by an affiliate as collateral for an institution’s loan or extension of credit to another person or company. In addition, a “derivative transaction” with an affiliate is now deemed to be a “covered transaction” to the extent that such a transaction causes an institution or its subsidiary to have a credit exposure to the affiliate. A separate provision of the Dodd-Frank Act states that an insured depository institution may not “purchase an asset from, or sell an asset to” a bank insider (or their related interests) unless (1) the transaction is conducted on market terms between the parties and (2) if the proposed transaction represents more than 10 percent of the capital stock and surplus of the insured institution, it has been approved in advance by a majority of the institution’s non-interested directors.

 

Dividends. Applicable law provides that a financial institution, such as the Bank or Morris Plan, may pay dividends from its undivided profits in an amount declared by its Board of Directors, subject to prior regulatory approval if the proposed dividend, when added to all prior dividends declared during the current calendar year, would be greater than the current year's net income and retained earnings for the previous two calendar years.

 

Federal law generally prohibits the Bank or Morris Plan from paying a dividend to the Corporation if it would thereafter be undercapitalized. The FDIC may prevent a financial institution from paying dividends if it is in default of payment of any assessment due to the FDIC. In addition, payment of dividends by a bank may be prevented by the applicable federal regulatory authority if such payment is determined, by reason of the financial condition of such bank, to be an unsafe and unsound banking practice.

 

Community Reinvestment Act. The CRA requires that the federal banking regulators evaluate the records of a financial institution in meeting the credit needs of its local community, including low and moderate income neighborhoods. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could result in the imposition of additional requirements and limitations on the Bank or on Morris Plan.

 

Capital Regulations. The OCC has adopted risk-based capital ratio guidelines to which the Bank is subject. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations. Risk-based capital ratios are determined by allocating assets and specified off-balance sheet commitments to four risk weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk.

 

These guidelines divide a bank's capital into two tiers. The first tier (Tier 1) includes common equity, certain non-cumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts of consolidated subsidiaries, less goodwill and certain other intangible assets (except mortgage servicing rights and purchased credit card relationships, subject to certain limitations). Supplementary (Tier 2) capital includes, among other items, cumulative perpetual and long-term limited-life preferred stock, mandatory convertible securities, certain hybrid capital instruments, term subordinated debt and the allowance for loan and lease losses, subject to certain limitations, less required deductions. Banks are required to maintain a total risk-based capital ratio of 8%, of which 4% must be Tier 1 capital. The OCC may, however, set higher capital requirements when a bank's particular circumstances warrant. Banks experiencing or anticipating significant growth are expected to maintain capital ratios, including tangible capital positions, well above the minimum levels.

 

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In addition, the OCC established guidelines prescribing a minimum Tier 1 leverage ratio (Tier 1 capital to adjusted total assets as specified in the guidelines). These guidelines provide for a minimum Tier 1 leverage ratio of 3% for banks that meet certain specified criteria, including that they have the highest regulatory rating and are not experiencing or anticipating significant growth. All other banks are required to maintain a Tier 1 leverage ratio of 3% plus an additional cushion of at least 1% to 2% basis points.

 

Certain actual regulatory capital ratios under the OCC's risk-based capital guidelines for the Bank at December 31, 2012, are shown below:

 

Tier 1 Capital to Risk-Weighted Assets   14.78%
Total Risk-Based Capital to Risk-Weighted Assets   15.67%
Tier 1 Leverage Ratio   10.98%

 

The federal bank regulators also have issued a joint policy statement to provide guidance on sound practices for managing interest rate risk. The statement sets forth the factors the federal regulatory examiners will use to determine the adequacy of a bank's capital for interest rate risk. These qualitative factors include the adequacy and effectiveness of the bank's internal interest rate risk management process and the level of interest rate exposure. Other qualitative factors that will be considered include the size of the bank, the nature and complexity of its activities, the adequacy of its capital and earnings in relation to the bank's overall risk profile, and its earning exposure to interest rate movements. The interagency supervisory policy statement describes the responsibilities of a bank's board of directors in implementing a risk management process and the requirements of the bank's senior management in ensuring the effective management of interest rate risk. Further, the statement specifies the elements that a risk management process must contain.

 

The federal banking regulators have also issued regulations revising the risk-based capital standards to include a supervisory framework for measuring market risk. The effect of these regulations is that any bank holding company or bank which has significant exposure to market risk must measure such risk using its own internal model, subject to the requirements contained in the regulations, and must maintain adequate capital to support that exposure. These regulations apply to any bank holding company or bank whose trading activity equals 10% or more of its total assets, or whose trading activity equals $1 billion or more. Examiners may require a bank holding company or bank that does not meet the applicability criteria to comply with the capital requirements if necessary for safety and soundness purposes. These regulations contain supplemental rules to determine qualifying and excess capital, calculate risk-weighted assets, calculate market risk-equivalent assets and calculate risk-based capital ratios adjusted for market risk.

 

Morris Plan is also subject to the capital adequacy guidelines of the FDIC in its examination and regulation of Morris Plan. In addition, the Bank and Morris Plan are also subject to the "prompt corrective action" regulations, which implement a capital-based regulatory scheme designed to promote early intervention for troubled banks. This framework contains five categories of compliance with regulatory capital requirements, including "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized", and "critically undercapitalized". As of December 31, 2012, the Bank and Morris Plan were qualified as "well capitalized." It should be noted that a bank's capital category is determined solely for the purpose of applying the "prompt corrective action" regulations and that the capital category may not constitute an accurate representation of the bank's overall financial condition or prospects. The degree of regulatory scrutiny of a financial institution increases, and the permissible activities of the institution decrease, as it moves downward through the capital categories. Bank holding companies controlling financial institutions can be required to boost the institutions' capital and to partially guarantee the institutions' performance.

 

Ability-to-Repay Requirement and Qualified Mortgage Rule. The Dodd-Frank Act contains additional provisions that affect consumer mortgage lending. First, it significantly expands underwriting requirements applicable to loans secured by 1-4 family residential real property and augments federal law combating predatory lending practices. In addition to numerous new disclosure requirements, the Dodd-Frank Act imposes new standards for mortgage loan originations on all lenders, including banks and savings associations, in an effort to encourage lenders to verify a borrower’s ability to repay, while also establishing a presumption of compliance for certain “qualified mortgages.” Most significantly, the new standards limit the total points and fees that the Bank and/or a broker may charge on conforming and jumbo loans to 3% of the total loan amount. In addition, the Dodd-Frank Act generally requires lenders or securitizers to retain an economic interest in the credit risk relating to loans that the lender sells and other asset-backed securities that the securitizer issues if the loans have not complied with the ability-to-repay standards. The risk retention requirement generally will be 5%, but could be increased or decreased by regulation.

 

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In 2013, the CFPB issued a final rule, effective January 10, 2014, that implements the Dodd-Frank Act’s ability-to-repay requirements, and clarifies the presumption of compliance for “qualified mortgages.”  Further, the final rule also clarifies that qualified mortgages do not include “no-doc” loans and loans with negative amortization, interest-only payments, balloon payments, terms in excess of 30 years, or points and fees paid by the borrower that exceed 3% of the loan amount, subject to certain exceptions. In addition, for qualified mortgages, the monthly payment must be calculated on the highest payment that will occur in the first five years of the loan, and the borrower’s total debt-to-income ratio generally may not be more than 43%. The final rule also provides that certain mortgages that satisfy the general product feature requirements for qualified mortgages and that also satisfy the underwriting requirements of Fannie Mae and Freddie Mac (while they operate under federal conservatorship or receivership) or the U.S. Department of Housing and Urban Development, Department of Veterans Affairs, or Department of Agriculture or Rural Housing Service are also considered to be qualified mortgages. This second category of qualified mortgages will phase out as the aforementioned federal agencies issue their own rules regarding qualified mortgages, the conservatorship of Fannie Mae and Freddie Mac ends, and, in any event, after seven years.

 

As set forth in the Dodd-Frank Act, subprime (or higher-priced) mortgage loans are subject to the ability-to-repay requirement, and the final rule provides for a rebuttable presumption of lender compliance for those loans. The final rule also applies the ability-to-repay requirement to prime loans, while also providing a conclusive presumption of compliance ( i.e. , a safe harbor) for prime loans that are also qualified mortgages. Additionally, the final rule generally prohibits prepayment penalties (subject to certain exceptions) and sets forth a 3-year record retention period with respect to documenting and demonstrating the ability-to-repay requirement and other provisions.

 

USA Patriot Act. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”) is intended to strengthen the ability of U.S. Law Enforcement to combat terrorism on a variety of fronts. The potential impact of the USA Patriot Act on financial institutions is significant and wide-ranging. The USA Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires financial institutions to implement additional policies and procedures with respect to, or additional measures designed to address, any or all of the following matters, among others: money laundering and currency crimes, customer identification verification, cooperation among financial institutions, suspicious activities and currency transaction reporting.

 

S.A.F.E. Act Requirements. Regulations issued under the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 ( the “S.A.F.E. Act” ) require residential mortgage loan originators who are employees of institutions regulated by the foregoing agencies, including national banks, to meet the registration requirements of the S.A.F.E. Act. The S.A.F.E. Act requires residential mortgage loan originators who are employees of regulated financial institutions to be registered with the Nationwide Mortgage Licensing System and Registry, a database created by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators to support the licensing of mortgage loan originators by the states. Employees of regulated financial institutions are generally prohibited from originating residential mortgage loans unless they are registered.

 

Other Regulations

 

Federal law extensively regulates other various aspects of the banking business such as reserve requirements. Current federal law also requires banks, among other things to make deposited funds available within specified time periods. In addition, with certain exceptions, a bank and a subsidiary may not extend credit, lease or sell property or furnish any services or fix or vary the consideration for the foregoing on the condition that (i) the customer must obtain or provide some additional credit, property or services from, or to, any of them, or (ii) the customer may not obtain some other credit, property or service from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of credit extended.

 

Interest and other charges collected or contracted by the Bank or Morris Plan are subject to state usury laws and federal laws concerning interest rates. The loan operations are also subject to federal and state laws applicable to credit transactions, such as the:

 

·Truth-In-Lending Act and state consumer protection laws governing disclosures of credit terms and prohibiting certain practices with regard to consumer borrowers;
·Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
·Equal Credit Opportunity Act and other fair lending laws, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
·Fair Credit Reporting Act of 1978 and Fair and Accurate Credit Transactions Act of 2003, governing the use and provision of information to credit reporting agencies;
·Fair Debt Collection Practices Act, governing the manner in which consumer debts may be collected by collection agencies; and rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.
   
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The deposit operations also are subject to the:

 

·Customer Information Security Guidelines. The federal bank regulatory agencies have adopted final guidelines (the "Guidelines") for safeguarding confidential customer information. The Guidelines require each financial institution, under the supervision and ongoing oversight of its Board of Directors, to create a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazards to the security or integrity of such information; protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer; and implement response programs for security breaches.
·Electronic Funds Transfer Act and Regulation E. The Electronic Funds Transfer Act, which is implemented by Regulation E, governs automatic deposits to and withdrawals from deposit accounts and customers' rights and liabilities arising from the use of automated teller machines and other electronic banking service.
·Gramm-Leach-Bliley Act, Fair and Accurate Credit Transactions Act. The Gramm-Leach-Bliley Act, the Fair and Accurate Credit Transactions Act, and the implementing regulations govern consumer financial privacy, provide disclosure requirements and restrict the sharing of certain consumer financial information with other parties.

 

The federal banking agencies have established guidelines which prescribe standards for depository institutions relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings, compensation fees and benefits, and management compensation. The agencies may require an institution which fails to meet the standards set forth in the guidelines to submit a compliance plan. Failure to submit an acceptable plan or adhere to an accepted plan may be grounds for further enforcement action.

 

As noted above, the new Bureau of Consumer Financial Protection will have authority for amending existing consumer compliance regulations and implementing new such regulations. In addition, the Bureau will have the power to examine the compliance of financial institutions with an excess of $10 billion in assets with these consumer protection rules. The Bank’s and Morris Plan’s compliance with consumer protection rules will be examined by the OCC and the FDIC, respectively, since neither the Bank nor Morris Plan meet this $10 billion asset level threshold.

 

Enforcement Powers. Federal regulatory agencies may assess civil and criminal penalties against depository institutions and certain "institution-affiliated parties", including management, employees, and agents of a financial institution, as well as independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institution's affairs.

 

In addition, regulators may commence enforcement actions against institutions and institution-affiliated parties. Possible enforcement actions include the termination of deposit insurance. Furthermore, regulators may issue cease-and-desist orders to, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the regulator to be appropriate.

 

Effect of Governmental Monetary Policies. The Corporation's earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Bank's monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature or impact of future changes in monetary and fiscal policies. 

 

Available Information

 

The Corporation files annual reports on Form 10-K, quarterly reports on Form 10-Q, proxy statements and other information with the Securities and Exchange Commission. Such reports, proxy statements and other information can be read and copied at the public reference facilities maintained by the Securities and Exchange Commission at the Public Reference Room, 100 F Street, NE, Washington, D.C. 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a web site (http://www.sec.gov) that contains reports, proxy statements, and other information. The Corporation’s filings are also accessible at no cost on the Corporation's website at www.first-online.com.

 

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ITEM 1A.RISK FACTORS

 

Difficult conditions in the capital markets and the economy generally may materially adversely affect the Corporation’s business and results of operations

 

From December 2007 through June 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U.S. was greatly reduced. Although economic conditions have begun to improve, certain sectors, such as real estate, remain weak and unemployment remains high. Local governments and many businesses are still in serious difficulty due to lower consumer spending and the lack of liquidity in the credit markets.

