ITEM 1. BUSINESS
Forward Looking Statements
When used in this Annual Report on Form 10-K, statements in this report that are not statements of historical fact, including without limitation, statements that include terms such as “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook,” or similar expressions or future conditional verbs such as “may,” “will,” “should,” “would,” or “could” constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements regarding future financial and operating results, plans, objectives, expectations and intentions involve risks and uncertainties, many of which are beyond First Financial Holdings, Inc.’s (“First Financial”) control or are subject to change. No forward-looking statement is a guarantee of future performance and actual results could differ materially from those anticipated by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, the general business environment; general economic conditions nationally and in the States of North Carolina and South Carolina; interest rates; the North and South Carolina real estate markets; the demand for loans; the credit risk associated with lending activities, including changes in the level and trend of delinquent and nonperforming loans and charge-offs; changes in the allowance for loan losses and provision for loan losses for First Federal Bank (“First Federal”) that may be affected by deterioration in the housing and real estate markets; results of examinations by banking regulators, including the possibility that any such regulatory authority may, among other things, require First Federal to increase its allowance for loan losses, write-down assets, change First Federal’s regulatory capital position or affect its ability to borrow funds or maintain or increase deposits, which could adversely affect liquidity and earnings; First Federal’s ability to comply with its loss share agreements with the Federal Deposit Insurance Corporation (“FDIC”); First Financial’s ability to control operating costs and expenses; First Financial’s ability to obtain regulatory approval for acquisitions or other regulatory applications; First Financial’s ability to successfully integrate any assets, liabilities, customers, systems, or management personnel acquired, or may acquire in the future, into its operations and its ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; competitive conditions between banks and non-bank financial services providers; regulatory and shareholder approvals required for the consummation of the proposed merger with SCBT Financial Corporation (“SCBT”); regulatory changes including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and regulations related thereto; and the other risks described as detailed from time to time in filings with the Securities Exchange Commission (“SEC”), including those set forth under “Item 1A.
ITEM 1A. RISK FACTORS
An investment in our common stock involves certain risks. Before you invest in our common stock, you should be aware that there are various risks, including those described below, which could affect the value of your investment in the future. The trading price of our common stock could decline due to any of these risks and you may lose all or part of your investment. The risk factors described in this section, as well as any cautionary language in this report, provide examples of risks, uncertainties and events that could have a material adverse effect on our business, including our operating results and financial condition. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition and results of operations. The value or market price of our common stock could decline due to any of these identified or other risks and you could lose all or part of your investment.
First Financial believes that its primary risk exposures, among others, are credit, market, liquidity, operational, legal, reputational and strategic. Credit risk arises from the potential that a borrower or counterparty will fail to perform on an obligation. Credit risk assessment also entails making sure that lending standards continue to evolve to keep up with developments in the marketplace. Market risk is the risk to a financial institution’s condition resulting from adverse movements in market rates or prices, such as interest rates, foreign exchange rates, or equity prices. Liquidity risk is the potential that an institution will be unable to meet its obligations as they come due because of an inability to liquidate assets or obtain adequate funding or that it cannot easily unwind or offset specific exposures without significantly lowering market prices because of inadequate market depth or market disruptions. Operational risk is the potential that inadequate information systems, operational problems, breaches in internal controls, cyber-attacks, fraud, or unforeseen catastrophes will result in unexpected losses. Legal risk is the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect First Financial’s operations or condition. Failure to abide by extensive rules and regulations from the SEC as well as federal and state banking authorities can lead to governmental investigations and sanctions. Reputational risk is the potential that negative publicity regarding an institution’s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions. Strategic risk is the risk to earnings or capital arising from adverse business decisions or improper implementation of those decisions. This risk is a function of the compatibility of First Financial’s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals, and the quality of implementation.
Effective risk management practices require active oversight, participation, and interaction by and between the Board and executive management. Executive management has established appropriate risk committees and sub-committees as external and internal circumstances warrant.
General Business Risks
A large portion of our loan portfolio is secured by residential and commercial real estate. Continued deterioration in residential and commercial real estate values could lead to additional losses, which may have a negative impact on our capital and financial condition and results of operations.
At December 31, 2012, $2.0 billion or 79.3% of our loan portfolio was secured by residential and commercial real estate properties. This type of lending is generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations. The decline in residential and commercial real estate values due to the downturn in the housing market and weakness in the economy has reduced the value of the real estate collateral securing these loans and has increased the risk that we will incur losses if borrowers default on their loans.
We originate commercial real estate loans for various purposes which are secured by commercial properties. These loans typically involve higher principal amounts than residential or consumer loans and, if non-owner occupied, repayment is normally dependent on income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service, which may be adversely affected by changes in the economy or local market conditions. Commercial real estate loans may expose us to greater credit risk than loans secured by residential mortgages because the collateral securing these loans typically cannot be sold as easily as residential real estate. In addition, many of our commercial and multi-family real estate loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment. If we foreclose on a commercial real estate loan, our holding period for the collateral may be longer than for a residential mortgage loan because there may be fewer potential purchasers of the collateral. Accordingly, if we make any errors in judgment in the collectability of our commercial real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios. As of December 31, 2012, our commercial real estate loans totaled $491.6 million or 19.7% of our loan portfolio and approximately 48.2% of these loans are owner occupied.
Construction and land loans totaled $146.4 million or 5.9% of our loan portfolio at December 31, 2012. Land loans include raw land, residential lot financing primarily for individuals, land acquisition and development loans and loans secured by land used for business purposes. Construction and land development loans are based on estimates of costs and value associated with the completed projects. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to accurately evaluate the total funds required to complete a project and the related loan-to-value (“LTV”) ratio. These loans typically involve higher principal amounts and repayment is substantially dependent on the success of the finished project as well as the ability of the borrower to sell or lease the property or obtain permanent take-out financing. If our estimate of the value of a project at completion proves to be overstated, we may have inadequate security for repayment of the loan and may incur a loss.
Residential loans with high LTV ratios are more sensitive to declining property values than those with lower combined LTV ratios and therefore may experience a higher incidence of default and severity of losses. On occasion, there have been residential first mortgages originated under specific lending programs that allow borrowers to obtain up to 100% of the appraised value and finance closing costs, resulting in an LTV at origination of 100% or greater. At December 31, 2012, we had $90.9 million of residential mortgage loans originated with LTVs of 100% or greater. We generally require private mortgage insurance in order to reduce our exposure on loans with LTVs greater than 80% at origination. Our exposure is also reduced for loans guaranteed under Veterans Administration (“VA”) or Federal Housing Administration (“FHA”) programs. Residential mortgage loans with an original LTV of 100% or greater, which were not guaranteed or did not have private mortgage insurance, totaled $62.2 million at December 31, 2012. There was an additional $297.8 million of loans with original LTVs between 80% and 100% that were not guaranteed or did not have private mortgage insurance as of December 31, 2012.
At December 31, 2012, $384.7 million or 15.4% of our loan portfolio, consisted of home equity loans, and the risks associated with these loans, including the risk of higher rates of delinquency and defaults, will continue to increase if housing prices continue to decline. Certain borrowers currently have little or no equity remaining in their properties due to declining valuations. In addition, as of December 31, 2012, manufactured housing loans totaled $280.1 million or 11.2% of our loan portfolio. Manufactured housing lending involves additional risks as a result of higher LTVs usually associated with these types of loans. The values of manufactured homes decline over time and higher levels of inventories of repossessed and used manufactured homes may affect the values of collateral and result in higher charge-offs and provisions for loan losses.
Repayment of our commercial business loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.
Our commercial business loans are originated primarily based on the identified cash flow and general liquidity of the borrower and secondarily on the underlying collateral provided by the borrower and/or repayment capacity of any guarantor. The borrower’s cash flow may be unpredictable and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use. In addition, business assets may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Accordingly, the repayment of commercial business loans depends primarily on the cash flow and credit worthiness of the borrower and secondarily on the underlying collateral value provided by the borrower and liquidity of the guarantor.
Our allowance for loan losses may not be sufficient to absorb losses in our loan portfolio. Additions to the allowance for loan losses may be required by increasing our provision for loan losses, which would cause our net income to decline and could have a negative impact on our capital and financial positions.
We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, which we believe is appropriate to provide for probable losses inherent in our loan portfolio. The amount of this allowance is determined by our management through periodic reviews and consideration of several factors, including, but not limited to:
·our general allowance, based on our historical default and loss experience and certain macroeconomic factors based on management’s expectations of future events; and
·our specific allowance, based on our evaluation of impaired loans and their underlying collateral.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, regulatory agencies periodically review our 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, we 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 our financial condition and results of operations.
The value of real estate in our market area has been substantially affected by the current economic environment, increased levels of inventories of unsold homes and higher foreclosure rates. As a result, property values have declined substantially and slow housing conditions have affected some borrowers’ ability to sell completed development projects in a timely manner. While certain of our markets are experiencing some stability in economic conditions and real estate value, if current national trends in unemployment, housing and real estate market declines and weaknesses in the economy continue, we may experience increases in delinquent loans, nonperforming assets and credit losses. As a result, we may be required to record a higher provision for loan losses and to charge off additional loans in the future, which could materially adversely affect our financial condition and results of operations. If real estate values decline further, the collateral for our loans will provide less security. As a result, our ability to recover on defaulted loans by selling the underlying real estate will be diminished, and we will be more likely to suffer losses on defaulted loans.
Higher levels of delinquent and nonperforming loans and charge-offs may affect our provision for loan losses, which totaled $20.1 million for the year ended December 31, 2012. If our levels of delinquent and nonperforming loans and charge-offs increase, our allowance for loan losses may not be adequate, and we may be required to make further increases in our provision for loan losses and to charge-off additional loans, which could adversely affect our results of operations. No assurance can be given that we will not sustain credit losses requiring additions to the provision for loan losses in excess of present levels.
We may be subject to losses resulting from repurchase requests arising out of our residential mortgage business.
Like other companies with residential mortgage loan origination and servicing operations, we face the risk of litigation and claims from investors in mortgage loans originated or serviced by us (or securities backed by such loans). Included among these potential claims are claims by investors seeking the repurchase of loans where the loans allegedly breached origination covenants or representations and warranties made to the investors in the applicable purchase and sale agreements. During 2012, we repurchased $541 thousand of loans previously sold. While we do not believe that future repurchase obligations will materially change our financial condition or results of operations, our future repurchases are dependent on economic factors, investor demand strategies, housing market trends and other circumstances, which are beyond our control and, accordingly, there can be no assurance that our repurchases will not increase in the future. Future repurchases could result in increases to our net charge-offs, provision for loan losses and noninterest expenses.
The recent negative developments in the financial industry, the domestic and international credit markets and the economy in general may continue to adversely impact our earnings and could increase our credit risk associated with our loan portfolios.