 

Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures, as well as projected future failures, have had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to a significant increase in deposit insurance premiums paid by financial institutions.

 

The Corporation’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 that the Corporation offers, is highly dependent upon the business environment in the markets where the Corporation operates and in the United States as a whole. 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 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.

 

The business environment has been adverse for many households and businesses in the United States and worldwide. While economic conditions in the United States and worldwide have begun to improve, there can be no assurance that this improvement will continue. Such conditions have affected, and could continue to adversely affect, the credit quality of the Corporation’s loans, results of operations and financial condition.

 

In response to economic and market conditions, from time to time the Corporation has undertaken initiatives to reduce its cost structure where appropriate. These initiatives may not be sufficient to meet current and future changes in economic and market conditions and allow the Corporation to maintain profitability. In addition, costs actually incurred in connection with these restructuring actions may be higher than our estimates of such costs or may not lead to the anticipated cost savings.

 

Recently enacted and potential further financial regulatory reforms could have a significant impact on our business, financial condition and results of operations

 

The Dodd−Frank Wall Street Reform and Consumer Protection Act (the “Dodd−Frank Act”), enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Corporation. The changes resulting from the Dodd−Frank Act may impact the profitability of business activities, require changes to certain business practices, impose more stringent capital, liquidity and leverage requirements or otherwise adversely affect the Corporation’s business. In particular, the potential impact of the Dodd−Frank Act on the Corporation’s operations and activities, both currently and prospectively, include, among others:

 

·a reduction in the ability to generate or originate revenue−producing assets as a result of compliance with heightened capital standards;
·increased cost of operations due to greater regulatory oversight, supervision and examination of banks and bank holding companies, and higher deposit insurance premiums;·
·the limitation on the ability to raise new capital through the use of trust preferred securities, as any new issuances of these securities will no longer be included as Tier 1 capital going forward;
·a potential reduction in fee income due to limits on interchange fees applicable to larger institutions which could effectively reduce the fees we can charge; and
·the limitation on the ability to expand consumer product and service offerings due to anticipated stricter consumer protection laws and regulations.

 

Further, the Corporation may be required to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements under the Dodd−Frank Act, which may negatively impact results of operations and financial condition.

 

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Contemplated and proposed legislation, state and federal programs, and increased government control or influence may adversely affect the Corporation by increasing the uncertainty on its lending operations and expose it to increased losses. Statutes and regulations may be altered which potentially increase the Corporation’s cost of service and underwrite mortgage loans.

 

In June 2012 the respective federal bank regulatory agencies proposed for comment proposed rulemakings for new capital standards generally consistent with Basel III. The comment period for these notices of proposed rulemakings has expired, but final regulations have not yet been released and the federal bank regulatory agencies announced that the implementation of the proposed rules under Basel III was indefinitely delayed. If and when implemented, Basel III would require capital to be held in the form of tangible common equity, generally increase the required capital ratios, phase out certain kinds of intangibles treated as capital and certain types of instruments, such as trust preferred securities, and change the risk weightings of assets used to determine required capital ratios. Such changes, including changes regarding interpretations and implementation, could affect the Corporation in substantial and unpredictable ways and could have a material adverse effect on us. Further, among other things, such changes could subject us to additional costs and limit the types of financial services and products we may offer.

 

The Corporation cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may impact the Corporation’s financial condition and results of operations. However, the costs of complying with any additional laws or regulations could have a material adverse effect on the Corporation’s financial condition and results of operations.

 

The recent repeal of federal prohibitions on payment of interest on business demand deposits could increase our interest expense and have a material adverse effect on us

 

All federal prohibitions on the ability of financial institutions to pay interest on business demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, some financial institutions have commenced offering interest on these demand deposits to compete for customers. If competitive pressures require us to pay interest on these demand deposits to attract and retain business customers, our interest expense would increase and our net interest margin would decrease. This could have a material adverse effect on us. Further, the effect of the repeal of the prohibition could be more significant in a higher interest rate environment as business customers would have a greater incentive to seek interest on demand deposits.

 

The Corporation is subject to interest rate risk

 

The Corporation’s earnings and cash flows are largely dependent upon the Corporation’s 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 the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, could influence not only the interest that is received on loans and securities and the interest that is paid on deposits and borrowings, but such changes could also affect (i) the Corporation’s ability to originate loans and obtain deposits, and (ii) the fair value of the Corporation’s financial assets and liabilities. Currently, the Corporation is in an asset-sensitive position. In a rising interest rate environment, the Corporation may be unable to sell its lower-yielding mortgage loans, thus impacting its ability to generate higher yielding loans which could adversely impact earnings.

 

The Corporation is subject to lending risk

 

There are inherent risks associated with the Corporation's lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Corporation operates as well as those across Indiana, Illinois and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. Credit issues may continue to broaden during 2013 depending on the severity and duration of the stagnant economy and the current credit cycle.

 

The Corporation originates commercial real estate loans, commercial loans, consumer loans and residential real estate loans primarily within its market areas. Commercial real estate, commercial, and consumer loans may expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans may not be sold as easily as residential real estate. These loans also have greater credit risk than residential real estate for the following reasons:

·Commercial Real Estate Loans. Repayment is dependent upon income being generated in amounts sufficient to cover operating expenses and debt service.

·Commercial Loans. Repayment is dependent upon the successful operation of the borrower’s business.

·Consumer Loans. Consumer loans (such as personal lines of credit) are collateralized, if at all, with assets that may not provide an adequate source of payment of the loan due to depreciation, damage, or loss.

 

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The Corporation is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Corporation to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Corporation.

 

The Corporation's allowance for loan losses may be insufficient

 

The Corporation maintains an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents management's best estimate of probable incurred losses that are inherent within the existing portfolio of loans. The level of the allowance reflects management's continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Corporation's control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review the Corporation's allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses, the Corporation will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Corporation's financial condition and results of operations.

 

The Corporation may foreclose on collateral property and would be subject to the increased costs associated with ownership of real property, resulting in reduced revenues and earnings

 

The Corporation forecloses on collateral property from time to time to protect its investment and thereafter owns and operates such property, in which case it is exposed to the risks inherent in the ownership of real estate. The amount that the Corporation, as a mortgagee, may realize after a default is dependent upon factors outside of its control, including, but not limited to: (i) general or local economic conditions; (ii) neighborhood values; (iii) interest rates; (iv) real estate tax rates; (v) operating expenses of the mortgaged properties; (vi) environmental remediation liabilities; (vii) ability to obtain and maintain adequate occupancy of the properties; (viii) zoning laws; (ix) governmental rules, regulations and fiscal policies; and (x) acts of God. Certain expenditures associated with the ownership of real estate, principally real estate taxes, insurance, and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the income earned from such property, and the Corporation may have to advance funds in order to protect its investment, or it may be required to dispose of the real property at a loss. These expenditures and costs could adversely affect the Corporation’s ability to generate revenues, resulting in reduced levels of profitability.

 

The Corporation operates in a highly competitive industry and market area

 

The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors include banks and many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Corporation's competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can.

 

The Corporation's ability to compete successfully depends on a number of factors, including, among other things:

 

·The ability to develop, maintain and build upon long-term customer relationships based on top quality service, and safe, sound assets;
·The ability to expand the Corporation's market position;
·The scope, relevance and pricing of products and services offered to meet customer needs and demands;
·The rate at which the Corporation introduces new products and services relative to its competitors;
·Customer satisfaction with the Corporation's level of service; and
·Industry and general economic trends.
   
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Failure to perform in any of these areas could significantly weaken the Corporation's competitive position, which could adversely affect the Corporation's growth and profitability, which, in turn, could have a material adverse effect on the Corporation's financial condition and results of operations.

 

The Corporation is subject to extensive government regulation and supervision

 

The Corporation, primarily through the Bank, is subject to extensive federal regulation and supervision. Banking regulations are primarily intended to protect depositors' funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Corporation's lending practices, capital structure, investment practices, and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways. Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation's business, financial condition and results of operations. While the Corporation has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.

 

The Corporation is dependent on certain key management and staff

 

The Corporation relies on key personnel to manage and operate its business. The loss of key staff may adversely affect the Corporation’s ability to maintain and manage these portfolios effectively, which could negatively affect the Corporation’s revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in the Corporation's net income.

 

The Corporation’s internal operations are subject to a number of risks

 

The Corporation’s internal operations are subject to certain risks, including but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

 

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. The Corporation'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 the Corporation's operations. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Corporation's business and, in turn, the Corporation's financial condition and results of operations.

 

The Corporation’s earnings could be adversely impacted by incidences of fraud and compliance failures that are not within our direct control

 

Financial institutions are inherently exposed to fraud risk. A fraud can be perpetrated by a customer of the Bank, an employee, a vendor, or members of the general public. We are most subject to fraud and compliance risk in connection with the origination of loans, ACH transactions, ATM transactions and checking transactions. Our largest fraud risk, associated with the origination of loans, includes the intentional misstatement of information in property appraisals or other underwriting documentation provided to us by third parties. Compliance risk is the risk that loans are not originated in compliance with applicable laws and regulations and our standards. There can be no assurance that we can prevent or detect acts of fraud or violation of law or our compliance standards by the third parties that we deal with. Repeated incidences of fraud or compliance failures would adversely impact the performance of our loan portfolio.

 

The Corporation's information systems may experience an interruption or breach in security

 

The Corporation relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation's customer relationship management, general ledger, deposit, loan and other systems. While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Corporation's information systems could damage the Corporation's reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation's financial condition and results of operations.

 

16
 

 

The Corporation has opened new offices

 

The Corporation has placed a strategic emphasis on expanding its banking office network. Executing this strategy carries risks of slower than anticipated growth in the new offices, which require a significant investment of both financial and personnel resources. Lower than expected loan and deposit growth in new offices can decrease anticipated revenues and net income generated by those offices, and opening new offices could result in more additional expenses than anticipated and divert resources from current core operations.

 

The geographic concentration of the Corporation’s markets makes the Corporation’s business highly susceptible to local economic conditions

 

Unlike larger banking organizations that are more geographically diversified, the Corporation’s operations are currently concentrated in three counties located in central Indiana. As a result of this geographic concentration, the Corporation’s financial results depend largely upon economic conditions in these market areas. Deterioration in economic conditions in the Corporation’s market could result in one or more of the following:

 

an increase in loan delinquencies;
an increase in problem assets and foreclosures;
a decrease in the demand for the Corporation’s products and services; and
a decrease in the value of collateral for loans, especially real estate, in turn reducing customers’ borrowing power, the value of assets associated with problem loans and collateral coverage.

 

Future growth or operating results may require the Corporation to raise additional capital but that capital may not be available or it may be dilutive

 

The Corporation is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. To the extent the Corporation’s future operating results erode capital or the Corporation elects to expand through loan growth or acquisition it may be required to raise capital. The Corporation’s ability to raise capital will depend on conditions in the capital markets, which are outside of its control, and on the Corporation’s financial performance. Accordingly, the Corporation cannot be assured of its ability to raise capital when needed or on favorable terms. If the Corporation cannot raise additional capital when needed, it will be subject to increased regulatory supervision and the imposition of restrictions on its growth and business. These could negatively impact the Corporation’s ability to operate or further expand its operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on its financial condition and results of operations.

 

The Corporation may not be able to pay dividends in the future in accordance with past practice

 

The Corporation has historically paid a semi-annual dividend to common stockholders.  The payment of dividends is subject to legal and regulatory restrictions.  Any payment of dividends in the future will depend, in large part, on the Corporation’s earnings, capital requirements, financial condition and other factors considered relevant by the Corporation’s Board of Directors.

 

The price of the Corporation’s common stock may be volatile, which may result in losses for investors

 

General market price declines or market volatility in the future could adversely affect the price of the Corporation’s common stock. In addition, the following factors may cause the market price for shares of the Corporation’s common stock to fluctuate:

 

·announcements of developments related to the Corporation’s business;
·fluctuations in the Corporation’s results of operations;
·sales or purchases of substantial amounts of the Corporation’s securities in the marketplace;
·general conditions in the Corporation’s banking niche or the worldwide economy;
·a shortfall or excess in revenues or earnings compared to securities analysts’ expectations;
·changes in analysts’ recommendations or projections; and
·the Corporation’s announcement of new acquisitions or other projects.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

17
 

 

ITEM 2. PROPERTIES

 

The Corporation is located in a four-story office building in downtown Terre Haute, Indiana that was first occupied in June 1988. It is leased to the Bank. The Bank also owns two other facilities in downtown Terre Haute. One is available for lease and the other is a 50,000-square-foot building housing operations and administrative staff and equipment. In addition, the Bank holds in fee six other branch buildings. One of the branch buildings is a single-story 36,000-square-foot building which is located in a Terre Haute suburban area. Four other branch bank buildings are leased by the Bank. The expiration dates on the three leases are May 31, 2016, February 14, 2016 and May 31, 2014. The other lease is on a month to month basis.

 

Facilities of the Corporation’s banking center in Daviess County include an office in Washington, Indiana. This building is held in fee.

 

Facilities of the Corporation’s banking centers in Clay County include three offices in Brazil, Indiana and offices in Clay City and Poland, Indiana. All five buildings are held in fee.

 

Facilities of the Corporation’s banking centers in Vermillion County include two offices in Clinton, Indiana and offices in Cayuga and Newport, Indiana. All four buildings are held in fee.

 

Facilities of the Corporation’s banking centers in Sullivan County include offices in Sullivan, Carlisle, Dugger, Farmersburg and Hymera, Indiana. All five buildings are held in fee.

 

Facilities of the Corporation’s banking center in Gibson County include an office in Princeton, Indiana. This building is held in fee.

 

Facilities of the Corporation’s banking center in Greene County include an office in Worthington, Indiana. This building is held in fee.

 

Facilities of the Corporation’s banking centers in Knox County include offices in Monroe City, Sandborn and two in Vincennes, Indiana. All four buildings are held in fee.

 

Facilities of the Corporation’s banking centers in Parke County include two offices in Rockville, Indiana and offices in Marshall, Montezuma and Rosedale, Indiana. All five buildings are held in fee.

 

Facilities of the Corporation’s banking center in Putnam County include an office in Greencastle, Indiana. This building is held in fee.

 

Facilities of the Corporation’s banking center in Vanderburgh County include an office in Evansville, Indiana. This building is held in fee.

 

Facilities of the Corporation’s banking centers in Crawford County include its main office and a drive-up facility in Robinson, Illinois and a branch facility in Oblong, Illinois. All three of the buildings are held in fee.

 

Facilities of the Corporation’s banking center in Lawrence County include an office in Lawrenceville, Illinois. This building is held in fee.

 

Facilities of the Corporation’s banking centers in Livingston include three offices in Pontiac, Illinois. All of the buildings are held in fee.

 

Facilities of the Corporation’s banking center in McLean County include two offices in Bloomington, Illinois, an office in Downs, Illinois and an office in Gridley, Illinois. These building are all held in fee.

 

Facilities of the Corporation’s banking center in Wayne County include an office in Fairfield, Illinois. This building is held in fee.

 

Facilities of the Corporation’s banking center in Jasper County include an office in Newton, Illinois. This building is held in fee.

 

Facilities of the Corporation’s banking center in Coles County include an office in Charleston, Illinois. This building is held in fee.

 

Facilities of the Corporation’s banking center in Clark County include an office in Marshall, Illinois. This building is held in fee.

 

Facilities of the Corporation’s banking center in Champaign County include two offices in Champaign, Illinois, an office in Mohomet, Illinois, and two offices in Urbana, Illinois. One of the banking centers in Champaign is held in fee while the land is leased. The land lease expires September 6, 2036. One of the banking centers in Champaign is leased and the lease expires on December 31, 2017. The banking center in Mohomet is leased and the lease expires on June 30, 2016. One of the banking centers in Urbana is held in fee while the other banking center in Urbana is held in fee while the land is leased and the lease expires on November 30, 2014.

 

18
 

 

Facilities of the Corporation’s banking center in Vermilion County include five offices in Danville, Illinois, an office in Westville, Illinois, and an office in Ridge Farm, Illinois. One of the buildings in Danville is leased and the lease expires on December 31, 2016 and the other six buildings are held in fee.

 

Facilities of the Corporation’s banking centers in Richland County include two offices in Olney, Illinois. One building is held in fee and the other building is leased. The expiration date on the lease is March 1, 2015.

 

The facility of the Corporation’s subsidiary, The Morris Plan Company, includes an office facility in Terre Haute, Indiana. The building is leased by The Morris Plan Company. The expiration date on the lease is October 31, 2020.

 

Facilities of the Corporation’s subsidiary, Forrest Sherer, Inc., include its main office and one satellite office in Terre Haute, Indiana. The buildings are held in fee by Forrest Sherer, Inc.

 

Facilities of the Corporation’s subsidiary, FFB Management Co., Inc., include an office facility in Las Vegas, Nevada. This office facility is leased.

 

ITEM 3.LEGAL PROCEEDINGS

 

There are no material pending legal proceedings to which the Corporation or its subsidiaries is a party, other than ordinary routine litigation incidental to its business.

 

ITEM 4.MINE SAFETY DISCLOSURES

 

Not applicable

PART II

 

ITEM 5.MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

 

MARKET AND DIVIDEND INFORMATION

 

As of March 11, 2013 shareholders owned 13,307,498 shares of the Corporation's common stock. The stock is traded on the NASDAQ Global Select Market under the symbol “THFF”. On March 11, 2013, approximately 3,806 shareholders held our common stock.

 

Historically, the Corporation has paid cash dividends semi-annually and currently expects that comparable cash dividends will continue to be paid in the future. The following table gives quarterly high and low trade prices and dividends per share during each quarter for 2012 and 2011.

 

   2012   2011 
           Cash           Cash 
   Trade Price   Dividends   Trade Price   Dividends 
Quarter ended  High   Low   Declared   High   Low   Declared 
March 31  $36.84   $30.31        $35.00   $29.73      
June 30  $32.23   $27.09   $0.47   $33.98   $30.36   $0.47 
September 30  $32.93   $28.25        $33.91   $26.63      
December 31  $32.18   $28.07   $0.48   $34.23   $26.47   $0.47 

 

The Corporation periodically acquires shares of its common stock directly from shareholders in individually negotiated transactions. The Corporation has not adopted a formal policy or adopted a formal program for repurchases of shares of its common stock. There were no purchases of common stock by the Corporation during the quarter covered by this report. The Corporation contributed 49,825 shares of treasury stock to the ESOP in November of 2012. 

 

The graph below represents the five-year total return of the Corporation’s stock. The five year total return for our stock during this time was 23.73%. During this same period, the return on The Russell 2000 Index was 19.09% and the SNL Index of Banks $1 - $5 Billion actually had a negative return of 25.22%.

 

19
 

 

 

       Period Ending     
Index  12/31/07   12/31/08   12/31/09   12/31/10   12/31/11   12/31/12 
First Financial Corporation   100.00    148.59    113.77    135.04    131.74    123.73 
Russell 2000   100.00    66.21    84.20    106.82    102.36    119.09 
SNL Bank $1B-$5B   100.00    82.94    59.45    67.39    61.46    75.78 

 

20
 

  

ITEM 6.SELECTED FINANCIAL DATA

 

FIVE YEAR COMPARISON OF SELECTED FINANCIAL DATA

 

(Dollar amounts in thousands, except per share amounts)  2012   2011   2010   2009   2008 
                     
BALANCE SHEET DATA                         
Total assets  $2,895,408   $2,954,061   $2,451,095   $2,518,722   $2,302,675 
Securities   691,000    666,287    560,846    587,246    596,915 
Loans, net of unearned fees*   1,851,936    1,893,679    1,640,146    1,631,764    1,471,327 
Deposits   2,276,134    2,274,499    1,903,043    1,789,701    1,563,498 
Borrowings   160,256    246,449    159,899    363,173    406,653 
Shareholders’ equity   372,122    346,961    321,717    306,483    286,844 
                          
INCOME STATEMENT DATA                         
Interest income   122,305    116,341    123,582    126,255    133,954 
Interest expense   13,393    17,147    26,966    39,261    52,490 
Net interest income   108,912    99,194    96,616    86,994    81,464 
Provision for loan losses   8,773    5,755    9,200    11,870    7,855 
Other income   39,547    33,340    29,797    28,532    25,410 
Other expenses   93,056    75,187    77,202    73,381    66,447 
Net income   32,812    37,195    28,044    22,720    24,769 
                          
PER SHARE DATA:                         
Net Income   2.48    2.83    2.14    1.73    1.89 
Cash dividends   0.95    0.94    0.92    0.90    0.89 
                          
PERFORMANCE RATIOS:                         
Net income to average assets   1.13%   1.49%   1.11%   0.95%   1.09%
Net income to average shareholders’ equity   9.02    10.88    8.73    7.54    8.61 
Average total capital to average assets   13.25    14.57    13.56    13.25    13.28 
Average shareholders’ equity to average assets   12.55    13.68    12.76    12.56    12.60 
Dividend payout   38.40    33.29    43.08    51.99    47.10 

 

* 2008 includes $12,800 of credit card loans that are held-for-sale

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The Management's Discussion and Analysis of Financial Condition and Results of Operations, as well as disclosures found elsewhere in this report are based upon First Financial Corporation's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Corporation to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, securities valuation and goodwill. Actual results could differ from those estimates.

 

21
 

 

Allowance for loan losses. The allowance for loan losses represents management's estimate of probable incurred losses in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. The allowance for loan losses is determined based on management's assessment of several factors: reviews and evaluations of specific loans, changes in the nature and volume of the loan portfolio, current economic and nonperforming loans. Loans are considered impaired if, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest according to the contractual terms of the loan agreement. When a loan is deemed impaired, impairment is measured by using the fair value of underlying collateral,for loans deemed to be collateral dependent, the present value of the future cash flows discounted at the effective interest rate stipulated in the loan agreement, or the estimated market value of the loan. In measuring the fair value of the collateral, management uses assumptions (e.g., discount rate) and methodologies (e.g., comparison to the recent selling price of similar assets) consistent with those that would be utilized by unrelated third parties.

 

Changes in the financial condition of individual borrowers, economic conditions, historical loss experience, or the condition of the various markets in which collateral may be sold may affect the required level of the allowance for loan losses and the associated provision for loan losses. Should cash flow assumptions or market conditions change, a different amount may be recorded for the allowance for loan losses and the associated provision for loan losses.

 

Securities valuation and potential impairment. Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in accumulated other comprehensive income (loss), net of tax. The Corporation obtains market values from a third party on a monthly basis in order to adjust the securities to fair value. Equity securities that do not have readily determinable fair values are carried at cost. Additionally, all securities are required to be evaluated for other than temporary impairment (OTTI). In determining whether a market value decline is other than temporary, management considers the reason for the decline, the extent of the decline, the duration of the decline and whether the Corporation intends to sell a security or is more likely than not to be required to sell a security before recovery of its amortized cost. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, the OTTI shall be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings.

 

Changes in credit ratings, financial condition of underlying debtors, default experience and market liquidity affect the conclusions on whether securities are other-than-temporarily impaired. Additional losses may be recorded through earnings for other than temporary impairment, should there be an adverse change in the expected cash flows for these investments.

 

Goodwill. The carrying value of goodwill requires management to use estimates and assumptions about the fair value of the reporting unit compared to its book value. An impairment analysis is prepared on an annual basis. Fair values of the reporting units are determined by an analysis which considers cash flows streams, profitability and estimated market values of the reporting unit. The majority of the Corporation's goodwill is recorded at First Financial Bank, N. A.

 

Management believes the accounting estimates related to the allowance for loan losses, valuation of investment securities and the valuation of goodwill are "critical accounting estimates" because: (1) the estimates are highly susceptible to change from period to period because they require management to make assumptions concerning, among other factors, the changes in the types and volumes of the portfolios, valuation assumptions, and economic conditions, and (2) the impact of recognizing an impairment or loan loss could have a material effect on the Corporation's assets reported on the balance sheet as well as net income.

 

RESULTS OF OPERATIONS - SUMMARY FOR 2012

 

COMPARISON OF 2012 TO 2011

 

Net income for 2012 was $32.8 million, or $2.48 per share. This represents a 11.8% decrease in net income and a 12.4% decrease in earnings per share, compared to 2011. Return on assets at December 31, 2012 decreased 24.2% to 1.13% compared to 1.49% at December 31, 2011.

 

The primary components of income and expense affecting net income are discussed in the following analysis. 2012 includes income and expense associated with the purchase of Freestar Bank on December 30, 2011 that were not part of the results for 2011.

 

NET INTEREST INCOME

 

The principal source of the Corporation's earnings is net interest income, which represents the difference between interest earned on loans and investments and the interest cost associated with deposits and other sources of funding .Net interest income increased in 2012 to $108.9 million compared to $99.2 million in 2011. Total average interest earning assets increased to $2.67 billion in 2012 from $2.33 billion in 2011. The tax-equivalent yield on these assets decreased to 4.80% in 2012 from 5.23% in 2011. Total average interest-bearing liabilities increased to $2.02 billion in 2012 from $1.76 billion in 2011. The average cost of these interest-bearing liabilities decreased to 0.66% in 2012 from 0.98% in 2011.

 

The net interest margin decreased from 4.50% in 2011 to 4.30% in 2012. This decrease is primarily the result of the decreased income provided by earning assets. Earning asset yields decreased 43 basis points while the rate on interest-bearing liabilities decreased by 32 basis points.