Negative developments that began in the latter half of 2007 and that have continued through 2012 in the global credit and securitization markets have resulted in unprecedented volatility and disruption in the financial markets and a general economic downturn. As a result of this “credit crunch,” commercial as well as consumer loan portfolio performances have shown deterioration at our bank and at many other institutions and the competition for deposits and quality loans has increased significantly. In addition, the values of real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline. Global securities markets, and financial institution and financial institution holding company stock prices in particular, have been negatively affected, as has the ability of financial institutions and their holding companies to raise capital or borrow in the debt markets. As a result, significant new federal laws and regulations relating to financial institutions, including, without limitation, the EESA, the TARP CPP, and the Dodd-Frank Act, have been adopted. There can be no assurance that these government actions will achieve their purpose. In addition, the potential exists for additional federal or state laws and regulations regarding, among other matters, lending and funding practices and liquidity standards and bank regulatory agencies are expected to continue to be active in responding to concerns and trends identified in examinations, including the issuance of many formal enforcement orders. Negative developments in the financial industry, the domestic and international credit markets, and the economy in general and the impact of new legislation in response to those developments, may negatively impact our business operations, including our ability to originate or sell loans and materially and adversely impact our results of operations and financial condition. We can provide no assurance regarding the manner in which any new laws and regulations will affect us.
Our business is predominately conducted throughout coastal South Carolina, as well as in the Florence, and Greenville, South Carolina and Wilmington, North Carolina markets; continuation of the economic downturn in our primary market area could negatively impact our results of operations and our financial condition.
Because of our geographic concentration in South Carolina and North Carolina, continuation of the economic downturn in these markets could make it more difficult to attract deposits, originate quality loans and could cause higher rates of loss and delinquency on our loans than if our assets were more geographically diversified. Adverse economic conditions in our primary market areas, including, without limitation, declining real estate values, could cause our levels of nonperforming assets and loan losses to increase. If the economic downturn continues or a prolonged economic recession occurs in the economy as a whole, borrowers will be less likely to repay their loans as scheduled. A continued economic downturn could, therefore, result in losses that materially and adversely affect our business.
Our net interest income may decline based on the interest rate environment.
Our profitability is dependent in large part on our net interest income. Differences in volume, yields or interest rates and differences in income earning products such as investment securities and portfolio loans and interest-bearing liabilities such as deposits and borrowings determine our net interest income. We are exposed to changes in general interest rate levels and other economic factors beyond our control. Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. Depending on the terms and maturities of our assets and liabilities, we believe it is more likely than not a significant change in interest rates could have a material adverse effect on our profitability. Many factors cause changes in interest rates, including governmental monetary policies and domestic and international economic and political conditions. While we intend to manage the effects of changes in interest rates by adjusting the terms, maturities and pricing of our assets and liabilities, our efforts may not be effective and our financial condition and results of operations could suffer.
We may not be able to adequately anticipate and respond to changes in market interest rates.
We may be unable to anticipate changes in market interest rates, which are affected by many factors beyond our control including but not limited to inflation, recession, unemployment, money supply, monetary policy and other changes that affect financial markets both domestic and foreign. Our net interest income is affected not only by the level and direction of interest rates, but also by the shape of the yield curve and relationships between interest sensitive instruments and key driver rates, as well as balance sheet growth, customer loan and deposit preferences and the timing of changes in these variables. In the event rates increase, our interest costs on liabilities may increase more rapidly than our income on interest earning assets, resulting in a deterioration of net interest margins. As such, fluctuations in interest rates could have significant adverse effects on our financial condition and results of operations.
In addition, our mortgage operations provide a portion of our noninterest income. We generate mortgage revenues primarily from gains on the sale of residential mortgage loans pursuant to programs currently offered by Fannie Mae, Ginnie Mae or Freddie Mac and retain the servicing of sold loans. In a rising or higher interest rate environment, our originations of mortgage loans may decrease, resulting in fewer loans that are available to be sold to investors, which would decrease mortgage revenues in noninterest income. In addition, our results of operations are affected by the amount of noninterest expenses associated with mortgage activities, such as salaries and employee benefits, other loan expense and other costs. During periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to reduce expenses commensurate with the decline in loan originations.
Further economic downturns may adversely affect our investment securities portfolio and profitability.
During the fiscal year ended December 31, 2012, we recognized $503 thousand in other-than-temporary-impairment (“OTTI”) charges associated with our investment securities portfolio. These OTTI charges were determined based on anticipated adverse changes to the projected cash flows for each of the underlying securities caused by, among other things, constant default rates, severity of losses, geographic property value reductions, projected collateral losses, a change in historical prepayment speeds and a deterioration in the current level of subordination. We closely monitor these and our other investment securities for changes in credit risk. The valuation of our investment securities and the determination of any OTTI with respect to such securities is highly complex and involves a comprehensive process, including quantitative modeling and significant judgment. The valuation of our investment securities will also continue to be influenced by external market and other factors, including implementation of SEC and Financial Accounting Standards Board (“FASB”) guidance on fair value accounting and default rates for specific collateralized mortgage obligations (“CMOs”) and collateralized debt obligations (“CDOs”), rating agency actions and the prices at which observable market transactions occur. The current market environment significantly limits our ability to mitigate our exposure to valuation changes in our CMOs and CDOs by selling them. Accordingly, if market conditions do not improve or deteriorate further and we determine our holdings of these or other investment securities have additional OTTI, our future earnings and shareholders’ equity could be adversely affected.
If we are unable to continue to attract or retain core deposits, to obtain third party borrowings on favorable terms or to have access to interbank or other liquidity sources, our cost of funds will increase, adversely affecting our ability to generate funds necessary for lending operations, reducing net interest margin and negatively affecting results of operations.
We derive liquidity primarily through core deposit (checking, savings and money market accounts) growth and through the maturity, sale and cash flows from both investment securities and loans. Additionally, we have access to borrowing sources on an unsecured and a collateralized basis for both short-term and long-term purposes including, but not limited to, the FHLB, the Federal Reserve and other correspondent banks. If these funding sources are not sufficient or available, we may have to acquire funds through higher-cost sources and our liquidity position could be significantly constrained.
Although we currently have the ability to borrow funds on both a short-term and long-term basis as an additional source of liquidity, our ability to borrow funds at favorable rates may be negatively impacted if our ratings were downgraded from their current level, and could adversely affect our results of operations and financial condition.
Competition with other financial institutions may have an adverse effect on our ability to retain and grow our client base, which could have a negative effect on our financial condition or results of operations.
The banking and financial services industry is very competitive and includes services offered from other banks, savings and loan associations, credit unions, mortgage companies, other lenders and institutions offering uninsured investment alternatives. Legal and regulatory developments have made it easier for new and sometimes unregulated competitors to compete with us. The financial services industry continues to experience an ongoing trend towards consolidation in which fewer large national and regional banks and other financial institutions are replacing many smaller and more local banks. These larger banks and other financial institutions hold a large accumulation of assets and have significantly greater resources and a wider geographic presence or greater accessibility. In some instances, these larger entities operate without the traditional brick and mortar facilities that restrict geographic presence. Some competitors have more aggressive marketing campaigns and better brand recognition, and are able to offer more services, more favorable pricing or greater customer convenience than First Federal. In addition, competition has increased from new banks and other financial services providers that target our existing or potential customers. As consolidation continues among large banks, we expect other smaller institutions to try to compete in the markets we serve. This competition could reduce our net income by decreasing the number and size of the loans that we originate and the interest rates we charge on these loans. Additionally, these competitors may offer higher interest rates, which could decrease the deposits we attract or require us to increase rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations which could increase our cost of funds.
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 as part 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. Technological developments have allowed competitors, including some non-depository institutions, to compete more effectively in local markets and have expanded the range of financial products, services and capital available to our target customers. If we are unable to implement, maintain and use such technologies effectively, we may not be able to offer products or achieve cost-efficiencies necessary to compete in the industry. In addition, some of these competitors have fewer regulatory constraints and lower cost structures.
We may be adversely affected by the soundness of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could have a material adverse effect on our financial condition and results of operations.
We depend on the accuracy and completeness of information about clients and counterparties.
In deciding whether to extend credit or enter into other transactions with clients and counterparties, we may rely on information furnished to us by or on behalf of clients and counterparties, including financial statements and other financial information. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to clients, we may assume that a customer’s audited financial statements conform to accounting principles generally accepted in the United States of America (“GAAP”) and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. Our earnings are significantly affected by our ability to properly originate, underwrite and service loans. Our financial condition and results of operations could be negatively impacted to the extent we incorrectly assess the creditworthiness of our borrowers, fail to detect or respond to deterioration in asset quality in a timely manner or rely on financial statements that do not comply with GAAP or are materially misleading.
The accuracy of our financial statements and related disclosures could be affected because we are exposed to conditions or assumptions different from the judgments, assumptions or estimates used in our critical accounting policies.
The preparation of financial statements and related disclosure in conformity with GAAP requires us to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, included in this document, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered “critical” by us because they require judgments, assumptions and estimates that materially impact our consolidated financial statements and related disclosures. As a result, if future events differ significantly from the judgments, assumptions and estimates in our critical accounting policies, such events or assumptions could have a material impact on our audited consolidated financial statements and related disclosures.
Our potential inability to integrate companies we may acquire in the future could expose us to financial, execution and operational risks that could negatively affect our financial condition and results of operations. Acquisitions may be dilutive to common shareholders.
On occasion, we may engage in a strategic acquisition when we believe there is an opportunity to strengthen and expand our business. In addition, such acquisitions may involve the issuance of stock, which may have a dilutive effect on earnings per share. To fully benefit from such acquisition, however, we must integrate the administrative, financial, sales, lending, collections and marketing functions of the acquired company. If we are unable to successfully integrate an acquired company, we may not realize the benefits of the acquisition, and our financial results may be negatively affected. A completed acquisition may adversely affect our financial condition and results of operations, including our capital requirements and the accounting treatment of the acquisition. Completed acquisitions may also lead to exposure from potential asset quality issues, losses of key employees or customers, difficulty and expense of integrating operations and systems and significant unexpected liabilities after the consummation of these acquisitions. In addition, if we were to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in a goodwill impairment charge, which would adversely affect our results of operations.
Our ability to continue to receive the benefits of our loss share arrangements with the FDIC is conditioned on our compliance with certain requirements under the agreements.
We are the beneficiary of loss share agreements with the FDIC that call for the FDIC to fund a portion of our losses on certain assets we acquired in FDIC-assisted transactions. To recover a portion of our losses and retain the loss share protections, we must comply with certain requirements imposed by the agreements. Ongoing compliance risk under the loss share agreements with the FDIC is considerable and the event of noncompliance could result in coverage under the loss share being disallowed; increasing the actual losses to us. Our inability to overcome these risks could have a material adverse effect on our business, financial condition and results of operations.
Our loss share agreement with the FDIC will not cover all of our losses on the loans we acquired.