 

22
 

 

CONSOLIDATED BALANCE SHEET - AVERAGE BALANCES AND INTEREST RATES

   December 31, 
   2012   2011   2010 
(Dollar amounts in thousands)  Average
Balance
   Interest   Yield/
Rate
   Average
Balance
   Interest   Yield/
Rate
   Average
Balance
   Interest   Yield/
Rate
 
ASSETS                                             
Interest-earning assets:                                             
Loans (1) (2)  $1,863,014    100,083    5.37%  $1,637,471    92,167    5.63%  $1,636,254    96,786    5.92%
Taxable investment securities   498,509    13,541    2.72%   460,811    16,161    3.51%   469,945    18,597    3.96%
Tax-exempt investments (2)   243,070    14,651    6.03%   204,921    13,465    6.57%   194,011    13,415    6.91%
Federal funds sold   67,240    44    0.07%   25,117    36    0.14%   40,934    59    0.14%
Total interest-earning assets   2,671,833    128,319    4.80%   2,328,320    121,829    5.23%   2,341,144    128,857    5.50%
                                              
Non-interest earning assets:                                             
Cash and due from banks   65,445              58,030              57,940           
Premises and equipment, net   43,594              34,054              35,001           
Other assets   138,462              99,861              102,780           
Less allowance for loan losses   (20,134)             (22,154)             (20,083)          
TOTALS  $2,899,200             $2,498,111             $2,516,782           
                                              
LIABILITIES AND SHAREHOLDERS' EQUITY                                             
Interest-bearing liabilities:                                             
Transaction accounts  $1,176,403    1,736    0.15%  $974,275    1,501    0.15%  $870,538    1,856    0.21%
Time deposits   653,089    6,784    1.04%   616,164    10,626    1.72%   697,560    14,450    2.07%
Short-term borrowings   50,451    140    0.28%   43,040    187    0.43%   42,795    325    0.76%
Other borrowings   136,281    4,733    3.47%   125,102    4,833    3.86%   224,501    10,335    4.60%
Total interest-bearing liabilities:   2,016,224    13,393    0.66%   1,758,581    17,147    0.98%   1,835,394    26,966    1.47%
                                              
Non interest-bearing liabilities:                                             
Demand deposits   439,206              336,038              300,760           
Other   79,894              61,693              59,461           
    2,535,324              2,156,312              2,195,615           
                                              
Shareholders' equity   363,876              341,799              321,167           
TOTALS  $2,899,200             $2,498,111             $2,516,782           
                                              
Net interest earnings       $114,926             $104,682             $101,891      
                                              
Net yield on interest- earning assets             4.30%             4.50%             4.35%

 

(1) For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.

(2) Interest income includes the effect of tax equivalent adjustments using a federal tax rate of 35%.

 

23
 

 

The following table sets forth the components of net interest income due to changes in volume and rate. The table information compares 2012 to 2011 and 2011 to 2010.

 

   2012 Compared to 2011 Increase
(Decrease) Due to
   2011 Compared to 2010 Increase
(Decrease) Due to
 
(Dollar amounts in thousands)  Volume   Rate   Volume/
Rate
   Total   Volume   Rate   Volume/
Rate
   Total 
Interest earned on interest-earning assets:                                        
Loans (1) (2)  $12,695   $(4,201)  $(579)  $7,915   $72   $(4,688)  $(3)  $(4,619)
Taxable investment securities   1,322    (3,644)   (298)   (2,620)   (361)   (2,116)   41    (2,436)
Tax-exempt investment securities (2)   2,507    (1,113)   (207)   1,187    754    (668)   (38)   48 
Federal funds sold   60    (20)   (33)   7    (23)   0    0    (23)
Total interest income  $16,584   $(8,978)  $(1,117)  $6,489   $442   $(7,472)  $0   $(7,030)
                                         
Interest paid on interest-bearing liabilities:                                        
Transaction accounts   311    (63)   (13)   235    221    (515)   (61)   (355)
Time deposits   637    (4,227)   (253)   (3,843)   (1,686)   (2,418)   282    (3,822)
Short-term borrowings   32    (68)   (12)   (48)   2    (139)   (1)   (138)
Other borrowings   432    (488)   (44)   (100)   (4,576)   (1,662)   736    (5,502)
Total interest expense   1,412    (4,846)   (322)   (3,756)   (6,039)   (4,734)   956    (9,817)
Net interest income  $15,172   $(4,132)  $(795)  $10,245   $6,481   $(2,738)  $(956)  $2,787 

 

(1) For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.

(2) Interest income includes the effect of tax equivalent adjustments using a federal tax rate of 35%.

 

PROVISION FOR LOAN LOSSES

 

The provision for loan losses charged to expense is based upon credit loss experience and the results of a detailed analysis estimating an appropriate and adequate allowance for loan losses. The analysis includes the evaluation of impaired loans as prescribed under Accounting Standards Codification (ASC-310), pooled loans as prescribed under ASC 450-10, and economic and other risk factors as outlined in various Joint Interagency Statements issued by the bank regulatory agencies. For the year ended December 31, 2012, the provision for loan losses was $8.8 million net, an increase of $3.0 million, or 52.4%, compared to 2011. The 2012 provision was reduced by $2.2 million for the offset of loans identified in the analysis of potential loan losses that are subject to the loss share agreement with the FDIC. Of those anticipated losses, 80% can be reimbursed by the FDIC and the FDIC indemnification asset has a corresponding increase of $2.2 million for those anticipated losses. The decrease was the result of several components related to the analysis of the Corporation's Allowance for Loan and Lease Losses.

 

Net charge-offs for 2012 were $8.3 million as compared to $9.0 million for 2011 and $8.0 million for 2010. Non-accrual loans decreased to $35.8 million at December 31, 2012 from $38.1 million at December 31, 2011. The decrease occurred despite a $4.7 million increase in non-accruals from the acquisition of Freestar Bank on December 30, 2011. Loans past due 90 days and still on accrual increased to $3.4 million compared to $2.0 million at December 31, 2011.

 

NON-INTEREST INCOME

 

Non-interest income of $39.5 million increased $6.2 million from the $33.3 million earned in 2011. Electronic banking fees and gains from the sale of mortgage loans were the primary drivers of this increase.

 

NON-INTEREST EXPENSES

 

Non-interest expenses increased to $93.1 million for 2012 from $75.2 million for 2011. The largest increase was in salaries and benefits at $ 10.8 million. Salaries increased $5.6 million while benefits increased $5.2 million. The salaries relate to the acquisition of Freestar and staffing for the four new branch locations acquired from the FDIC. Those were expenses not in the financial statement of previous years. The benefits expense increase of $5.2 million was primarily driven by an increase in pension expense of $3.3 million. The pension plan was frozen for most employees during 2012. Other expenses were up $4.9 million from 2011. Over $1 million of these were one-time costs associated with the acquisition and integration of Freestar Bank.

 

24
 

 

INCOME TAXES

 

The Corporation's federal income tax provision was $13.8 million in 2012 compared to a provision of $14.4 million in 2011. The overall effective tax rate in 2012 of 29.6% increased as compared to a 2011 effective rate of 27.9%.

 

COMPARISON OF 2011 TO 2010

 

Net income for 2011 was $37.2 million or $2.83 per share compared to $28.0 million in 2010 or $2.14 per share. This increase in net income was primarily driven by the improved net interest margin of 15 basis points from 4.35% to 4.50%.

 

Net interest income increased $2.6 million in 2011 compared to 2010 as total average interest-earning assets remained stable. This increase was primarily the result of the cost of funding declining at a faster pace than the decline in the earnings on earning assets. The provision for loan losses decreased $3.4 million from $9.2 million in 2010 to $5.8 million in 2011. Net non-interest income and expense decreased $5.6 million from 2010 to 2011. Non-interest expenses decreased $2.0 million while non-interest income increased $3.5 million. The increase in non-interest income resulted primarily from reduced impairment losses and lower non-interest expense resulted from reduced FDIC expense and reduced incentive expense.

The provision for income taxes increased $2.4 million from 2010 to 2011 and the effective tax rate decreased 2% in 2011 from 2010 as nontaxable income increased.

 

COMPARISON AND DISCUSSION OF 2012 BALANCE SHEET TO 2011

 

The Corporation's total assets decreased 2.0% or $58.7 million at December 31, 2012, from a year earlier. Available-for-sale securities increased $24.7 million at December 31, 2012, from the previous year. Loans, net of unearned income, decreased by $41.8 million to $1.85 billion. Deposits increased by $1.6 million while borrowings decreased by $86.2 million. Total shareholders' equity increased $25.2 million to $372.1 million at December 31, 2012. Net income was partially offset by higher dividends. There were also 49,825 shares from the treasury with a value of $1.44 million that were contributed to the ESOP plan in 2012 compared to 46,250 shares with a value of $1.56 million in 2011.

Following is an analysis of the components of the Corporation's balance sheet.

 

SECURITIES

 

The Corporation's investment strategy seeks to maximize income from the investment portfolio while using it as a risk management tool and ensuring safety of principal and capital. During 2012 the portfolio's balance increased by 3.7%. The average life of the portfolio increased from 4.0 years in 2011 to 4.2 years in 2012. The portfolio structure will continue to provide cash flows to be reinvested during 2013.

 

   1 year and less   1 to 5 years   5 to 10 years   Over 10 Years   2012 
(Dollar amounts in thousands)  Balance   Rate   Balance   Rate   Balance   Rate   Balance   Rate   Total 
U.S. government sponsored entity mortgage-backed securities and agencies (1)  $1,382    4.78%  $3,261    6.06%  $62,178    4.60%  $184,872    5.75%  $251,693 
Collateralized mortgage obligations (1)   40    3.70%   1,096    4.87%   11,789    3.94%   220,395    2.92%   233,320 
States and political subdivisions   11,165    4.13%   37,782    3.92%   81,539    3.61%   68,999    3.87%   199,485 
Corporate obligations   -    0.00%   -    0.00%   -    0.00%   6,122    0.00%   6,122 
Total   12,587    4.20%   42,139    4.11%   155,506    4.03%   480,388    4.11%   690,620 
Equities        0.00%        0.00%        0.00%   380    0.00%   380 
TOTAL  $12,587        $42,139        $155,506        $480,768        $691,000 

 

(1) Distribution of maturities is based on the estimated life of the asset.

 

   1 year and less   1 to 5 years   5 to 10 years   Over 10 Years   2011 
(Dollar amounts in thousands)  Balance   Rate   Balance   Rate   Balance   Rate   Balance   Rate   Total 
U.S. government sponsored entity mortgage-backed securities and agencies (1)  $2    7.50%  $11,287    4.01%  $83,897    4.44%  $220,716    4.37%  $315,902 
Collateralized mortgage obligations (1)   -    0.00%   2,384    5.20%   19,438    4.39%   126,125    4.17%   147,947 
States and political subdivisions   8,465    7.22%   42,309    6.17%   71,071    5.40%   73,736    6.03%   195,581 
Corporate obligations   -    0.00%   -    0.00%   -    0.00%   4,771    1.94%   4,771 
Total   8,467    7.22%   55,980    5.69%   174,406    4.83%   425,348    4.57%   664,201 
Equities        0.00%        0.00%        0.00%   2,086    0.00%   2,086 
TOTAL  $8,467        $55,980        $174,406        $427,434        $666,287 

 

(1) Distribution of maturities is based on the estimated life of the asset.

 

25
 

 

LOAN PORTFOLIO

 

Loans outstanding by major category as of December 31 for each of the last five years and the maturities at year end 2012 are set forth in the following analyses. 

 

(Dollar amounts in thousands)  2012   2011   2010   2009   2008 
Loan Category                         
Commercial  $1,088,144   $1,099,324   $896,107   $870,977   $720,281 
Residential   496,237    505,600    437,576    447,379    436,388 
Consumer   268,507    289,717    307,403    314,561    303,123 
TOTAL  $1,852,888   $1,894,641   $1,641,086   $1,632,917   $1,459,792 
                          
Credit card loans held-for-sale  $-   $-   $-   $-   $12,800 

 

       After  One           
   Within   But Within   After Five       
(Dollar amounts in thousands)  One Year   Five Years   Years   Total   
MATURITY DISTRIBUTION                      
Commercial, financial and agricultural  $421,495   $538,980   $127,669   $1,088,144   
TOTAL                      
                       
Residential                  496,237   
Consumer                  268,507   
TOTAL                 $1,852,888   
                       
Loans maturing after one year with:                      
Fixed interest rates       $167,611   $114,053        
Variable interest rates        371,369    13,616        
TOTAL       $538,980   $127,669        

  

26
 

 

ALLOWANCE FOR LOAN LOSSES

 

The activity in the Corporation's allowance for loan losses is shown in the following analysis:

 

(Dollar amounts in thousands)  2012   2011   2010   2009   2008 
Amount of loans outstanding at December 31,  $1,852,888   $1,894,641   $1,641,086   $1,632,917   $1,459,792 
                          
Average amount of loans by year  $1,863,014   $1,637,471   $1,636,254   $1,563,274   $1,451,911 
                          
Allowance for loan losses at beginning of year  $19,241   $22,336   $19,437   $16,280   $15,351 
Loans charged off:                         
Commercial   4,176    5,336    7,099    2,997    2,406 
Residential   2,598    2,811    872    1,881    1,274 
Consumer   3,640    2,969    4,503    6,783    5,914 
Total loans charged off   10,414    11,116    12,474    11,661    9,594 
                          
Recoveries of loans previously charged off:                         
Commercial   644    938    2,319    574    704 
Residential   100    95    258    523    101 
Consumer   1,387    1,108    1,934    1,851    1,863 
Total recoveries   2,131    2,141    4,511    2,948    2,668 
Net loans charged off   8,283    8,975    7,963    8,713    6,926 
Provision charged to expense *   11,000    5,880    10,862    11,870    7,855 
Balance at end of year  $21,958   $19,241   $22,336   $19,437   $16,280 
Ratio of net charge-offs during period to average loans outstanding   0.44%   0.55%   0.49%   0.56%   0.48%

 

* In 2012 the provision charged to expense was reduced by $2.2 million for the increase to the FDIC

Indemnification asset. In 2011 and 2010 it was reduced by $125 thousand and $1.7 million, respectively.

 

The allowance is maintained at an amount management believes sufficient to absorb probable incurred losses in the loan portfolio. Monitoring loan quality and maintaining an adequate allowance is an ongoing process overseen by senior management and the loan review function. On at least a quarterly basis, a formal analysis of the adequacy of the allowance is prepared and reviewed by management and the Board of Directors. This analysis serves as a point in time assessment of the level of the allowance and serves as a basis for provisions for loan losses. The loan quality monitoring process includes assigning loan grades and the use of a watch list to identify loans of concern.