Although we have entered into loss share agreements with the FDIC under which the FDIC will bear a significant portion of the losses related to the specified loan portfolios, we are not protected for all losses resulting from charge-offs with respect to these loans. The loss share agreements have limited terms (five years for losses on non-single family estate loans, and ten years for losses on single-family residential real estate loans). Therefore, the FDIC will not reimburse us for any charge-off, related expenses or losses that we experience after the term of the loss share agreements, and any such charge-offs could have a negative effect on our financial condition and results of operations.
The FDIC required that we make a “true-up” payment to the FDIC if our realized losses are less than expected.
The Plantation loss share agreement contains a provision that obligates us to make a “true-up” payment to the FDIC if the realized losses are less than expected. The “true-up” calculation may be made after the fifth anniversary of the agreement and could potentially be evaluated for an additional three years. Any such “true-up” payment that is materially higher than the $3.5 million we have recorded as of December 31, 2012 could have an adverse effect on our financial condition and results of operations.
Negative public opinion regarding our company and the financial institutions industry in general could damage our reputation and adversely impact our earnings.
Reputation risk, or the risk to our business, earnings and capital from negative public opinion regarding our company and the financial institutions industry in general, is inherent in our business. Negative public opinion can result from actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract clients and employees and can expose us to litigation and regulatory action. Although we have taken steps to minimize reputation risk in dealing with our clients and communities, this risk will always be present given the nature of our business.
We are exposed to a possible loss of our senior management team and key employees. If we were to lose key employees, we may experience a disruption in our relationship with certain customers.
We are dependent on the continued efforts and abilities of our key employees and our executive officers. Our success depends, in large part, on our ability to retain our current key employees and attract new skilled people. Competition for the best people in most of our business activities can be intense and we may not be able to hire or retain sufficiently skilled people. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our markets, years of industry experience and the difficulty of promptly finding qualified replacement personnel. Many of our key employees have extensive customer relationships. Loss of a key employee with such customer relationships may lead to the loss of customers if they were to follow that employee to a competitor. Also, as we continue to grow operations, our success depends on our ability to continue to attract, manage and retain qualified middle management personnel. While we believe that our relationship with our senior management team, other key employees and key producers is good, we cannot guarantee that we will continue to attract or retain such personnel.
We are no longer subject to the US Treasury’s standards for executive compensation, and our compensation expense may increase.
As a result of our participation in the CPP, we were subject to the US Treasury’s standards for executive compensation and corporate governance during the period in which the US Treasury held shares of our Series A Preferred Stock. However, upon the completion of the US Treasury’s sale of all of its shares of our Series A Preferred Stock in March 2012, these executive compensation and corporate governance standards ceased to apply to First Financial. Our compensation expense for our executive officers and other senior employees may increase in future periods.
A failure in, interruption in or breach of our operational or security systems or infrastructure, or those of our third party service providers or other third parties, could disrupt our business, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs or cause losses.
We rely heavily on communications and information systems to conduct our business and are dependent on our ability to create and maintain an appropriate operational and organizational infrastructure. Our dependence on automated systems may further increase the risk that technical failures of or tampering with those systems will result in operational or systemic disruption that could be challenging to remediate or losses that are difficult to detect. Information security risks for financial institutions such as ours have generally increased in recent years in part because of the proliferation of new technologies; the use of the internet and telecommunications technologies to conduct financial transactions; and the increased sophistication and activities of organized crime, hackers, terrorists, activists and other external parties. As customer, public and regulatory expectations regarding operational and information security have increased, our operating systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions and breakdowns. Our business, financial, accounting and data processing systems, or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be electrical or telecommunication outages natural disasters such as earthquakes, tornadoes and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and cyber-attacks.
Our business relies on our digital technologies, computer and email systems, software and networks to conduct its operations. Although we have information security procedures and controls in place, our technologies, systems, networks and our customers’ devices may become the target of cyber-attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our or our customers’ or other third parties’ confidential information. Third parties with whom we do business or that facilitate our business activities, including financial intermediaries or vendors that provide service or security solutions for our operations and other unaffiliated third parties, including the South Carolina Department of Revenue, which had customer records exposed in a 2012 cyber-attack, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints.
While we have disaster recovery and other policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our 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. Our risk and exposure to these matters remains heightened because of the evolving nature of these threats. As a result, cyber security and the continued development and enhancement of our controls, processes and practices designed to protect our systems, computers, software, data and networks from attack, damage or unauthorized access remain a focus for us. As threats continue to evolve, we may be required to expend additional resources to continue to modify or enhance our protective measures or to investigate and remediate information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and clients, or cyber-attacks or security breaches of the networks, systems or devices that our clients use to access our products and services could result in client attrition, regulatory fines, penalties or intervention, reputation damage, reimbursement or other compensation costs and/or additional compliance costs, any of which could have a material effect on our results of operations or financial condition.
Our controls and procedures may fail or be circumvented, which could have a material adverse effect on our business, result of operations and financial condition.
We regularly review and update our internal controls, disclosure controls and procedures and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
Risks Related to the Proposed Merger with SCBT
On February 19, 2013, First Financial entered into the Agreement with SCBT pursuant to which First Financial plans to merge with and into SCBT, with SCBT continuing as the surviving corporation (referred to as the “merger”). The Agreement also provides that, immediately following the closing of the merger, First Federal will merge with and into SCBT Bank, with SCBT Bank continuing as the surviving bank in the merger. The following are risks to be considered in connection with the proposed merger.
First Financial cannot be sure of the market value of the merger consideration that First Financial shareholders will receive as a result of the proposed merger with SCBT.
Upon completion of the merger, each share of First Financial common stock will be converted into the right to receive 0.4237 of a share of SCBT common stock, subject to the payment of cash in lieu of fractional shares. The market value of the merger will vary from the closing price of SCBT common stock on the date we announced the merger, on the date that the proxy statement/prospectus is mailed to our shareholders for the special meeting to, among other things, approve the merger, on the date of the special shareholders meeting, on the date we complete the merger and thereafter. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in our respective businesses, operations and prospects, and regulatory considerations. Many of these factors are beyond our control.
Any change in the market price of SCBT common stock prior to completion of the merger will affect the market value of the merger consideration that First Financial’s shareholders will receive upon completion of the merger, and there will be no adjustment to the merger consideration for changes in the market price of either shares of SCBT common stock or shares of our common stock.
We may fail to realize all of the anticipated benefits of the merger.
The success of the merger will depend, in part, on the resulting institution’s ability to realized the anticipated benefits and cost savings from continuing the businesses of First Financial and SCBT. However, to realize these anticipated benefits and cost savings, the businesses of First Financial and SCBT must be successfully combined. The anticipated benefits and cost savings of the merger may not be realized fully or at all or may take longer to realize than expected.
First Financial has operated and, until the completion of the merger, will continue to operate, independently. It is possible that the integration process could result in the loss of key employees, the disruption of each company’s ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect our ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the merger. Integration efforts between the two companies will also divert the attention of management and resources and could result in deposit attrition or other adverse operational results. These integration matters could have an adverse effect on First Financial during the pre-merger transition period and on the combined company following the merger.
The merger is subject to the receipt of consents and approvals from government entities that may impose condition that could have an adverse effect on the combined company following the merger.
Before the merger may be completed, various approvals or consents must be obtained from the Federal Reserve, the FDIC, the SC Board and other various domestic and foreign banking, securities, antitrust, and other regulatory authorities. These government entities may impose conditions on the completion of the merger or require changes to the terms of the merger. Such conditions or changes could have the effect of delaying completion of the merger or imposing additional costs on or limiting the revenues of the combined company following the merger, any of which might have an adverse effect on the combined company following the merger.
If the merger is not completed, First Financial will have incurred incremental expenses without realizing the expected benefits of the merger.
First Financial has incurred incremental expenses in connection with the negotiation and planned completion of the transactions contemplated by the Agreement. If the merger is not completed, First Financial will have to recognize these expenses without realizing the expected benefits of the merger.
The merger is subject to certain closing conditions that, if not satisfied or waived, will result in the merger not being completed, which may cause the market price of our common stock to decline.
The merger is subject to customary conditions to closing, including the receipt of required regulatory approvals and approvals of the First Financial and the SCBT shareholders and that no injunction by any court of competent jurisdiction preventing the consummation of the merger shall be in effect. If any condition to the merger is not satisfied or waived, to the extent permitted by law, the merger will not be completed. In addition, First Financial and SCBT may terminate the Agreement under certain circumstances even if the merger is approved by First Financial and SCBT shareholders, including but not limited to if the merger has not been completed on or before December 31, 2013. If First Financial and SCBT do not complete the merger, the market price of our common stock may decline to the extent that the current market price of those shares reflects a market assumption that the merger will be completed. In addition, neither company would realize any of the expected benefits of having completed the merger. If the merger is not completed, additional risks could materialize, which could materially and adversely affect First Financial’s business, financial results, financial condition and stock price.
The market price of SCBT common stock after the merger may be affected by factors different from those currently affecting the shares of First Financial or SCBT.
The businesses of First Financial and SCBT differ in important respects and, accordingly, the results of operations of the combined company and the market price of the combined company’s shares of common stock may be affected by factors different from those currently affecting the independent result of operations of First Financial and SCBT.
The Agreement limits First Financial’s ability to pursue an alternative acquisition proposal and required First Financial to pay a termination fee of $14.9 million under limited circumstances relating to alternative acquisition proposals.
The Agreement prohibits First Financial and SCBT from soliciting, initiating or knowingly encouraging or facilitating certain alternative acquisition proposals with any third party, subject to exceptions set forth in the Agreement. The Agreement also provides for the payment by First Financial or SCBT of a termination fee in the amount of $14.9 million in the event that the other party terminates the Agreement for certain reasons. These provision might discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of First Financial from considering or proposing such an acquisition.
Legal and Regulatory Risks
We are subject to extensive and evolving regulations, which could restrict our activities, have an adverse impact on our operations and impose financial requirements or limitations on the conduct of our business.
We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various regulatory agencies. Effective July 21, 2011, First Financial became subject to Federal Reserve regulation and effective February 3, 2012, in conjunction with its charter change, First Federal became subject to regulation, supervision and examination by the SC Board and the Federal Reserve, in addition to being regulated by the FDIC as insurer of its deposits. Also, as a member of the FHLB, First Federal must comply with applicable regulations of the Federal Housing Finance Board and the FHLB. Regulation by these agencies is intended primarily for the protection of our depositors and the deposit insurance fund and not for the benefit of our shareholders. First Federal’s activities are also regulated under consum0er protection laws applicable to our lending, deposit and other activities. A sufficient claim against us under these laws could have a material adverse effect on our results of operations. In addition, we have non-bank operating subsidiaries from which we derive income. First Southeast Investors engages in providing investment management services, which is also heavily regulated at both a state and federal level.
In addition, changes in laws, regulations and regulatory practices affecting the financial services industry could subject us to additional costs, limit the types of financial services and products we 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 also result in heightened regulatory scrutiny and in sanctions by regulatory agencies (such as a memorandum of understanding, a written supervisory agreement or a cease-and-desist order), civil money penalties and/or reputation damage. Any of these consequences could restrict our ability to expand our business or could require us to raise additional capital or sell assets on terms that are not advantageous to us or our shareholders and could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, such violations may occur despite our best efforts.
Financial reform legislation enacted by the US Congress, and further changes in regulation to which we are exposed, will result in additional new laws and regulations that are expected to increase our costs of operations.
The Dodd-Frank Act has and will continue to significantly change bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.
The Dodd-Frank Act also created the Bureau of Consumer Financial Protection and gives it broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. Additionally, the Bureau of Consumer Financial Protection has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets.
Proposals for further regulation of the financial services industry are continually being introduced in the Congress of the United States of America. The agencies regulating the financial services industry also periodically adopt changes to their regulations. It is possible that additional legislative proposals may be adopted or regulatory changes may be made that would have an adverse effect on our business. In addition, it is expected that such regulatory changes will increase our operating and compliance cost. We can provide no assurance regarding the manner in which any new laws and regulations will affect us.
The short-term and long-term impact of the changing regulatory capital requirements and anticipated new capital rules is uncertain.
On September 12, 2010, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on
Banking Supervision, announced an agreement to a strengthened set of capital requirements for internationally active banking organizations in the US and around the world, known as Basel III. On June 7, 2012, the Federal Reserve Board, the OCC, and the FDIC issued a joint notice of proposed rulemaking that would implement sections of the Dodd-Frank Act that encompasses certain aspects of Basel III with respect to capital and liquidity. On November 9, 2012, following a public comment period, the US federal banking agencies announced that the originally proposed January 1, 2013 effective date for the proposed rules was being delayed so that the agencies could consider operational and transitional issues identified in the large volume of public comments received. The proposed rules, if adopted, would lead to significantly higher capital requirements and more restrictive leverage and liquidity ratios than those currently in place.
Various provisions of the Dodd-Frank Act increase the capital requirements of bank holding companies, such as First Financial, and non-bank financial companies that are supervised by the Federal Reserve Board. The leverage and risk-based capital ratios of these entities may not be lower than the leverage and risk-based capital ratios for insured depository institutions. In particular, bank holding companies, many of which have long relied on trust preferred securities as a component of their regulatory capital, will no longer be permitted to issue new trust preferred securities that count toward their Tier 1 capital. While the Basel III changes and other regulatory capital requirements will likely result in generally higher regulatory capital standards, it is difficult at this time to predict how any new standards will ultimately be applied to First Financial and First Federal.
In addition, in the current economic and regulatory environment, regulators of banks and bank holding companies have become more likely to impose capital requirements on bank holding companies and banks that are more stringent than those required by applicable existing regulations. The application of more stringent capital requirements for First Financial and First Federal could, among other things, result in lower returns on invested capital, require the issuance of additional capital, adversely affect our ability to pay dividends, require us to reduce business levels and result in regulatory actions if we were to be unable to comply with such requirements.
We are party to various lawsuits incidental to our business. Litigation is subject to many uncertainties such that the expenses and ultimate exposure with respect to many of these matters cannot be ascertained.
From time to time, customers and others make claims and take legal action pertaining to our performance of fiduciary responsibilities. Whether customer claims and legal action are legitimate or unfounded, if such claims and legal actions are not resolved in our favor they may result in significant financial liability and/or adversely affect the market perception of us and our products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Risks Related to an Investment in Our Common Stock
Since First Financial is a bank holding company, its ability to declare and pay dividends is dependent on certain federal and state regulatory considerations, including the guidelines of the Federal Reserve.
The Federal Reserve has issued a policy statement regarding the payment of dividends by bank holding companies. In accordance with this policy statement, the Federal Reserve may generally restrict or prohibit the payment of dividends if (i) First Financial’s net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) First Financial’s prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; (iii) First Financial will not meet, or is in danger of not meeting, its minimum regulatory capital ratios; or (iv) the Federal Reserve otherwise determines that the payment of dividends would constitute an unsafe or unsound practice. The Federal Reserve’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. Under the prompt corrective action regulations, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of First Financial to pay dividends or otherwise engage in capital distributions.
Since First Financial is a legal entity separate and distinct from First Federal and does not conduct stand-alone operations, its ability to pay dividends depends on the ability of First Federal to pay dividends to it. As a South Carolina chartered bank, First Federal is subject to limitations on the amount of dividends that it is permitted to pay. Unless otherwise instructed by the SC Board or the Commissioner of Banking, First Federal is generally permitted under South Carolina state banking regulations to pay cash dividends of up to 100% of net income in any calendar year without obtaining the prior approval of the SC Board. Under Federal Reserve regulations, a dividend cannot be paid by First Federal if it would be less than well-capitalized after the dividend. The Federal Reserve may also prevent the payment of a dividend by First Federal if it determines that the payment would be an unsafe and unsound banking practice.
In addition, as a result of First Federal’s charter conversion and Federal Reserve membership, First Federal is subject to Federal Reserve Supervisory Letter SR 91-17, which provides application and supervision standards for de novo state member banks and converting thrifts. The guidance includes standards for, among other things, cash flows between the bank and the holding company and capital levels. With respect to capital levels, the guidance generally provides that de novo state member banks and converting thrifts maintain a Tier 1 leverage capital ratio of 9.00% for the first three years as a state member bank, which could under certain
circumstances limit First Federal’s ability to pay a dividend to First Financial. First Federal had a Tier 1 leverage capital ratio of 9.97% at December 31, 2012.
Our stock price may be volatile, which could result in losses to our investors and litigation against us.
Our stock price has been volatile in the past and several factors could cause the price to fluctuate substantially in the future. These factors include but are not limited to actual or anticipated variations in earnings, changes in analysts’ recommendations or projections, our announcement of developments related to our businesses, operations and stock performance of other companies deemed to be peers, new technology used or services offered by traditional and non-traditional competitors, news reports of trends, irrational exuberance on the part of investors, new federal banking regulations and other issues related to the financial services industry. Our stock price may fluctuate significantly in the future, and these fluctuations may be unrelated to our performance. General market declines or market volatility in the future, especially in the financial institutions sector, could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Moreover, in the past, securities class action lawsuits have been instituted against some companies following periods of volatility in the market price of its securities. We could in the future be the target of similar litigation. Securities litigation could result in substantial costs and divert management’s attention and resources from our normal business.
Future sales of our stock by our shareholders or the perception that those sales could occur may cause our stock price to decline.
Although our common stock is listed for trading on the NASDAQ Global Select Market, the trading volume in our common stock is lower than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the relatively low trading volume of our common stock, significant sales of our common stock in the public market, or the perception that those sales may occur, could cause the trading price of our common stock to decline or to be lower than it otherwise might be in the absence of those sales or perceptions.
Economic and other circumstances may require us to raise capital at times or in amounts that are unfavorable to us. If we have to issue shares of common stock, they will dilute the percentage ownership interest of existing shareholders and may dilute the book value per share of our common stock and adversely affect the terms on which we may obtain additional capital.
We may need to incur additional debt or equity financing in the future to make strategic acquisitions or investments or to strengthen our capital position. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control and our financial performance. We cannot provide assurance that such financing will be available to us on acceptable terms or at all, or if we do raise additional capital that it will not be dilutive to existing shareholders.
If we determine, for any reason, that we need to raise capital, subject to applicable NASDAQ rules, our Board generally has the authority, without action by or vote of the shareholders, to issue all or part of any authorized but unissued shares of stock for any corporate purpose, including issuance of equity-based incentives under or outside of our equity compensation plans. Additionally, we are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur. If we issue preferred stock that has a preference over the common stock with respect to the payment of dividends or upon liquidation, dissolution or winding-up, or if we issue preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market price of our common stock could be adversely affected. Any issuance of additional shares of stock will dilute the percentage ownership interest of our shareholders and may dilute the book value per share of our common stock. Shares we issue in connection with any such offering will increase the total number of shares and may dilute the economic and voting ownership interest of our existing shareholders.
If we are unable or choose not to redeem our Series A Preferred Stock within five years from the issuance date, the cost of this capital to us will increase.
On March 29, 2012, the US Treasury completed the sale of its $65.0 million in First Financial Series A Preferred Stock to private investors through a registered public offering. If we are unable to redeem our Series A Preferred Stock prior to February 15, 2014, or if we choose not to redeem the preferred stock at that time, the cost of this capital will increase on that date, from 5.0% per annum ($3.3 million annually) to 9.0% per annum ($5.9 million annually). Depending on our financial condition at the time, this increase in the annual dividend rate could have a material negative effect on our liquidity and our financial results.
Anti-takeover provisions could negatively impact our shareholders.
Provisions in our Certificate of Incorporation and Bylaws, the corporate law of the State of Delaware and federal regulations could delay, defer or prevent a third party from acquiring us, despite the possible benefit to our shareholders, or otherwise adversely affect the market price of our common stock. These provisions include: supermajority voting requirements for certain business combinations with any person who beneficially owns 15% or more of our outstanding common stock; the election of directors to staggered terms of three years; advance notice requirements for nominations for election to our Board and for proposing matters that shareholders may act on at shareholder meetings, a requirement that only directors may fill a vacancy on our Board, and supermajority voting requirements to remove any of our directors. Our Certificate of Incorporation also authorizes our Board to issue preferred stock and preferred stock could be issued as a defensive measure in response to a takeover proposal. In addition, pursuant to federal banking regulations, as a general matter, no person or company, acting individually or in concert with others, may acquire more than 10% of our common stock without prior approval from the regulatory banking agencies.
These provisions may discourage potential takeover attempts, discourage bids for our common stock at a premium over market price or adversely affect the market price of, and the voting and other rights of the holders of, our common stock. These provisions could also discourage proxy contests and make it more difficult for holders of our common stock to elect directors other than the candidates nominated by our Board.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
First Financial’s corporate offices are located on Mall Drive in Charleston, South Carolina. This site is also the location of the commercial banking, wealth management, operations and administrative groups for First Federal, as well as the main office for First Southeast Investors and First Southeast 401(k). At December 31, 2012, First Financial’s subsidiaries operated through locations primarily along coastal South Carolina, Florence and Greenville, South Carolina and Wilmington, North Carolina. In addition, the non-bank subsidiaries have leased locations in Columbia and the upstate region of South Carolina. First Federal has 66 financial centers, of which 38 are owned, 14 are leased offices, and 14 are leased spaces inside a major retailer. In addition, First Federal leases properties for off-site ATMs and owns land for potential future branch locations. First Southeast Investors has 24 leased offices, of which 19 are located in a First Federal financial center. The owned locations do not have any major encumbrances and most of the leases have renewal or purchase options. At certain locations, a portion of the building is leased to unaffiliated tenants under long-term contracts. Additional information related to First Financial’s premises and equipment is incorporated herein by reference from Note 7 to the Consolidated Financial Statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, First Federal is subject to various legal proceedings and claims, which arise in the ordinary course of business. While the ultimate outcome of pending proceedings cannot be predicted with certainty, First Financial believes that final resolution of such litigation will not materially affect its consolidated financial position or results of operations. At such time that exposure is identified, it is First Financial’s policy to establish and accrue appropriate reserves during the accounting period in which a loss is deemed to be probable and the amount is determinable.