 

Included in the $1.9 billion of loans outstanding at December 31, 2012 are $27.8 million of covered loans, those loans acquired with the purchase of the First National Bank of Danville from the FDIC that are covered by the loss sharing agreement.

 

Also included are $245 million of loan acquired on December 30, 2011 in the Freestar acquisition. These acquired loans are recorded at fair value with no carryover of Freestar’s allowance for loan losses. The loans acquired had a contractual balance due of $254 million. The acquired portfolio includes purchased credit impaired loans with a contractual balance due of $29 million and a fair value of $20 million.

 

The analysis of the allowance for loan losses includes the allocation of specific amounts of the allowance to individual problem loans, generally based on an analysis of the collateral securing those loans. Portions of the allowance are also allocated to loan portfolios, based upon a variety of factors including historical loss experience, trends in the type and volume of the loan portfolios, trends in delinquent and non-performing loans, and economic trends affecting our market. These components are added together and compared to the balance of our allowance at the evaluation date. The Corporation’s unallocated allowance position of $1.7 million at December 31, 2012 has increased from $505 thousand at December 31, 2011. The unallocated position decreased in 2011. Management has determined the unallocated allowance position to be reasonable based on the trend analysis of the loan portfolio. Non-performing loans of $58.8 million at December 31, 2012 increased from $56.4 million at December 31, 2011. There was an additional $4.7 million of non-accrual loans added with the acquisition of Freestar Bank. Net charge-offs totaled $8.3 million compared to $9.0 million during 2011. The table below presents the allocation of the allowance to the loan portfolios at year-end.

 

   Years Ended December 31, 
(Dollar amounts in thousands)  2012   2011   2010   2009   2008 
Commercial  $10,987   $12,119   $12,809   $12,218   $9,963 
Residential   5,426    2,728    2,873    1,546    1,485 
Consumer   3,879    3,889    4,551    5,032    4,483 
Unallocated   1,666    505    2,103    641    349 
TOTAL ALLOWANCE FOR LOAN LOSSES  $21,958   $19,241   $22,336   $19,437   $16,280 

 

27
 

 

NONPERFORMING LOANS

 

Management monitors the components and status of nonperforming loans as a part of the evaluation procedures used in determining the adequacy of the allowance for loan losses. It is the Corporation's policy to discontinue the accrual of interest on loans where, in management's opinion, serious doubt exists as to collectability. The amounts shown below represent non-accrual loans, loans which have been restructured to provide for a reduction or deferral of interest or principal because of deterioration in the financial condition of the borrower and those loans which are past due more than 90 days where the Corporation continues to accrue interest. In 2012 there were two commercial loans totaling $5.1 million added to restructured loans and in 2010, and still outstanding the increase in restructured loans was mainly due to adding commercial loans totaling $14.9 million to restructured loans.The remainder is mostly smaller balance residential loans. The current economic environment has resulted in an increase in the use of restructured loans as a means to manage problem loans. Some restructured loans are also on non-accrual and are only included in the total of restructured loans.

 

(Dollar amounts in thousands)  2012   2011   2010   2009   2008 
Non-accrual loans  $36,794   $38,102   $38,517   $35,953   $12,486 
Restructured loans   19,671    16,275    17,094    90    98 
Accruing loans past due over 90 days   3,362    2,047    3,185    8,218    3,624 
   $59,827   $56,424   $58,796   $44,261   $16,208 

 

The ratio of the allowance for loan losses as a percentage of nonperforming loans was 37% at December 31, 2012, compared to 34% in 2011. The ratio of nonperforming loans excluding covered loans was 42% at December 31, 2012 and 41% at December 31, 2011. There were $2.4 and $3.6 million of covered loans included in restructured loans in 2012 and 2011 respectively. The following loan categories comprise significant components of the nonperforming loans at December 31, 2012 and 2011:

 

(Dollar amounts in thousands)  2012   2011 
Non-accrual loans:                    
Commercial loans  $21,900    60%  $26,590    70%
Residential loans   13,201    36%   9,477    25%
Consumer loans   1,693    5%   2,035    5%
   $36,794    100%  $38,102    100%
                     
Past due 90 days or more:                    
Commercial loans  $1,481    44%  $610    30%
Residential loans   1,750    52%   1,358    66%
Consumer loans   131    4%   79    4%
   $3,362    100%  $2,047    100%

 

   Covered Loans  (also included above) 
(Dollar amounts in thousands)  2012   2011 
Non-accrual loans:                    
Commercial loans  $4,114    95%  $5,086    91%
Residential loans   217    5%   506    9%
Consumer loans   -    0%   -    0%
   $4,331    100%  $5,592    100%
                     
Past due 90 days or more:                    
Commercial loans  $539    86%  $182    44%
Residential loans   91    14%   226    55%
Consumer loans   -    0%   5    1%
   $630    100%  $413    100%

 

Management considers the present allowance to be appropriate and adequate to cover probable incurred losses inherent in the loan portfolio based on the current economic environment. However, future economic changes cannot be predicted. Deteriorating economic conditions could result in an increase in the risk characteristics of the loan portfolio and an increase in the potential for loan losses.

 

28
 

 

 

DEPOSITS

 

The information below presents the average amount of deposits and rates paid on those deposits for 2012, 2011 and 2010.

 

   2012   2011   2010 
(Dollar amounts in thousands)  Amount   Rate   Amount   Rate   Amount   Rate 
Non-interest-bearing demand deposits  $439,206        $336,038        $300,760      
Interest-bearing demand deposits   439,368    0.19%   361,533    0.17%   330,168    0.23%
Savings deposits   737,035    0.13%   612,742    0.15%   540,370    0.20%
Time deposits: $100,000 or more   183,635    1.12%   181,380    1.58%   214,266    1.85%
Other time deposits   469,454    1.01%   434,784    1.79%   483,294    2.17%
TOTAL  $2,268,698        $1,926,477        $1,868,858      

  

The maturities of certificates of deposit of $100 thousand or more outstanding at December 31, 2012, are summarized as follows:

 

(Dollar amounts in thousands)    
3 months or less  $36,428 
Over 3 through 6 months   45,100 
Over 6 through 12 months   51,029 
Over 12 months   81,052 
TOTAL  $213,609 

 

OTHER BORROWINGS

 

Advances from the Federal Home Loan Bank decreased to $119.7 million in 2012 compared to $140.2 million in 2011. The FHLB advances acquired in the acquisition had a fair value of $16.6 million. Other borrowings acquired totaled $6.2 million in trust preferred securities that were included in the assumption of liabilities of PNB Holding Co, the parent company of Freestar Bank. These securities were called at the end of 2012. The Asset/Liability Committee reviews these investments and funding sources and considers the related strategies on a monthly basis. See Interest Rate Sensitivity and Liquidity below for more information.

 

CAPITAL RESOURCES

 

Bank regulatory agencies have established capital adequacy standards which are used extensively in their monitoring and control of the industry. These standards relate capital to level of risk by assigning different weightings to assets and certain off-balance-sheet activity. As shown in the footnote to the consolidated financial statements ("Regulatory Matters"), the Corporation's capital exceeds the requirements to be considered well capitalized at December 31, 2012.

 

First Financial Corporation's objective continues to be to maintain adequate capital to merit the confidence of its customers and shareholders. To warrant this confidence, the Corporation's management maintains a capital position which they believe is sufficient to absorb unforeseen financial shocks without unnecessarily restricting dividends to its shareholders. The Corporation's dividend payout ratio for 2012 and 2011 was 38.4% and 33.3%, respectively. The Corporation expects to continue its policy of paying regular cash dividends, subject to future earnings and regulatory restrictions and capital requirements.

 

INTEREST RATE SENSITIVITY AND LIQUIDITY

 

First Financial Corporation has established risk measures, limits and policy guidelines for managing interest rate risk and liquidity. Responsibility for management of these functions resides with the Asset/Liability Committee. The primary goal of the Asset/Liability Committee is to maximize net interest income within the interest rate risk limits approved by the Board of Directors.

 

Interest Rate Risk: Management considers interest rate risk to be the Corporation's most significant market risk. Interest rate risk is the exposure to changes in net interest income as a result of changes in interest rates. Consistency in the Corporation's net interest income is largely dependent on the effective management of this risk. The Asset/Liability position is measured using sophisticated risk management tools, including earnings simulation and market value of equity sensitivity analysis. These tools allow management to quantify and monitor both short-and long-term exposure to interest rate risk. Simulation modeling measures the effects of changes in interest rates, changes in the shape of the yield curve and the effects of embedded options on net interest income. This measure projects earnings in the various environments over the next three years. It is important to note that measures of interest rate risk have limitations and are dependent on various assumptions. These assumptions are inherently uncertain and, as a result, the model cannot precisely predict the impact of interest rate fluctuations on net interest income. Actual results will differ from simulated results due to timing, frequency and amount of interest rate changes as well as overall market conditions. The Committee has performed a thorough analysis of these assumptions and believes them to be valid and theoretically sound. These assumptions are continuously monitored for behavioral changes.

 

The Corporation from time to time utilizes derivatives to manage interest rate risk. Management continuously evaluates the merits of such interest rate risk products but does not anticipate the use of such products to become a major part of the Corporation's risk management strategy.

 

29
 

 

The table below shows the Corporation's estimated sensitivity profile as of December 31, 2012. The change in interest rates assumes a parallel shift in interest rates of 100 and 200 basis points. Given a 100 basis point increase in rates, net interest income would increase 3.56% over the next 12 months and increase 6.40% over the following 12 months. Given a 100 basis point decrease in rates, net interest income would decrease 0.91% over the next 12 months and decrease 2.78% over the following 12 months. These estimates assume all rate changes occur overnight and management takes no action as a result of this change.

 

Basis Point  Percentage Change in Net Interest Income 
Interest Rate Change  12 months   24 months   36 months 
Down 200   -1.70%   -5.17%   -7.45%
Down 100   -0.91%   -2.78%   -3.98%
Up 100   3.56%   6.40%   9.46%
Up 200   4.91%   10.50%   16.97%

 

Typical rate shock analysis does not reflect management's ability to react and thereby reduce the effects of rate changes, and represents a worst-case scenario.

 

Liquidity Risk Liquidity is measured by the bank's ability to raise funds to meet the obligations of its customers, including deposit withdrawals and credit needs. This is accomplished primarily by maintaining sufficient liquid assets in the form of investment securities and core deposits. The Corporation has $12.6 million of investments that mature throughout the coming 12 months. The Corporation also anticipates $111.6 million of principal payments from mortgage-backed securities. Given the current rate environment, the Corporation anticipates $8.9 million in securities to be called within the next 12 months.

 

CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENT LIABILITIES AND OFF-BALANCE SHEET ARRANGEMENTS

 

The Corporation has various financial obligations, including contractual obligations and commitments that may require future cash payments.

 

Contractual Obligations: The following table presents, as of December 31, 2012, significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements.

 

   Payments Due in 
   Note   One year   One year to   Three to   Over Five     
(Dollar amounts in thousands)  Reference   or less   Three Years   Five Years   Years   Total 
Deposits without a stated maturity       $1,666,791   $-   $-   $-   $1,666,791 
Consumer certificates of deposit        345,615    200,528    61,864    1,336    609,343 
Short-term borrowings   11    40,551    -    -    -    40,551 
Other borrowings   12    61,320    47,594    10,791    -    119,705 

 

The Corporation has obligations under its pension, supplemental executive retirement plan and post-retirement medical benefits plan as described in Note 15 to the consolidated financial statements.

 

Commitments: The following table details the amount and expected maturities of significant commitments as of December 31, 2012. Further discussion of these commitments is included in Note 14 to the consolidated financial statements.

 

   Total Amount   One year   Over One 
(Dollar amounts in thousands)  Committed   or less   Year 
Commitments to extend credit:               
Unused loan commitments  $362,010   $183,456   $178,554 
Commercial letters of credit   7,717    4,109    3,608 

 

Commitments to extend credit, including loan commitments, standby and commercial letters of credit do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon.

 

OUTLOOK

 

The Corporation's primary market is west-central Indiana and east-central Illinois. The market is primarily driven by the retail, higher education and health care industries. Typically, this market does not expand or contract at rates that are experienced by both the state and national economies. It is not anticipated that labor conditions will improve dramatically in 2013, although a gradual improvement in both the labor markets and retail sales is anticipated. The Corporation anticipates moderate growth opportunities in 2013.

 

30
 

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The information contained under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risk” on pages 29 and 30 of this Form 10-K is incorporated herein by reference in response to this item.

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

The management of First Financial Corporation (the "Corporation") has prepared and is responsible for the preparation and accuracy of the consolidated financial statements and related financial information included in the Annual Report.

 

The management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Corporation's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Corporation's internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Corporation; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Corporation are being made only in accordance with authorizations of management and directors of the Corporation; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Corporation's assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the Corporation's system of internal control over financial reporting as of December 31, 2012, in relation to criteria for effective internal control over financial reporting as described in "Internal Control—Integrated Framework," issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management concluded that, as of December 31, 2012, its system of internal control over financial reporting is effective and meets the criteria of the "Internal Control—Integrated Framework."

 

Crowe Horwath LLP, independent registered public accounting firm, has issued a report dated March 15, 2013 on the Corporation's internal control over financial reporting.