On March 5, 2013, an alleged shareholder of First Financial filed a lawsuit in the Court of Chancery in the State of Delaware captioned Arthur Walter v. R. Wayne Hall et al., naming First Financial, members of the Board and SCBT as defendants. This lawsuit is purportedly brought on behalf of a putative class of First Financial’s common shareholders and seeks a declaration that it is properly maintainable as a class action, with the plaintiff as the proper class representative. The lawsuit alleges that First Financial, First Financial’s Board and SCBT breached duties and/or aided and abetted such breaches by failing to obtain adequate consideration for First Financial’s shareholders in the merger. Among other relief, the complaint seeks to enjoin the merger. First Financial believes that the claims asserted are without merit.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
First Financial’s common stock is traded on the NASDAQ Global Select Market under the symbol “FFCH.” There were 5,202 shareholders of record and beneficial owners as of December 31, 2012. The following table presents First Financial’s high and low stock prices and cash dividends paid per share during each quarter for the last two fiscal years as well as the transition reporting period.
The timing and amount of cash dividends to be paid is determined by the Board and is dependent upon First Financial’s earnings, capital position, financial condition and other relevant factors. Other restrictions on First Financial’s ability to pay dividends are incorporated herein by reference from “Item 1. Business - Regulation and Supervision” as well as Note 12 to the Consolidated Financial Statements.
Equity Compensation Plan Information
Equity compensation plan information is provided under Item 12 of this Annual Report and is incorporated herein by reference.
Issuer Purchases of Equity Securities
First Financial did not repurchase any equity securities during the fiscal year ended December 31, 2012.
Stock Performance Graph
The following graph compares the cumulative total return of First Financial’s common stock with the SNL Bank Index and the NASDAQ Bank Index since September 30, 2007. The SNL Bank Index is a market capitalization weighted index which includes all Major Exchange (NYSE, NYSE Amex, NASDAQ) banks in SNL’s coverage universe (over 350 banks but not First Financial). The NASDAQ Bank Index (symbol: IXBK) is a market capitalization weighted index which includes over 650 banks listed on NASDAQ (including First Financial). Both indices are designed to effectively represent the performance of the broad and diverse US banking industry. The presentation assumes that $100 was invested at the closing price on September 30, 2007 in First Financial’s common stock and in each index and that all dividends were reinvested. The returns shown are not necessarily indicative of future performance.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Change in Fiscal Year
On December 20, 2011, First Financial’s Board approved an amendment to change the fiscal year end from September 30th to December 31st of each year. The change was effective December 31, 2011 and the current fiscal year began on January 1, 2012 and ended on December 31, 2012. The change in fiscal year end resulted in a three-month transition period which began on October 1, 2011 and ended on December 31, 2011, and is presented in this Annual Report.
Discontinued Operations
As a result of First Financial’s sale of First Southeast, which was completed on June 1, 2011, and Kimbrell, which was completed on September 30, 2011, the financial condition, operating results, and the gain or loss on the sales, net of transaction costs and taxes, for these subsidiaries have been segregated from the financial condition and operating results of First Financial’s continuing operations throughout this document and, as such, are presented as discontinued operations. While all prior periods have been revised retrospectively to align with this treatment, these changes do not affect First Financial’s reported consolidated financial condition or operating results for any of the prior periods.
Non-GAAP Measures
In addition to results presented in accordance with GAAP, the summary of selected consolidated financial data table includes non-GAAP financial measures such as the tangible book value per common share, efficiency ratio, pre-tax pre-provision earnings and tangible common equity to tangible assets ratio. First Financial believes these non-GAAP financial measures provide additional information that is useful to investors in understanding its underlying performance, business and performance trends and such measures help facilitate performance comparisons with others in the banking industry. Non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited. Although First Financial believes the above non-GAAP financial measures enhance investors’ understanding of First Financial’s business and performance, these non-GAAP measures should not be considered in isolation or as a substitute for GAAP basis financial measures. Reconciliations of the non-GAAP measures are contained in “Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following presents management’s discussion and analysis of First Financial’s financial condition and results of operations and should be read in conjunction with the accompanying Consolidated Financial Statements and Notes. The discussion highlights the principal factors affecting earnings (loss) for the fiscal year ended December 31, 2012, the quarter ended December 31, 2011, and the fiscal year ended September 30, 2011; and the significant changes in balance sheet items from September 30, 2011 to December 31, 2012; and is intended to help the reader understand, from management’s perspective, the Consolidated Financial Statements, Notes to Consolidated Financial Statements and the accompanying tables, charts and financial statistics appearing elsewhere in this report. Where applicable, this discussion also reflects management’s insights regarding known events and trends that have or may reasonably be expected to have a material effect on First Financial’s operations and financial condition.
Nature of First Financial’s Business
First Financial has two primary sources of revenue, net interest income and noninterest income. Net interest income is the difference between interest income, the income earned on loans and investments and interest expense, the interest paid on deposits and borrowings. Noninterest income represents fees and other revenue from financial services provided to customers. The majority of noninterest income comes from service charges and fees on deposit accounts and mortgage and other loan income.
First Financial’s revenue tends to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, and competitive conditions within the marketplace, as well as residential housing markets in the communities it serves. First Financial’s earnings and business are affected by the general economic and political conditions in the US and abroad and by the monetary and fiscal policies of various federal regulatory authorities, including the Federal Reserve. First Federal strives to manage the effects of interest rates through its asset/liability management process but the effect of fluctuating economic conditions and federal regulatory policies on First Financial’s future profitability cannot be predicted with any certainty. General economic conditions in the primary markets First Financial serves have begun to show some stabilization, as evidenced by the unemployment rate for the Charleston, South Carolina metropolitan statistical area (“MSA”) decreasing from 7.8% in November 2011 to 6.8% in November 2012 (most recent available data). The leading index for South Carolina (as defined by the Federal Reserve) also has improved in recent months, increasing from 2.01% in November 2011 to 3.89% in November 2012. First Financial has a credit policy in place to address credit risk, the effect of the economy on credit risk and its potential effect on future periods. One of the primary factors in determining potential loss given default is to evaluate the trend residential and commercial property values. The Case-Shiller Housing Index tracks residential home inventory, sales and prices in the twenty largest MSAs in the US. The Case-Shiller index for the Charlotte MSA (the closest market to those markets served by First Financial) has also improved in recent months, from -2.6% in October 2011 to 4.1% in October 2012 (with any value over zero displaying positive trends).
Moody’s Commercial Property Price Index is a compilation of 20 indices based on commercial property type in areas throughout the US. This index also improved from 137.44 in October 2011 to 144.10 in October 2012. While all of these metrics were better than the most prior year, their improvements are relatively small yet display a general stability in the economic conditions of First Financial’s primary markets.
Significant Developments
Under terms of the Agreement entered into on February 19, 2013, First Financial plans to merge with and into SCBT. First Financial common shareholders will receive 0.4237 shares of SCBT common stock for each share of First Financial common stock, subject to the payment of cash in lieu of fractional shares, which equated to an estimated deal value at announcement of $302.4 million in aggregate, based on SCBT’s closing stock price on February 19, 2013. The merger is expected to close in the third quarter of 2013, subject to customary closing conditions, regulatory approval, and the approval of both First Financial and SCBT shareholders. Additional information related to the potential merger is incorporated herein by reference from Note 22 to the Consolidated Financial Statements.
During the second quarter of 2012, First Financial initiated a number of transactions to better position its balance sheet. The repositioning is expected to enhance net interest income, noninterest income and net interest margin in future periods. During the quarter ended June 30, 2012, First Financial prepaid $125.0 million of long-term FHLB advances with an average rate of 3.15%, incurring a termination charge of $8.5 million ($5.3 million after-tax). To fund the debt prepayment, mortgage-backed securities totaling $203.6 million with an average yield of 1.79% were sold, generating a $3.5 million gain ($2.2 million after-tax). In aggregate, these transactions resulted in a net charge of $3.1 million after-tax, or $(0.19) per common share. The remaining proceeds from the investment sales were reinvested during the second and third quarters of 2012 in assets with higher projected returns for the current interest rate environment and outlook. First Financial believes the balance sheet repositioning is an economically accretive transaction as the net loss is expected to have a breakeven point of less than two years.
On April 27, 2012, First Federal assumed all deposits and substantially all assets and certain other liabilities of Plantation Federal Bank (“Plantation”), a full-service community bank headquartered in Pawleys Island, South Carolina, from the FDIC, as receiver for Plantation. Plantation operated three branches along the coast of South Carolina under the name of Plantation Federal and three branches in the Greenville, South Carolina market under the name of First Savers Bank. The transaction was made pursuant to a purchase and assumption agreement, in the FDIC’s customary form and with defined loss sharing arrangements, entered into by First Federal and the FDIC as of April 27, 2012. As a result of the transaction, First Federal recorded a bargain purchase gain of $13.9 million during 2012.
On April 20, 2012, First Federal acquired five branches from Liberty Savings Bank (“Liberty”) in the Hilton Head, South Carolina market and the transaction included $22.2 million of performing loans and $113.2 million of deposits, as of the transaction date. First Federal consolidated three of the acquired branches with existing First Federal financial centers, adding a net of two new financial centers in the Hilton Head market.
In February 2012, First Federal (formerly known as First Federal Savings and Loan Association of Charleston) converted from a federal savings and loan association to a South Carolina-chartered commercial bank and First Financial converted from a savings and loan holding company to a bank holding company. In addition, First Federal received approval to become a member of the Federal Reserve System and First Financial became a bank holding company. As a result of the charter conversion and membership in the Federal Reserve System, the SC Board and the Federal Reserve serve as First Federal’s primary regulators. The Federal Reserve also serves as First Financial’s primary regulator. In addition to retaining its bank holding company status, First Financial also became a financial holding company on December 13, 2012.
On October 25, 2011, First Financial entered into a definitive agreement to sell certain performing loans and classified assets with an aggregate contractual principal balance of $197.9 million to affiliates of Värde Partners, Inc. The loans had previously been written down to an estimated fair value of $60.3 million when they were reclassified to held for sale in June 2011. During the quarter ended December 31, 2011, First Financial completed the sale of the bulk loan pool and recorded a gain on the sale of $20.8 million. The sale was the result of First Financial’s strategy to reduce its level of delinquent and nonperforming loans to reduce the inherent risk in the loan portfolio, minimize further negative migration and reduce potential future losses due to further collateral value deterioration.
During 2011, First Financial sold the stock of First Southeast, its insurance agency subsidiary, to Hub International, LLC and sold substantially all of the assets of Kimbrell, its managing general insurance agency subsidiary, to Burns and Wilcox, Ltd, a Kaufman Financial Group company. Both transactions were completed in exchange for cash. The financial condition, operating results, and the gain or loss on the sales, net of transaction costs and taxes, for these subsidiaries have been segregated from the financial condition and operating results of First Financial’s continuing operations throughout this Annual report and, as such, are presented as discontinued operations.
Results of Operations
First Financial recorded net income available to common shareholders of $24.9 million for the year ended December 31, 2012, compared with $14.6 million for the quarter ended December 31, 2011, and net losses available to common shareholders of $(45.0) and $(40.6) million for the years ended September 30, 2011 and 2010, respectively. Diluted net income (loss) per common share was $1.51 for the
year ended December 31, 2012, compared with $0.88, $(2.72), and $(2.46) per common share for the quarter ended December 31, 2011 and the years ended September 30, 2011 and 2010, respectively.
Net Interest Income
The following table presents an analysis of net interest income, interest spread and net interest margin with average balances and related weighted average interest rates.
Year ended December 31, 2012 compared with year ended December 31, 2011
The increase in net interest margin was primarily the result of (1) a lower cost of deposits related to organic growth in core deposits and acquired deposits from Liberty and Plantation; (2) a balance sheet repositioning strategy completed in the second quarter of 2012; (3) improved performance on the former Cape Fear Bank (“Cape Fear”) nonperforming loans, which resulted in a shift to accretable yield as well as recognizing cash payments in interest income; and (4) the accretion and amortization of purchase accounting adjustments, which resulted from the Plantation and Liberty acquisitions. During 2012, the performance of the Cape
Fear loan pools acquired from the FDIC was better than originally projected. As a result, the cumulative cash payments received have exceeded First Federal’s initial investment in one of the pools and $3.6 million was recognized in interest income. The net interest margin for 2012, adjusted for the cash received in excess of the initial investment and recorded to interest income as well as incremental loan accretion, was 4.09%.
The increase in net interest income was principally caused by the $3.6 million excess cash payments recognized in interest income due to the improved performance of a Cape Fear loan pool and increases in earning assets from the Plantation and Liberty transactions, partially offset by the impact of the balance sheet repositioning.
Quarter ended December 31, 2011 compared with quarter ended December 31, 2010
The increase in net interest margin was primarily the result of the decrease in the yield on interest-bearing liabilities exceeding the decrease in the yield on earning assets as First Financial continued to grow core deposits, especially noninterest-bearing deposits. The decrease in net interest income was primarily the result of a decline in average earning assets due to the bulk loan sale, combined with the decline in loans due to the generally lower demand from creditworthy borrowers and loan charge-offs.
Year ended September 30, 2011 compared with year ended September 30, 2010
The decrease in net interest margin was primarily the result of the decline in rates on earning assets exceeding the decline in the average rate paid on deposits.
The following table presents changes in interest income, interest expense and net interest income due to volume and rate variances for major categories of earning assets and interest-bearing liabilities.
Note: The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar amounts of the change in each.
Year ended December 31, 2012 compared with year ended December 31, 2011
The increase in net interest income reflects volume and rate variances that were positive in the aggregate. The positive volume and rate variances were primarily the result of the Plantation and Liberty acquisitions completed in 2012. The effects of the acquisitions were partially offset by negative volume and rate variances on investment securities available for sale and negative rate variances on advances from FHLB and long-term debt. The positive rate variance on deposits was due to the continued decline in rates paid on core and time deposits resulting from an ongoing strategy to reduce maturing high rate retail and wholesale time deposits and a shift in funding to core deposits. The positive loan rate and volume variances were due primarily to the acquisition of Plantation loans, the related purchase accounting, and the improved performance of a Cape Fear loan pool. The variances on investment securities were the result of the balance sheet repositioning (which negatively impacted volume, but positively impacted rate) as well as normal portfolio cash flows (which are being replaced with new, lower-yielding securities). The variances on advances from FHLB and long term debt were due to the balance sheet repositioning.
Quarter ended December 31, 2011 compared with quarter ended December 31, 2010
The decrease in net interest income reflects volume and rate variances that were both negative in the aggregate. The negative volume variance was primarily the result of a decline in loan balances, partially offset by a decline in time deposit balances. The decrease in the loan portfolio was primarily the result of the bulk loan sale as well as declines due to generally lower loan demand from creditworthy borrowers combined with loan payments and paydowns. The decrease in time deposits was primarily the result of an ongoing strategy to reduce maturing high rate retail and wholesale time deposits due to lower funding needs. The negative rate variance was primarily the result of the continued low interest rate environment, as reductions in interest and dividends on investments were higher than the reductions in deposit interest expense. The decrease in interest on investment securities was primarily the result of replacing maturing investment securities with new purchases at considerably lower yields. The decrease in interest expense was primarily the result of First Financial’s ongoing strategy to shift funding from maturing high rate deposits to lower cost core deposits, including noninterest bearing deposits.
Year ended September 30, 2011 compared with year ended September 30, 2010
The decrease in net interest income reflects volume variances that were negative in the aggregate as well as rate variances that were negative in the aggregate. The volume variance was primarily a result of a decline in loan balances due to recording loans to be sold at their estimated fair value, combined with generally lower loan demand from creditworthy borrowers, loan charge-offs and transfers to OREO. In addition, cash flows from investment securities were used during the year to fund maturing deposits or paydown borrowings rather than being fully reinvested. The rate variance was primarily the result of the continued low interest rate environment, as cash flows from loans and maturing investment securities were at considerably higher rates than new originations and purchases. The negative rate variance on loans was also impacted by the sustained elevated levels of nonperforming loans during fiscal 2011 prior to the reclassification to loans held for sale, as compared with a gradual increase in nonperforming loans
during fiscal 2010. These decreases were partially offset by a reduction in deposit interest expense as First Financial continued to reprice deposits.
Provision for Loan Losses
After determining what First Financial believes is an adequate allowance for loan losses based on the estimated risk inherent in the loan portfolio, the provision for loan losses is calculated based on the net effect of the change in the allowance for loan losses and net charge-offs. The provision for loan losses totaled $20.1 million for the year ended December 31, 2012, compared with $7.4 million for the quarter ended December 31, 2011, $109.9 million for the year ended September 30, 2011, and $125.2 million for the year ended September 30, 2010. The decreases from fiscal 2011 and 2010 were related to the continued improvement in historical loss trends and a general stabilization of credit metrics following the bulk loan sale of certain performing and nonperforming loans in October 2011. The reclassification of these loans to held for sale and the ultimate sale resulted in charge-offs of $97.2 million during fiscal 2011 and a $30.1 million reduction in the allowance for loan losses due to measuring those loans at estimated fair value and reclassifying them to loans held for sale, which excluded them from the allowance for loan losses calculation. The provision for fiscal 2011 included $67.1 million related to the reclassification of loans held for sale and $42.8 million as a result of First Federal’s normal credit practices. The provision for loan losses was lower than net charge-offs for 2012 and the quarter ended December 31, 2011 due to the general stabilization in economic conditions and credit metrics for First Federal’s loan portfolio as well as the improvement in loss trends after the bulk loan sale. See “Allowance for Loan Losses” for additional discussion regarding the calculation of the allowance for loan losses and information related to loan charge-offs.
Noninterest Income
The following table summarizes the components of noninterest income.
Year ended December 31, 2012 compared with year ended December 31, 2011
The increase in noninterest income during the year ended December 31, 2012 was impacted by the gains on the Plantation acquisition and the sale or call of investment securities in 2012 as well as higher mortgage and other loan income and service charges on deposit accounts, was partially offset by the gain on the sold loan pool in 2011. Mortgage and other loan income increased due to higher residential mortgage origination levels related to the continued low interest rate environment and the addition of correspondent lenders. Service charges on deposit accounts increased due to a transaction volumes.
Quarter ended December 31, 2011 compared with quarter ended December 31, 2010
The increase in noninterest income during the quarter ended December 31, 2011 was predominately the result of the gain on the bulk loan sale, higher service charges on deposit accounts due to additional transaction-related revenue from increases in both volume and fees and lower OTTI losses on investment securities recognized in earnings. The lower OTTI in 2012 was due to some stabilization in the financial markets.
Year ended September 30, 2011 compared with year ended September 30, 2010
The increase in noninterest income during the year ended September 30, 2011 was attributed to lower OTTI losses recognized in earnings during 2011, a gain on the sale of investment securities, and higher service charges on deposit accounts, partially offset by lower other income as well as mortgage and other loan income. The securities gain was due to the sale of one security, which had previously been written-off through OTTI. The increase in service charges on deposit accounts was due to higher transaction-related revenue resulting from increases in transaction volume as well as transaction fees. The decrease in other income was primarily the result of two transactions which occurred in 2010: a $1.5 million settlement with the FDIC related to Cape Fear and a $1.4 million gain on the donation of a branch location. The decrease in mortgage and other loan income was primarily the result of unfavorable hedge adjustments on mortgage servicing rights and the mortgage pipeline hedges due to a decrease in the spread between the rates on US Treasuries and long-term mortgage rates and lower late fees due to the overall stabilization in
nonperforming loan trends, partially offset by gains on the resolution of some loans in the bulk sale pool prior to the final disposition of the pool.
Noninterest Expense
The following table summarizes the components of noninterest expense.
Year ended December 31, 2012 compared with year ended December 31, 2011
The increase in noninterest expense during the year ended December 31, 2012 was due in large part to the FHLB termination charge recorded in 2012 related to the balance sheet repositioning strategy. Noninterest expense without the impact of the FHLB termination charge increased $10.6 million or 9.0% over 2011. In addition to the impact of the Plantation and Liberty acquisitions, other significant variances included higher occupancy costs, professional services, other loan expense, FDIC indemnification impairment and other expenses, partially offset by lower OREO expenses, FDIC insurance and regulatory fees and goodwill impairment in 2011. Occupancy costs increased due to expenses associated with closing four in-store branches during 2012. Professional services increased due to various strategic initiatives implemented during 2012. Other loan expense increased due to higher foreclosure-related expenses as well as higher loan origination and servicing costs due to expanding mortgage origination channels. Other expenses increased as a result of debit card rewards program management expenses related to higher customer debit card usage and a $487 thousand post-sale settlement recorded in 2012 related to the 2011 sale of one of the insurance agencies. The decrease in OREO expenses was primarily the effect of fewer write-downs on OREO properties, recognition of more gains on the sales of properties, and less OREO related expense. The decrease in FDIC insurance and regulatory fees was due to the new assessment methodology implemented by the FDIC during 2011.