 

31
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Shareholders and Board of Directors of First Financial Corporation:

We have audited the accompanying consolidated balance sheets of First Financial Corporation as of December 31, 2012 and 2011 and the related consolidated statements of income and comprehensive income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. We also have audited First Financial Corporation's internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). First Financial Corporation's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the company's internal control over financial reporting based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Financial Corporation as of December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion First Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control —Integrated Framework issued by the COSO.

 

 

Crowe Horwath LLP

 

Indianapolis, Indiana March 15, 2013

 

32
 

 

CONSOLIDATED BALANCE SHEETS

 

   December 31, 
(Dollar amounts in thousands, except per share data)  2012   2011 
ASSETS          
Cash and due from banks  $87,230   $134,280 
Federal funds sold   20,800    11,725 
Securities available-for-sale   691,000    666,287 
Loans, net of allowance of $21,958 in 2012 and $19,241 in 2011   1,829,978    1,874,438 
Restricted Stock   21,292    22,282 
Accrued interest receivable   12,024    12,947 
Premises and equipment, net   47,308    40,105 
Bank-owned life insurance   77,295    82,646 
Goodwill   37,612    36,897 
Other intangible assets   3,893    5,142 
Other real estate owned   7,722    4,964 
FDIC Indemnification Asset   2,632    2,384 
Other assets   56,622    59,964 
TOTAL ASSETS  $2,895,408   $2,954,061 
           
LIABILITIES AND SHAREHOLDERS’ EQUITY          
Deposits:          
Non-interest-bearing  $465,954   $435,236 
Interest-bearing:          
Certificates of deposit of $100 or more   213,610    242,001 
Other interest-bearing deposits   1,596,570    1,597,262 
    2,276,134    2,274,499 
Short-term borrowings   40,551    100,022 
Other borrowings   119,705    146,427 
Other liabilities   86,896    86,152 
TOTAL LIABILITIES   2,523,286    2,607,100 
           
Shareholders’ equity          
Common stock, $.125 stated value per share;          
Authorized shares-40,000,000          
Issued shares-14,490,609 in 2012 and 14,450,966 in 2011.          
Outstanding shares-13,287,348 in 2012 and 13,197,880 in 2011   1,808    1,806 
Additional paid-in capital   69,989    69,328 
Retained earnings   338,342    318,130 
Accumulated other comprehensive income (loss)   (7,472)   (10,494)
Less: Treasury shares at cost-1,203,261 in 2012 and 1,253,086 in 2011   (30,545)   (31,809)
           
TOTAL SHAREHOLDERS’ EQUITY   372,122    346,961 
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY  $2,895,408   $2,954,061 

See accompanying notes. 

 

33
 

 

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

 

   Years Ended December 31, 
(Dollar amounts in thousands, except per share data)  2012   2011   2010 
INTEREST AND DIVIDEND INCOME:               
Loans, including related fees  $99,196   $91,392   $96,206 
Securities:               
Taxable   13,542    16,161    18,597 
Tax-exempt   7,246    6,779    6,664 
Other   2,321    2,009    2,115 
TOTAL INTEREST AND DIVIDEND INCOME   122,305    116,341    123,582 
                
INTEREST EXPENSE:               
Deposits   8,520    12,127    16,306 
Short-term borrowings   140    187    325 
Other borrowings   4,733    4,833    10,335 
TOTAL INTEREST EXPENSE   13,393    17,147    26,966 
                
NET INTEREST INCOME   108,912    99,194    96,616 
                
Net Provision for loan losses   8,773    5,755    9,200 
                
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES   100,139    93,439    87,416 
                
NON-INTEREST INCOME:               
Trust and financial services   5,804    4,544    4,547 
Service charges and fees on deposit accounts   9,742    8,995    10,342 
Other service charges and fees   9,710    8,289    7,759 
Securities gain, net   886    6    1,321 
Other-than-temporary loss               
Total impairment loss   (11)   (110)   (4,260)
Loss recognized in other comprehensive income               
Net impairment loss recognized in earnings   (11)   (110)   (4,260)
Insurance commissions   7,422    7,347    6,759 
Gain on sale of mortgage loans   4,590    1,957    2,206 
Other   1,404    2,312    1,123 
TOTAL NON-INTEREST INCOME   39,547    33,340    29,797 
NON-INTEREST EXPENSES:               
Salaries and employee benefits   56,211    45,362    44,887 
Occupancy expense   5,746    4,777    4,707 
Equipment expense   5,489    4,352    4,761 
Federal Deposit Insurance   1,949    1,804    2,847 
Other   23,661    18,892    20,000 
TOTAL NON-INTEREST EXPENSE   93,056    75,187    77,202 
INCOME BEFORE INCOME TAXES   46,630    51,592    40,011 
                
Provision for income taxes   13,818    14,397    11,967 
NET INCOME  $32,812   $37,195   $28,044 
OTHER COMPREHENSIVE INCOME               
Change in unrealized gains/losses on securities, net of reclassifications and taxes  $691   $8,857   $449 
Change in funded status of post retirement benefits, net of taxes  $2,331   $(9,982)  $(1,914)
COMPREHENSIVE INCOME  $35,834   $36,070   $26,579 
EARNINGS PER SHARE:               
BASIC AND DILUTED  $2.48   $2.83   $2.14 
Weighted average number of shares outstanding (in thousands)   13,240    13,163    13,120 

See accompanying notes.

 

34
 

 

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

 

               Accumulated         
               Other         
   Common   Additional   Retained   Comprehensive   Treasury     
(Dollar amounts in thousands, except per share data)  Stock   Capital   Earnings   Income/(Loss)   Stock   Total 
                         
Balance, January 1, 2010  $1,806   $68,739   $277,357   $(7,904)  $(33,515)  $306,483 
                               
Net income   -    -    28,044    -    -    28,044 
Other comprehensive loss, net of tax:                              
Change in net unrealized gains/losses on securities available-for-sale, net   -    -    -    449    -    449 
Change in unrealized gains/losses on post-retirement benefits   -    -    -    (1,914)   -    (1,914)
Contribution of 45,000 shares to ESOP   -    205    -    -    1,142    1,347 
Treasury stock purchase (23,000 shares)   -    -    -    -    (610)   (610)
Cash Dividends, $.92 per share   -    -    (12,082)   -    -    (12,082)
                               
Balance, December 31, 2010   1,806    68,944    293,319    (9,369)   (32,983)   321,717 
                               
Net income   -    -    37,195    -    -    37,195 
Change in net unrealized gains/(losses) on securities available for-sale   -    -    -    8,857    -    8,857 
Change in net unrealized gains/(losses) on retirement plans   -    -    -    (9,982)   -    (9,982)
Contribution of 46,250 shares to ESOP   -    384    -    -    1,174    1,558 
Cash Dividends, $.94 per share   -    -    (12,384)   -    -    (12,384)
                               
Balance, December 31, 2011   1,806    69,328    318,130    (10,494)   (31,809)   346,961 
                               
Net income   -    -    32,812    -    -    32,812 
Change in net unrealized gains/(losses) on securities available for-sale   -    -    -    691    -    691 
Change in net unrealized gains/(losses) on retirement plans   -    -    -    2,331    -    2,331 
Omnibus Equity Incentive Plan   2    486                   488 
Contribution of 49,825 shares to ESOP   -    175    -    -    1,264    1,439 
Cash Dividends, $.95 per share   -    -    (12,600)   -    -    (12,600)
                               
Balance, December 31, 2012  $1,808   $69,989   $338,342   $(7,472)  $(30,545)  $372,122 

See accompanying notes.

 

35
 

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

    Years Ended December 31,  
(Dollar amounts in thousands, except per share data)   2012     2011     2010  
CASH FLOWS FROM OPERATING ACTIVITIES:                        
Net Income   $ 32,812     $ 37,195     $ 28,044  
Adjustments to reconcile net income to net cash provided by operating activities:                        
Net (accretion) amortization on securities     3,492       274       (840 )
Provision for loan losses     8,773       5,755       9,200  
Securities impairment loss recognized in earnings     11       110       4,260  
Securities (gains) losses     (886 )     (6 )     (1,321 )
Depreciation and amortization     5,105       3,897       4,643  
Provision for deferred income taxes     (143 )     624       (5,940 )
Net change in accrued interest receivable     923       500       797  
Contribution of shares to ESOP     1,439       1,558       1,347  
Stock compensation expense     488       -       -  
Gain on sale of mortgage loans     (4,590 )     (1,957 )     (2,206 )
Loss on sales of other real estate     69       370       283  
Other, net     7,160       (7,739 )     10,293  
NET CASH FROM OPERATING ACTIVITIES     54,653       40,581       48,560  
CASH FLOWS FROM INVESTING ACTIVITIES:                        
Sales of securities available-for-sale     25,812       25       12,248  
Calls, maturities and principal reductions on securities available-for-sale     142,475       139,179       223,862  
Purchases of securities available-for-sale     (194,475 )     (134,770 )     (211,062 )
Loans made to customers, net of payments     (137,684 )     (106,012 )     (132,997 )
Net change in federal funds sold     (9,075 )     1,044       16,472  
Purchase of bank owned life insurance     (1,551 )     (4,500 )     -  
Redemption of bank owned life insurance     9,180       -       -  
Redemption of restricted stock     1,185       4,952       2,527  
Purchase of restricted stock     (186 )     -       -  
Purchase of customer list     (114 )     -       -  
Cash received from sale of mortgage loans     167,227       86,601       116,462  
Cash received (disbursed) from purchase of business unit     -       14,849       (609 )
Sale of other real estate     4,285       4,573       3,727  
Additions to premises and equipment     (10,945 )     (1,476 )     (2,406 )
NET CASH FROM INVESTING ACTIVITIES     (3,866 )     4,465       28,224  
CASH FLOWS FROM FINANCING ACTIVITIES:                        
Net change in deposits     149       10,202       113,180  
Net change in other short-term borrowings     (59,471 )     36,746       3,670  
Dividends paid     (12,425 )     (12,231 )     (11,940 )
Purchases of treasury stock     -       -       (610 )
Proceeds from other borrowings     -       -       2,000  
Repayments on other borrowings     (26,090 )     (3,994 )     (208,944 )
NET CASH FROM FINANCING ACTIVITIES     (97,837 )     30,723       (102,644 )
NET CHANGE IN CASH AND CASH EQUIVALENTS     (47,050 )     75,769       (25,860 )
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR     134,280       58,511       84,371  
CASH AND CASH EQUIVALENTS, END OF YEAR   $ 87,230     $ 134,280     $ 58,511  
                         
SUPPLEMENTAL DISCLOSURES OF CASH FLOW AND NONCASH INFORMATION:                        
Cash paid for the year for:                        
Interest   $ 13,837     $ 17,358     $ 28,051  
Income Taxes   $ 12,638     $ 16,565     $ 15,713  

See accompanying notes.

 

36
 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES:

 

BUSINESS

 

Organization: The consolidated financial statements of First Financial Corporation and its subsidiaries (the Corporation) include the parent company and its wholly-owned subsidiaries, First Financial Bank, N.A. headquartered in Vigo County, Indiana, The Morris Plan Company of Terre Haute (Morris Plan), Forrest Sherer Inc., a full-line insurance agency headquartered in Terre Haute, Indiana, and FFB Risk Management Co., Inc., a captive insurance subsidiary headquartered in Las Vegas, Nevada. Inter-company transactions and balances have been eliminated.

 

First Financial Bank also has two investment subsidiaries, Portfolio Management Specialists A (Specialists A) and Portfolio Management Specialists B (Specialists B), which were established to hold and manage certain assets as part of a strategy to better manage various income streams and provide opportunities for capital creation as needed. Specialists A and Specialists B subsequently entered into a limited partnership agreement, Global Portfolio Limited Partners. Portfolio Management Specialists B also owns First Financial Real Estate, LLC. At December 31, 2012, $583.7 million of securities and loans were owned by these subsidiaries. Specialists A, Specialists B, Global Portfolio Limited Partners and First Financial Real Estate LLC are included in the consolidated financial statements.

 

The Corporation, which is headquartered in Terre Haute, Indiana, offers a wide variety of financial services including commercial, mortgage and consumer lending, lease financing, trust account services and depositor services through its four subsidiaries. The Corporation's primary source of revenue is derived from loans to customers, primarily middle-income individuals, and investment activities.

 

The Corporation operates 68 branches in west-central Indiana and east-central Illinois. First Financial Bank is the largest bank in Vigo County. It operates 11 full-service banking branches within the county; one in Daviess County, Indiana.; five in Clay County, Indiana; one in Gibson County, Indiana.; one in Greene County, Indiana; four in Knox County, Indiana; five in Parke County, Indiana; one in Putnam County, Indiana; five in Sullivan County, Indiana; one in Vanderburgh County, Indiana,; four in Vermillion County, Indiana; five in Champaign County, Illinois; one in Clark County, Illinois; one in Coles County, Illinois; three in Crawford County, Illinois; one in Jasper County, Illinois; one in Lawrence County, Illinois; three in Livingston County, Illinois; four in McLean County, Illinois; two in Richland County, Illinois; six in Vermilion County, Illinois; and one in Wayne County, Illinois. It also has a main office in downtown Terre Haute and an operations center/office building in southern Terre Haute.

 

Regulatory Agencies: First Financial Corporation is a multi-bank holding company and as such is regulated by various banking agencies. The holding company is regulated by the Seventh District of the Federal Reserve System. The national bank subsidiary is regulated by the Office of the Comptroller of the Currency. The state bank subsidiary is jointly regulated by the state banking organization and the Federal Deposit Insurance Corporation.

 

SIGNIFICANT ACCOUNTING POLICIES

 

Use of Estimates: To prepare financial statements in conformity with U.S. generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and disclosures provided, and actual results could differ. The allowance for loan losses, goodwill, carrying value of intangible assets, loan servicing rights, other-than-temporary securities impairment and the fair values of financial instruments are particularly subject to change.

 

Cash Flows: Cash and cash equivalents include cash and demand deposits with other financial institutions. Net cash flows are reported for customer loan and deposit transactions and short-term borrowings. Non-cash transactions include loans transferred to other real estate of $7.1 million, $3.5 million and $4.5 million for the years ended December 31, 2012, 2011 and 2010 respectively.

 

Securities: The Corporation classifies all securities as "available for sale." Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value with unrealized holdings gains and losses, net of taxes, reported in other comprehensive income within shareholders' equity.

 

Interest income includes amortization of purchase premium or discount. Premiums and discounts are amortized on the level yield method without anticipating prepayments. Mortgage-backed securities are amortized over the expected life. Realized gains and losses on sales are based on the amortized cost of the security sold. Management evaluates securities for other-than temporary impairment (OTTI) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.

 

Loans: Loans that management has the intent and ability to hold for the foreseeable future until maturity or pay-off are reported at the principal balance outstanding, net of unearned interest, purchase premiums and discounts, deferred loan fees and costs, and allowance for loan losses. Loans held for sale are reported at the lower of cost or market, on an aggregate basis. Interest income is accrued on the unpaid principal balance and includes amortization of net deferred loan fees and costs over the loan term without anticipating prepayments. The recorded investment in loans includes accrued interest receivable and net deferred loan fees and costs over the loan term without anticipating prepayments. Interest income is not reported when full loan repayment is in doubt, typically when the loan is impaired or payments are significantly past due. Past-due status is based on the contractual terms of the loan.

 

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. In all cases, loans are placed on non-accrual or charged-off if collection of principal or interest is considered doubtful. The above policies are consistent for all segments of loans.

 

37
 

 

Certain Purchased Loans: The Corporation purchases individual loans and groups of loans, some of which have shown evidence of credit deterioration since origination. These purchased loans are recorded at the amount paid, such that there is no carryover of the seller's allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses. Such purchased loans are accounted for individually. The Corporation estimates the amount and timing of expected cash flows for each purchased loan, and the expected cash flows in excess of amount paid are recorded as interest income over the remaining life of the loan (accretable yield). The excess of the loan's contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

 

Over the life of the loan, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a provision for loan loss is recorded. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

 

Concentration of Credit Risk: Most of the Corporation's business activity is with customers located within west central Indiana and east central Illinois. Therefore, the Corporation's exposure to credit risk is significantly affected by changes in the economy of this area. A major economic downturn in this area would have a negative effect on the Corporation's loan portfolio.

 

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.

A loan is impaired when full payment under the loan terms is not expected. Loans for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgages and consumer loans, and on an individual basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows, using the loan's existing rate, or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment and, accordingly, they are not separately identified for impairment disclosures.

 

The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. The historical loss experience is based on the actual loss history experienced over the most recent four years, using a weighted average which places more emphasis on the more current years within the loss history window. This actual loss experience is supplemented with other current factors based on the risks present for each portfolio segment. These current factors include consideration of the following: levels of and trends in delinquent, classified, and impaired loans; levels of and trends in charge-offs and recoveries; national and local economic trends and conditions; changes in lending policies and procedures; trends in volume and terms of loans; experience, ability, and depth of lending management and other relevant staff; credit concentrations; value of underlying collateral for collateral dependent loans; and other external factors such as competition and legal and regulatory requirements. The following portfolio segments have been identified: commercial loans, residential loans and consumer loans. A characteristic of the commercial loan segment is that the loans are for business purchases. A characteristic of the residential loan segment is that the loans are secured by residential properties. A characteristic of the consumer loan segment is that the loans are to for automobiles and other consumer purchases. Local economic conditions, including elevated unemployment rates, resulted in higher consumer loan delinquencies. For these reasons, consumer loans have the highest adjustments to the historical loss rate. These same factors along with declining real estate values resulted in the residential loan portfolio segment having the next highest level of adjustment to the historical loss rate. The commercial loan portfolio segment had the lowest level of adjustment to the historical loss rate. Adjustments were made for the increasing levels of and trends in delinquent, classified and impaired commercial loans. Commercial loans are generally well secured, which mitigates the risk of loss and has contributed to the low historical loss rate.

 

FDIC Indemnification Asset: The FDIC indemnification asset results from the loss share agreements in the 2009 FDIC-assisted transaction. The asset is measured separately from the related covered assets as they are not contractually embedded in the assets and are not transferable with the assets should the Corporation choose to dispose of them. It represents the acquisition date fair value of expected reimbursements from the FDIC which was determined to be $12.1 million. Pursuant to the terms of the loss sharing agreement, covered loans and other real estate are subject to a stated loss threshold whereby the FDIC will reimburse the Corporation for up to 95% of losses incurred. These expected reimbursements do not include reimbursable amounts related to future covered expenditures. These cash flows are discounted to reflect a metric of uncertainty of the timing and receipt of the loss sharing reimbursement from the FDIC. This asset decreases when losses are realized and claims are paid by the FDIC or when customers repay their loans in full and expected losses do not occur. This asset also increases when estimated future losses increase. When estimated future losses increase, the Corporation records a provision for loan losses and increases its allowance for loan losses accordingly. The related increase in the FDIC indemnification asset is recorded as an offset to the provision for loan losses. During 2012, 2011 and 2010, the provision for loan losses was offset by $2.2 million, $125 thousand and $1.7 million related to the increases in the FDIC indemnification asset.

 

Foreclosed Assets: Assets acquired through or instead of loan foreclosures are initially recorded at fair value less estimated selling costs when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair valueless estimated costs to sell. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed.

 

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Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed over the useful lives of the assets, which range from 3 to 33 years for furniture and equipment and 5 to 39 years for buildings and leasehold improvements.

 

Restricted Stock: Restricted stock includes Federal Home Loan Bank (FHLB) of Indianapolis and Chicago and Federal Reserve stock. This restricted stock is carried at cost and periodically evaluated for impairment. Because this stock is viewed as a long-term investment, impairment is based on ultimate recovery of par value. Both cash and stock dividends are reported as income.

 

Servicing Rights: Servicing rights are recognized separately when they are acquired through sales of loans. When mortgage loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively, is based on third-party valuations that incorporate assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, ancillary income, prepayment speeds and default rates and losses. All classes of servicing assets are subsequently measured using the amortization method, which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.

 

Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Corporation later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. Changes in valuation allowances are reported with Other Service Fees on the income statement. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.

 

Servicing fee income, which is included in Other Service Fees on the income statement, is for fees earned for servicing loans.

 

The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. Servicing fees totaled $1.3 million, $1.2 million and $1.2 million for the years ended December 31, 2012, 2011 and 2010. Late fees and ancillary fees related to loan servicing are not material.

 

Stock based compensation: Compensation cost is recognized for restricted stock awards and units issued to employees based on the fair value of these awards at the date of grant. Market price of the Corporation’s common stock at the date of grant is used for restricted stock awards. Compensation expense is recognized over the requisite service period.

 

Transfers of Financial Assets: Transfers of financial assets are accounted for as sales, when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Corporation, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

 

Bank-Owned Life Insurance: The Corporation has purchased life insurance policies on certain key executives. Bank-owned life insurance is recorded at its cash surrender value, or the amount that can be realized. Income on the investments in life insurance is included in other interest income.

 

Goodwill and Other Intangible Assets: Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill resulting from business combinations after January 1, 2009 represents the future economic benefits arising from other assets acquired that are not individually identified and separately recognized. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. The Corporation has selected November 30 as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on our balance sheet.

 

Other intangible assets consist of core deposit and acquired customer list intangible assets arising from the whole bank, insurance agency and branch acquisitions. They are initially measured at fair value and then are amortized on an accelerated basis over their estimated useful lives, which are 12 and 10 years, respectively.

 

Long-Term Assets: Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.

 

Benefit Plans: Pension expense is the net of service and interest cost, return on plan assets and amortization of gains and losses not immediately recognized. The amount contributed is determined by a formula as decided by the Board of Directors. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service.

 

Employee Stock Ownership Plan: Shares of treasury stock are issued to the ESOP and compensation expense is recognized based upon the total market price of shares when contributed.

 

Deferred Compensation Plan: A deferred compensation plan covers all directors. Under the plan, the Corporation pays each director, or their beneficiary, the amount of fees deferred plus interest over 10 years, beginning when the director achieves age 65. A liability is accrued for the obligation under these plans. The expense incurred for the deferred compensation for each of the last three years was $142 thousand, $144 thousand and $183 thousand, resulting in a deferred compensation liability of $2.6 million at both December 31, 2012 and 2011.

 

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Incentive Plans: A long-term incentive plan established in 2000 provides for the payment of incentive rewards as a 15-year annuity to all directors and certain key officers. That plan was in place through December 31, 2009, and compensation expense is recognized over the service period. Payments under the plan generally do not begin until the earlier of January 1, 2015, or the January 1 immediately following the year in which the participant reaches age 65. There was no compensation expense related to this plan for 2012, 2011and 2010. There is a liability of $15.0 million and $15.4 million as of year-end 2012 and 2011. In 2010 the Corporation adopted incentive compensation plans designed to reward key officers based on certain performance measures. The short-term portion of the plan is paid out within 75 days of year end and the long-term plan vests over a three year period and will payout within 75 days of the three year vesting period beginning with December 31, 2012. The compensation expense related to the plans in 2012, 2011 and 2010 was $1.3 million, $972 thousand and $2.2 million, respectively, and resulted in a liability of $1.6 million at December 31, 2012 and $2.2 million at December 31, 2011.

 

The Omnibus Equity Incentive Plan is a long term incentive plan that was designed to align the interests of participants with the interest of shareholders. Under the plan, awards may be made based on certain performance measures. The grants are made in restricted stock units that are subject to a vesting schedule.

 

Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

 

A tax position is recognized as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded

 

The Corporation recognizes interest and/or penalties related to income tax matters in income tax expense.

 

Loan Commitments and Related Financial Instruments: Financial instruments include credit instruments, such as commitments to make loans and standby letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

 

Earnings Per Share: Earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. The Corporation does not have any potentially dilutive securities. Earnings and dividends per share are restated for stock splits and dividends through the date of issue of the financial statements.

 

Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale and changes in the funded status of the retirement plans, which are also recognized as separate components of equity.

 

Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount of range of loss can be reasonably estimated. Management does not believe there are currently such matters that will have a material effect on the financial statements.

 

Dividend Restriction: Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company or by the holding company to shareholders.

 

Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or market conditions could significantly affect the estimates.

 

Operating Segment: While the Corporation's chief decision-makers monitor the revenue streams of the various products and services, the operating results of significant segments are similar and operations are managed and financial performance is evaluated on a corporate-wide basis. Accordingly, all of the Corporation's financial service operations are considered by management to be aggregated in one reportable operating segment, which is banking.

 

Adoption of New Accounting Standards: In October 2012, the Financial Accounting Standards Board (“FASB”) issued guidance on the subsequent accounting for an indemnification asset recognized at the acquisition date as a result of a government assisted acquisition of a financial institution. When an entity recognizes such an indemnification asset and subsequently a change in the cash flows expected to be collected on the indemnification asset occurs as a result of a change in the cash flows expected to be collected on the indemnified asset, the guidance requires the entity to recognize the change in the measurement of the indemnification asset on the same basis as the indemnified assets. Any amortization of changes in value of the indemnification asset should be limited to the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets. The amendments are effective for fiscal years beginning on or after December 15, 2012 and early adoption is permitted. The amendments are to be applied prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution. The effect of adopting this standard did not have a material effect on the Corporation’s operating results or financial condition.

 

In July 2012, the FASB amended existing guidance relating to testing indefinite-lived intangible assets for impairment. The amendment permits an assessment of qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, it is concluded that it is not more likely than not that the indefinite-lived intangible asset is impaired, then no further action is required. However, after the same assessment, if it is concluded that it is more like than not that the indefinite-lived intangible asset is impaired, then a quantitative impairment test should be performed whereby the fair value of the indefinite-lived intangible asset is compared to the carrying amount. The amendments in this guidance are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. The effect of adopting this standard did not have a material effect on the Corporation’s operating results or financial condition.

 

In September 2011, the FASB amended existing guidance relating to goodwill impairment testing. The amendment permits an assessment of qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing these events or circumstances, it is concluded that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. The amendments in this guidance are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The effect of adopting this standard did not have a material effect on the Corporation’s operating results or financial condition.

 

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2.FAIR VALUES OF FINANCIAL INSTRUMENTS:

 

Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

 

Level 1: Quoted prices (unadjusted) of identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

Level 2: Significant other observable inputs other than Level 1 prices such as such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

Level 3: Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

The fair value of securities available-for-sale is determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs).

 

For those securities that cannot be priced using quoted market prices or observable inputs, a Level 3 valuation is determined. These securities are primarily trust preferred securities, which are priced using Level 3 due to current market illiquidity and certain investments in bank equities and state and municipal securities. The fair value of the trust preferred securities is obtained from a third party provider without adjustment. As described previously, management obtains values from other pricing sources to validate the Standard & Poors pricing that they currently utilize. The fair value of certain investments in bank equities is based on the prices of recent stock trades and is considered Level 3 because these stocks are not publicly traded. The fair value of state and municipal obligations are derived by comparing the securities to current market rates plus an appropriate credit spread to determine an estimated value. Illiquidity spreads are then considered. Credit reviews are performed on each of the issuers. The significant unobservable inputs used in the fair value measurement of the Corporation’s state and municipal obligations are credit spreads related to specific issuers. Significantly higher credit spread assumptions would result in significantly lower fair value measurement. Conversely, significantly lower credit spreads would result in a significantly higher fair value measurement.