Quarter ended December 31, 2011 compared with quarter ended December 31, 2010
While noninterest expense was essentially unchanged, increases in other expense and OREO expenses were substantially offset by reductions in salaries and employee benefits, professional services, and FDIC insurance and regulatory fees. The increase in other expense was caused by higher processing fees related to a new debit card reward program for deposit customers, higher loss reserves for First Federal’s reinsurance subsidiary, and higher operational losses related to uncollectible foreclosure expenses. The increase in OREO was primarily the result of higher valuation adjustments on foreclosed properties held. The decrease in salaries and employee benefits was driven by lower staff levels due to initiatives implemented during 2011. The reduction in professional services was primarily the result of using external resources to assist in the implementation of several strategic initiatives including loss-sharing management, OREO management and compensation studies during the 2010 quarter. The decrease in FDIC insurance and regulatory fees was due to the new asset-based assessment methodology implemented by the FDIC during 2011.
Year ended September 30, 2011 compared with year ended September 30, 2010
The increase in noninterest expense during the year ended September 30, 2011 was primarily the result of higher salaries and benefits, other loan expense, professional services and the goodwill impairment charge, partially offset by lower OREO expenses, other expense, furniture and equipment expense, as well as FDIC insurance and regulatory fees. The increase in salaries and benefits was due to new hires throughout 2010 and $1.8 million recorded for separation agreements. The increase in other loan expense was primarily the result of higher levels of foreclosure related expenses. The increase in professional services was driven by $521 thousand in legal and other advisory services related to preparing the loans held for bulk sale pool for final disposition, as well as utilizing outside resources related to loss-share management, and the implementation of several strategic initiatives. The goodwill impairment charge was related to First Financial’s insurance premium financing operations. The decrease in OREO
expenses were primarily the result of a $1.3 million reduction in 2011 due to the receipt of OREO valuation loss claims and recoverable expenses on OREO from Cape Fear, as well as lower fair value writedowns on OREO properties in the 2011. The decrease in other expense was principally due to a $1.2 million contribution in conjunction with the donation of a branch location recorded during 2010. The decrease in furniture and equipment expense was primarily the result of the elimination of certain contracted services. The decrease in FDIC insurance and regulatory fees was primarily the result of the new asset-based methodology implemented by the FDIC effective July 1, 2011.
Income Taxes
The income tax expense from continuing operations for fiscal 2012 totaled $19.4 million, compared with a tax expense of $9.8 million for the quarter ended December 31, 2011, tax benefit of $(23.7) million for the year ended September 30, 2011, and a tax benefit of $(26.0) million for the year ended September 30, 2010. The increases were primarily the result of the change in pre-tax income, a $1.2 million net write-down of the state deferred tax asset during 2012 related to First Federal’s charter conversion and the establishment of a $5.0 million deferred tax liability related to the gain on the Plantation acquisition in 2012. The effective tax rate for continuing operations was 40.23%, 38.54%, 38.62%, and 39.78%, for fiscal 2012, the quarter ended December 31, 2011, and the years ended September 30, 2011 and 2010, respectively. The fluctuations in the effective tax rate for continuing operations were primarily the result of the state deferred tax asset write-down in 2012, partially offset by higher tax-exempt income resulting from purchasing bank owned life insurance. First Financial regularly monitors its deferred tax assets and liabilities, which totaled a net deferred tax liability of $3.6 million at December 31, 2012. Refer to Note 13 to the Consolidated Financial Statements for additional information.
Line of Business Results
Prior to September 30, 2011, First Financial had two principal operating segments, banking and insurance, which were evaluated regularly to determine how to allocate resources and assess performance. During fiscal 2011, First Financial sold its insurance agency subsidiary, First Southeast and its managing general insurance agency, Kimbrell, and their results of operations are now segregated from continuing operations and displayed as (loss) income from discontinued operations on a net basis. As of September 30, 2011, First Financial considered its former Banking and Other business segments to not be independent and determined that they are one operating segment. First Financial continues to monitor the revenue streams of its various financial products and services but now manages its operations and evaluates its financial performance on a consolidated basis.
Financial Condition
Total assets at December 31, 2012 were $3.2 billion, an increase of $68.6 million or 2.18% over December 31, 2011, and essentially unchanged from September 30, 2011. The increase over December 31, 2011 was principally due to the Plantation and Liberty acquisitions, partially offset by a decrease in investment securities as part of repositioning the balance sheet during 2012. While total assets were essentially unchanged from September 30, 2011, increases in total loans, bank owned life insurance, the FDIC indemnification asset and cash and cash equivalents were essentially offset by decreases in total investment securities, loans held for sale and other assets as described below.
Cash and Cash Equivalents
Cash and cash equivalents totaled $117.5 million at December 31, 2012, an increase of $40.8 million or 53.2% over December 31, 2011 and an increase of $31.5 million or 36.7% over September 30, 2011. The increases were due to holding short-term excess funds at the Federal Reserve in an interest-bearing account.
Investment Securities
The primary objectives in managing the investment securities portfolio include maintaining a portfolio of high quality investments with competitive returns. First Financial maintains balances in investments based on a continuing assessment of cash flows, the level of loan production, current interest rate risk strategies and the assessment of the potential future direction of market interest rate changes.
The amortized cost and estimated fair value on investment follows.
The fair value of securities available for sale decreased $150.8 million or 37.3% from December 31, 2011 and decreased $158.3 million or 38.4% from September 30, 2011. The decreases were primarily the result of a balance sheet repositioning strategy implemented during 2012, when First Financial sold mortgage-backed securities totaling $203.6 million with an average yield of 1.79% and generated a $3.5 million gain. The decreases were also due to normal principal reductions, cash flows from called securities, and changes in market interest rates, partially offset by new purchases. The decreases in securities held to maturity were principally caused by normal cash flows, partially offset by new security purchases. The decreases in nonmarketable securities were due to redeeming a portion of FHLB stock, which was no longer required due to paying down FHLB advances as part of the balance sheet repositioning, partially offset by acquiring Federal Reserve bank stock after becoming a Federal Reserve member bank.
First Financial performs a thorough credit review of its investment securities portfolio on a quarterly basis to evaluate the underlying collateral as well as the supporting credit enhancement and structure. As a result, OTTI charges of $503 thousand, $180 thousand, $879 thousand and $2.9 million were recorded in noninterest income during the year ended December 31, 2012, the quarter ended December 31, 2011, and the years ended September 30, 2011 and 2010, respectively. See Notes 1 and 3 to the Consolidated Financial Statements for additional information.
Maturities and average yields of investment securities are presented in the table below.
Yields on tax-exempt securities are calculated on a tax-equivalent basis using a federal tax rate of 35%. Yields on available for sale securities are calculated based on amortized cost of the security.
For purposes of the maturity table, mortgage-backed securities, collateralized debt obligations, and collateralized mortgage obligations, which are not due at any single maturity date, have been included in maturity groupings based on their contractual maturity. The expected life of mortgage-backed securities will differ from contractual maturities because borrowers may have the right to call or prepay the underlying mortgage with or without call or prepayment penalty.
Weighted average yield is calculated using the amortized cost basis of the underlying security.
Loans
At December 31, 2012, total loans represented 77.6% of total assets. Total loans at December 31, 2012 increased $109.9 million or 4.6% over December 31, 2011 and $140.0 million or 5.9% over September 30, 2011. The increases were primarily the result of the Plantation and Liberty acquisitions which occurred during the second quarter of 2012, partially offset by normal loan portfolio activity. The following table summarizes outstanding loans by purpose of the loan.
The majority of loans are originated to borrowers in First Federal’s local market areas of Charleston, Florence, Georgetown, Greenville, Hilton Head, and Myrtle Beach, South Carolina as well as Wilmington, North Carolina. First Federal’s principal lending activity has historically consisted of the origination of residential mortgage loans secured by first mortgages on owner occupied, one-to-four family residences and, to a lesser extent, on loans for the construction of one-to-four family residences. First Federal also originates commercial real estate loans and commercial business loans. While First Federal intends to increase its commercial and small business loan originations, a substantial portion of the loan portfolio is currently secured by real estate. First Federal originates consumer loans with an emphasis on home equity lines of credit and loans as well as manufactured housing and marine loans. The marine portfolio increased during 2012 due to the addition of a new product line focused on larger yacht loans. The credit risk related to the loan portfolio is considered in the calculation of the allowance for loan losses as discussed in the “Asset Quality” and “Allowance for Loan Losses” sections below.
Loans held for sale have historically been comprised of residential mortgage loans awaiting sale in the secondary market, which generally settle in 15 to 45 days. The increase in loans held for sale at December 31, 2012 as compared with December 31, 2011 was due to higher levels of residential mortgage loans to be sold in the secondary market as a result of expanding First Federal’s correspondent lending channel during 2012. Loans held for sale at September 30, 2011 was comprised of $40.8 million in residential mortgage loans awaiting sale in the secondary market and $54.1 million of loans in the bulk loan sale pool. The decrease in loans held for sale at December 31, 2012 as compared with September 30, 2011 was primarily the result of completing the bulk loan pool sale in October 2011, partially offset by the correspondent lending expansion.
In April 2009 and April 2012, First Federal entered into purchase and assumption agreements with the FDIC to acquire certain assets and liabilities of Cape Fear and Plantation, respectively, under which all Cape Fear loans and certain Plantation commercial loans and OREO were covered under loss share agreements with the FDIC (“acquired covered loans” or “acquired covered assets”). In addition, First Federal acquired five branches from Liberty in April 2012. The Plantation loans and OREO not covered under its loss share agreement and all of the Liberty loans are considered “acquired non-covered loans” or “acquired non-covered assets.” Loans that were originated through First Federal’s normal origination channels (i.e., not acquired in an acquisition) that are part of the loan portfolio or have subsequently migrated to OREO are considered “legacy loans” or “legacy assets.” See Notes 4 and 6 to the Consolidated Financial Statements for additional information.
The following tables summarize acquired loans.
See Note 4 to the Consolidated Financial Statements for the regulatory definition of criticized and classified.
See Note 4 to the Consolidated Financial Statements for the regulatory definition of criticized and classified.
The following table presents the contractual terms to maturity for loans outstanding at December 31, 2012. Demand loans, loans having no stated schedule of repayment and no stated maturity, and overdrafts are reported as due in one year or less. The table does not include an estimate of prepayments, which can significantly affect the average life of loans and may cause First Federal’s actual principal payment experience to differ materially from that shown. For example, the average life of mortgage loans tends to increase when current market interest rates are substantially higher than the interest rates on existing loans and decrease when the interest rates on existing loans are substantially higher than current market interest rates.
Residential Mortgage Loans
Residential mortgage loans are comprised of residential one-to-four family, which represent 92.7% of total residential mortgage loans, as well as construction and land loans. First Federal generally underwrites residential one-to-four family loans based on the applicant’s employment, debt-to-income levels, credit history and the appraised value of the subject property. Properties securing one-to-four family loans are generally appraised by independent appraisers who have been approved by First Federal. Borrowers are required to obtain title and hazard insurance, and flood insurance, if necessary, in an amount equal to the regulatory maximum. The following tables segment the residential one-to-four family portfolio as of December 31, 2012 by geographic location and year of origination. Geographic data is presented by MSA where available, or by county as a proxy.