 

The fair value of derivatives is based on valuation models using observable market data as of the measurement date (Level 2 inputs).

 

   December 31, 2012 
   Fair Value Measurment Using 
(Dollar amounts in thousands)  Level 1   Level 2   Level 3   Carrying Value 
U.S. Government entity mortgage-backed securities  $-   $1,886   $-   $1,886 
Mortgage-backed securities, residential   -    244,676    -    244,676 
Mortgage-backed securities, commercial   -    5,131    -    5,131 
Collateralized mortgage obligations   -    233,320    -    233,320 
State and municipal obligations   -    189,574    9,911    199,485 
Collateralized debt obligations   -    -    6,122    6,122 
Equity Securities   380    -    -    380 
TOTAL  $380   $674,587   $16,033   $691,000 
Derivative Assets       $2,053           
Derivative Liabilities        (2,053)          

 

   December 31, 2011 
   Fair Value Measurment Using 
(Dollar amounts in thousands)  Level 1   Level 2   Level 3   Carrying Value 
U.S. Government entity mortgage-backed securities  $-   $4,013   $-   $4,013 
Mortgage-backed securities, residential   -    311,788    -    311,788 
Mortgage-backed securities, commercial   -    101    -    101 
Collateralized mortgage obligations   -    147,947    -    147,947 
State and municipal obligations   -    186,056    9,525    195,581 
Collateralized debt obligations   -    -    4,771    4,771 
Equity Securities   375    -    1,711    2,086 
TOTAL  $375   $649,905   $16,007   $666,287 
Derivative Assets       $2,447           
Derivative Liabilities        (2,447)          

 

There were no transfers between Level 1 and Level 2 during 2012 and 2011.

 

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The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the twelve months ended December 31, 2012 and 2011.

 

   Fair Value Measurements Using SignificantUnobservable Inputs (Level 3) 
   December 31, 2012 
       State and   Collateralized     
       municipal   debt     
   Equities   obligations   obligations   Total 
Beginning balance, January 1  $1,711   $9,525   $4,771   $16,007 
Total realized/unrealized gains or losses                    
Included in earnings   (446)   -    (96)   (542)
Included in other comprehensive income   -    -    1,556    1,556 
Transfers & Purchases   -    1,186    -    1,186 
Settlements   (1,265)   (800)   (109)   (2,174)
Ending balance, December 31  $-   $9,911   $6,122   $16,033 

 

   Fair Value Measurements Using SignificantUnobservable Inputs (Level 3) 
   December 31, 2011 
       State and   Collateralized     
       municipal   debt     
   Equities   obligations   obligations   Total 
Beginning balance, January 1  $1,518   $-   $2,190   $3,708 
Total realized/unrealized gains or losses                    
Included in earnings   -    -    -    - 
Included in other comprehensive income   193    -    2,581    2,774 
Transfers & Purchases   -    9,672    -    9,672 
Settlements   -    (147)   -    (147)
Ending balance, December 31  $1,711   $9,525   $4,771   $16,007 

  

There were no unrealized gains and losses recorded in earnings for the year ended December 31, 2012or 2011.

 

The fair value for certain local municipal securities with a fair value of $1.2 million as of December 31, 2012 were acquired and classified Level 3 because of a lack of observable market data for these investments due to a little market activity for these securities. The fair value for certain local municipal securities with a fair value of $9.7 million as of December 31, 2011 was transferred out of Level 2 into Level 3 because of a lack of observable market data for these investments due to a decrease in the market activity for this security.

 

Impaired loans disclosed in footnote 7, which are measured for impairment using the fair value of collateral, are valued at Level 3. They are carried at a fair value of $26.0 million, after a valuation allowance of $7.6 million at December 31, 2012 and at a fair value of $28.4 million, net of a valuation allowance of $4.3 million at December 31, 2011. The impact to the provision for loan losses for the twelve months ended December 31, 2012 and December 31, 2011 was $4.2 million and $3.3 million, respectively. Other real estate owned is valued at Level 3. Other real estate owned at December 31, 2012 with a value of $7.7 million was reduced $234 thousand for fair value adjustment. At December 31, 2012 other real estate owned was comprised of $5.7 million from commercial loans and $2.0 million from residential loans. Other real estate owned at December 31, 2011 with a value of $5.0 million was reduced $892 thousand for fair value adjustment. At December 31, 2011 other real estate owned was comprised of $2.8 million from commercial loans and $2.2 million from residential loans.

 

Fair value is measured based on the value of the collateral securing those loans, and is determined using several methods. Generally the fair value of real estate is determined based on appraisals by qualified licensed appraisers. Appraisals for real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the cost to replace current property. The market comparison evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and the investor’s required return. The final fair value is based on a reconciliation of these three approaches. If an appraisal is not available, the fair value may be determined by using a cash flow analysis, a broker’s opinion of value, the net present value of future cash flows, or an observable market price from an active market. Fair value of other real estate is based upon the current appraised values of the properties as determined by qualified licensed appraisers and the Company’s judgment of other relevant market conditions. Appraisals are obtained annually and reductions in value are recorded as a valuation through a charge to expense. The primary unobservable input used by management in estimating fair value are additional discounts to the appraised value to consider market conditions and the age of the appraisal, which are based on management’s past experience in resolving these types of properties. These discounts range from 5% to 20%. Other real estate and impaired loans carried at fair value are primarily comprised of smaller balance properties.

 

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The following table presents quantitative information about recurring and non-recurring Level 3 fair value measurements at December 31, 2012.

 

   Fair Value   Valuation Technique(s)  Unobservable Input(s)  Range 
State and municipal obligations  $9,911   Discounted cash flow  Discount rate   3.05%-5.50% 
           Probability of default   0%
Other real estate  $7,722   Sales comparison/income approach  Discount rate for age of appraisal and market conditions   5.00%-20.00% 
Impaired Loans   25,948   Sales comparison/income approach  Discount rate for age of appraisal and market conditions    0.00%-50.00% 

 

The following table presents loans identified as impaired by class of loans as of December 31, 2012 and 2011.

 

   December 31, 2012     
(Dollar amounts in thousands)  Carrying Value   Allowance
for Loan
Losses
Allocated
   Fair Value 
Commercial               
Commercial & Industrial  $17,098   $3,153   $13,945 
Farmland   891    191    700 
Non Farm, Non Residential   7,386    293    7,093 
Agriculture   -    -    - 
All Other Commercial   1,209    52    1,157 
Residential               
First Liens   1,254    126    1,128 
Home Equity   179    -    179 
Junior Liens   -    -    - 
Multifamily   5,540    3,794    1,746 
All Other Residential   -    -    - 
Consumer               
Motor Vehicle   -    -    - 
All Other Consumer   -    -    - 
TOTAL  $33,557   $7,609   $25,948 

 

   December 31, 2011     
(Dollar amounts in thousands)  Carrying Value   Allowance
for Loan
Losses
Allocated
   Fair Value 
Commercial               
Commercial & Industrial  $17,890   $2,664   $15,226 
Farmland   891    49    842 
Non Farm, Non Residential   9,260    957    8,303 
Agriculture   -    -    - 
All Other Commercial   1,517    66    1,451 
Residential               
First Liens   1,963    190    1,773 
Home Equity   -    -    - 
Junior Liens   879    347    532 
Multifamily   250    -    250 
All Other Residential   -    -    - 
Consumer               
Motor Vehicle   -    -    - 
All Other Consumer   -    -    - 
TOTAL  $32,650   $4,273   $28,377 

 

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The carrying amounts and estimated fair values of financial instruments are shown below. Carrying amount is the estimated fair value for cash and due from banks, federal funds sold, accrued interest receivable and payable, demand deposits, short-term and certain other borrowings, and variable-rate loans or deposits that reprice frequently and fully. Security fair values are determined as previously described. It is not practicable to determine the fair value of restricted stock due to restrictions placed on their transferability. For the FDIC indemnification asset the carrying value is the estimated fair value as it represents amounts to be received from the FDIC in the near term. For fixed-rate loans or deposits, variable rate loans or deposits with infrequent repricing or repricing limits, and for longer-term borrowings, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. Fair value of debt is based on current rates for similar financing. The fair value of off-balance sheet items is not considered material.

 

The carrying amount and estimated fair value of assets and liabilities are presented in the table below and were determined based on the above assumptions:

 

   December 31, 2012         
   Carrying   Fair Value  
(Dollar amounts in thousands)  Value   Level 1   Level 2   Level 3   Total 
Cash and due from banks  $87,230   $21,333   $65,897   $-   $87,230 
Federal funds sold   20,800    -    20,800    -    20,800 
Securities available—for—sale   691,000    380    674,587    16,033    691,000 
Restricted stock   21,292    n/a    n/a    n/a    n/a 
Loans, net   1,829,978    -    -    1,916,256    1,916,256 
FDIC Indemnification Asset   2,632    -    2,632    -    2,632 
Accrued interest receivable   12,024    -    2,980    9,044    12,024 
Deposits   (2,276,134)   -    (2,280,910)   -    (2,280,910)
Short—term borrowings   (40,551)   -    (40,551)   -    (40,551)
Federal Home Loan Bank advances   (119,705)   -    (124,933)   -    (124,933)
Accrued interest payable   (1,163)   -    (1,163)   -    (1,163)

 

   December 31, 2011         
   Carrying    Fair Value  
(Dollar amounts in thousands)  Value   Level 1   Level 2   Level 3   Total 
Cash and due from banks  $134,280   $19,356   $114,924   $-   $134,280 
Federal funds sold   11,725    -    11,725    -    11,725 
Securities available-for-sale   666,287    375    649,905    16,007    666,287 
Restricted stock   22,282    n/a    n/a    n/a    n/a 
Loans, net   1,874,438    -         1,888,263    1,888,263 
FDIC Indemnification Asset   2,384    -    2,384    -    2,384 
Accrued interest receivable   12,947    -    3,303    9,644    12,947 
Deposits   (2,274,499)   -    (2,279,739)   -    (2,279,739)
Short-term borrowings   (100,022)   -    (100,022)   -    (100,022)
Federal Home Loan Bank advances   (140,231)   -    (144,089)   -    (144,089)
Other borrowings   (6,196)   -    (6,196)   -    (6,196)
Accrued interest payable   (1,829)   -    (1,829)   -    (1,829)

  

3.RESTRICTIONS ON CASH AND DUE FROM BANKS:

 

Certain affiliate banks are required to maintain average reserve balances with the Federal Reserve Bank. The amount of those reserve balances was approximately $9.2 million and $9.3 million at December 31, 2012 and 2011, respectively.

 

44
 

 

4.SECURITIES:

 

The fair value of securities available-for-sale and related gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:

 

   December 31, 2012 
   Amortized   Unrealized     
(Dollar amounts in thousands)  Cost   Gains   Losses   Fair Value 
U.S. Government entity mortgage-backed securities  $1,807   $79   $-   $1,886 
Mortgage-backed securities, residential   231,316    13,373    (13)   244,676 
Mortgage-backed securities, commercial   5,146    1    (16)   5,131 
Collateralized mortgage obligations   230,739    2,827    (246)   233,320 
State and municipal obligations   187,044    12,518    (77)   199,485 
Collateralized debt obligations   12,243    1,761    (7,882)   6,122 
Equity Securities   320    60    -    380 
TOTAL  $668,615   $30,619   $(8,234)  $691,000 

 

   December 31, 2011 
   Amortized   Unrealized     
(Dollar amounts in thousands)  Cost   Gains   Losses   Fair Value 
U.S. Government entity mortgage-backed securities  $3,979   $34   $-   $4,013 
Mortgage-backed securities, residential   296,646    15,142    -    311,788 
Mortgage-backed securities, commercial   98    3    -    101 
Collateralized mortgage obligations   144,850    3,097    -    147,947 
State and municipal obligations   183,854    11,738    (11)   195,581 
Collateralized debt obligations   14,031    150    (9,410)   4,771 
Equity Securities   1,596    490    -    2,086 
TOTAL  $645,054   $30,654   $(9,421)  $666,287 

 

As of December 31, 2011, the Corporation does not have any securities from any issuer, other than the U.S. Government, with an aggregate book or fair value that exceeds ten percent of shareholders' equity.

 

Securities with a carrying value of approximately $333.1 million and $264.0 million at December 31, 2012 and 2011, respectively, were pledged as collateral for short-term borrowings and for other purposes.

 

Below is a summary of the gross gains and losses realized by the Corporation on investment sales during the years ended December 31, 2012, 2011 and 2010, respectively.

 

(Dollar amounts in thousands)  2012   2011   2010 
Proceeds  $25,812   $25   $12,248 
Gross gains   891    2    1,507 
Gross losses   (5)   -    (213)

 

Additional gains of $2 thousand and losses of $2 thousand in 2012 and $4 thousand and $27 thousand of gains, respectively in 2011 and 2010 resulted from redemption premiums on called securities.

 

Contractual maturities of debt securities at year-end 2012 were as follows. Securities not due at a single maturity or with no maturity date, primarily mortgage-backed and equity securities, are shown separately.