The years of origination groupings above were determined to isolate loan originations year which contributed to the “credit crunch” (2005 - 2008), and the periods prior to (2004 & prior) and post (2009 - 2012) those origination years.
Generally, First Federal lends up to 80% of the lesser of the appraised value or purchase price for residential mortgage loans. On occasion, there have been first mortgages originated under specific lending programs that allow borrowers to obtain up to 100% of the appraised value and finance the closing costs, resulting in a LTV ratio of 100% or greater at origination. Loans with a high LTV at origination may experience a higher risk of credit default. At December 31, 2012, 2011, and September 30, 2011 there were $90.9 million, $88.0 million and $88.3 million of such loans, respectively. Private mortgage insurance is generally required in order to reduce exposure on loans with LTVs at origination greater than 80%. Exposure is also reduced in cases where the loans are guaranteed under VA or FHA programs. The amount of residential one-to-four family loans with an LTV at the time of origination greater than 100% which were either not guaranteed or do not have private mortgage insurance totaled $62.2 million, $55.5 million and $55.1 million at December 31, 2012, 2011 and September 30, 2011, respectively.
First Federal offers adjustable-rate mortgage loans (“ARMs”) and fixed-rate mortgage loans with terms generally ranging from ten to thirty years. Generally, these loans meet Fannie Mae, Ginnie Mae or Freddie Mac requirements for sale in the secondary market. First Federal generally retains ARMs and jumbo mortgages, and periodically retains some of the fixed rate loans in the loan portfolio to meet asset/liability management objectives. Traditional types of ARMs have up to thirty year terms and interest rates which adjust annually after being fixed for a period of three, five, seven or ten years in accordance with a designated index. ARMs may be originated with a 1%, 2% or 5% cap on the interest rate increase or decrease in the initial repricing period, a 1% or 2% cap on any increase or decrease in the interest rate per year thereafter, with a 4%, 5% or 6% limit on the amount by which the interest rate can increase or decrease over the life of the loan. These loans are underwritten based on the fully-indexed rate. Loans of this type have embedded interest rate risk if rates should rise during the initial fixed rate period as the income earned by First Federal would be lower than current market rates until the interest rate reset date. While ARMs allow First Federal to decrease the sensitivity of its assets as a result of changes in interest rates, the extent this mitigates interest sensitivity is limited by the periodic and lifetime interest rate adjustment limits. Potential credit risk results from higher interest charges to be paid by the borrower as a result of increases in interest rates or the expiration of interest-only periods. It is possible that during periods of rising interest rates the risk of default on ARMs may increase as a result of the higher required payment from the borrower. Given the recent market environment, the loan production of ARMs has been substantially reduced in favor of fixed rate mortgages.
The following table segments the residential one-to-four family portfolio into its respective products types.
Commercial Loans
Commercial loans are comprised of general purpose, owner-occupied and non-owner occupied real estate, construction, and land loans. First Federal offers a variety of commercial loan services to a diversified customer base over a range of industries.
Commercial business loans include commercial and industrial business loans, lines of credit, equipment loans and letters of credit. First Federal focuses its efforts on local or regional, small- to medium-sized companies that operate in the local market area. These loans are typically secured by non-real estate collateral or are unsecured and are used for general business purposes, including working capital financing, equipment financing and general expansion. These loans are generally approved based on the borrower’s historical and projected cash flows at the time of the loan, with consideration given to the value of the underlying collateral. However, the borrower’s actual cash flow may be less than expected and the value of the collateral securing these loans may fluctuate or depreciate over time. Collateral on these loans may consist of a blanket lien on accounts receivable, inventory or equipment and is normally backed by a personal guarantee from the owners of the business; however some short-term loans may be made on an unsecured basis.
Loan terms vary but do not typically exceed five years. The interest rates on such loans are either fixed rates or floating rates indexed to the prime rate or LIBOR plus a margin to the index. Commercial business lending standards include credit file documentation and analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral, as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower’s past, present and future cash flows is also an important aspect of the credit analysis.
Commercial real estate loans consist of commercial mortgages on both owner occupied and income-producing properties. Owner occupied commercial real estate loans are viewed as cash flow loans and undergo an underwriting process similar to commercial and industrial loans as well as that of a real estate loan. Income-producing commercial real estate loans are secured by non-owner occupied locations with sole purpose of receiving investment or rental income. Repayment of these loans is often substantially dependent on the borrower’s success to lease the property. As of December 31, 2012, 48.2% of commercial real estate loans were owner occupied, which are expected to have a lower risk profile than non-owner occupied or investment commercial real estate. Commercial real estate loans are primarily secured by office and warehouse space, professional buildings, retail sites, multi-family properties, and industrial facilities in First Federal’s primary market area. Commercial real estate loans typically involve higher principal amounts than residential and consumer loans. If non-owner occupied, repayment is normally dependent on income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and service debt. Generally, the LTV ratio for commercial real estate loans does not exceed 80% on purchases or refinances. Based on policy guidelines, First Federal obtains appraisals from approved independent appraisers, or uses other forms of evaluation which are acceptable under policy or regulatory guidelines, on all properties securing commercial real estate loans. These loans may pose a greater credit risk than loans secured by residential real estate because the collateral may not be sold as easily as residential real estate, as there may be fewer potential purchasers of the collateral, which might result in a longer holding period. If any errors in judgment are made regarding the collectability of commercial real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred with the residential mortgage or consumer loan portfolios.
Commercial real estate loans are generally priced at a higher rate of interest than residential one-to-four family loans and interest rates are determined by market conditions existing at the time of the loan commitment. The amortization of the loans may vary but will not usually exceed twenty years. Terms are based on either variable (prime rate or LIBOR based) or fixed rates. Fixed rate loans are generally for a period of three to five years; however some rates are fixed up to twenty years. Many commercial real estate loans are not fully amortizing and contain balloon payments.
The following tables segment commercial real estate loans as of December 31, 2012 by geographic location and the year of origination. Geographic data is presented by MSA where available, or by county as a proxy.
The years of origination groupings above were determined to isolate loan originations year which contributed to the “credit crunch” (2005 - 2008), and the periods prior to (2004 & prior) and post (2009 - 2012) those origination years.
First Federal has significantly reduced origination levels for construction and land loans in recent years given the current conditions of the real estate market. New originations are generally limited to owner occupied construction projects and require higher levels of equity in the project as well as adherence to more defined underwriting standards. Commercial land loans are generally secured by property in First Federal’s primary market areas. These loans are secured by a first lien on the property, are limited to 65% of the lower of the acquisition price or the appraised value of the land, and generally have a term of up to two years with an interest rate based on the prime rate. Title insurance is required and, if applicable, a hazardous waste survey reporting that the land is free of hazardous or toxic waste. Construction loans are underwritten utilizing feasibility studies, independent appraisals, sensitivity analysis for absorption and lease rates as well as financial analysis of the developers and property owners. Construction and land development loans are based on estimates of costs and value associated with the completed project, which may prove to be inaccurate. These loans often involve the disbursement of substantial funds during the construction phase with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related LTV ratio. Construction and land loans are closely monitored through on-site inspections and are considered to have a higher risk than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.
Consumer Loans
First Federal offers a variety of consumer loans, including home equity lines of credit and loans, manufactured housing, marine, yacht, automobile, credit cards and personal secured and unsecured loans. Generally, consumer loans have shorter terms to maturity and higher interest rates than residential mortgage loans. Consumer loan approvals are generally based on employment and financial information solicited from prospective borrowers as well as credit records obtained from various reporting agencies. The borrower’s financial stability and credit history as well as the availability of collateral are the primary factors considered in granting such loans. The borrower’s geographic location is also considered, with preference given to borrowers in First Federal’s primary markets. Consumer loans entail greater risk than residential one-to-four family loans, particularly in the case of consumer loans that are unsecured or secured by rapidly depreciating assets such as boats or automobiles, or second-lien loans such as home equity lines of credit in markets where residential property values have declined significantly in recent years. In these cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding balance as a result of the greater likelihood of damage, loss, or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. Consumer loan collections are dependent on the borrower’s continuing financial stability, and are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. In addition, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans.
Home equity lines of credit and loans are typically used for improvements on residential properties, debt consolidation and education expenses. Home equity lines of credit generally have a ten to fifteen year term and interest rate tied to the prime rate. As of December 31, 2012, 34% of home equity loans were secured by a First Federal-held first mortgage on residential property, and 66% were secured by a first and second mortgage. The maximum LTV ratio is typically 85% at origination, which takes into account both the balance of the first mortgage and the home equity loans. Further declines in home values may contribute to current LTV ratios in excess of 85% and private mortgage insurance is not obtained for these loans. In addition, management reviews home equity lines regularly using an automated valuation service to update property values based on current market sales and property listings on at least an annual basis unless otherwise warranted for a more frequent review. In addition, borrower credit scores are updated on a semi-annual basis and analyzed for potential deterioration as well as increased risk of default. Home equity lines with significant declines in the value of the underlying collateral or material changes in the borrower’s financial condition are further evaluated to determine if future advances on the line should be suspended. Based on current credit reviews, as of December 31, 2012, 20.7% of First Federal’s home equity lines were suspended from future advances. First Federal does not actively participate in wholesale or brokered home equity loan origination.
The following tables segment home equity loans as of December 31, 2012 by the geographic location, year of origination, and lien position. Geographic data is presented by MSA where available, or by county as a proxy.
The years of origination groupings above were determined to isolate loan originations year which contributed to the “credit crunch” (2005 - 2008), and the periods prior to (2004 & prior) and post (2009 - 2012) those origination years.
Manufactured housing lending involves additional risks as a result of higher LTV ratios usually associated with consumer loans. Consequently, manufactured housing loans bear a higher rate of interest, generally have a higher probability of default, may involve higher delinquency rates and may require higher reserves than other types of consumer loans. The geographic concentration of First Federal’s manufactured housing portfolio as of December 31, 2012 follows.
Mortgage Activities and Servicing
Mortgage activities involve the origination and sale of residential one-to-four mortgages and the subsequent servicing of mortgage loans sold. Mortgage activities are conducted for the purpose of generating fee income on the origination of loans, gains on the sales of loans, and servicing fee income. As part of it its total residential mortgage origination function, First Federal operates a correspondent lending program to purchase residential first mortgage loans sourced by unaffiliated banks, mortgage lenders and brokers in South Carolina, North Carolina, Georgia, Massachusetts, New Jersey, Virginia, and Pennsylvania. These loans are subject to underwriting standards consistent with the loans originated at First Federal locations and are accepted for purchase only after approval by First Federal’s underwriters. Loans funded through the correspondent program totaled $476.0 million for the year ended December 31, 2012, as compared with $116.8 million for the quarter ended December 31, 2011 and $222.0 million for the year ended September 30, 2011. The increase for the twelve month period was due to higher origination levels related to the continued low interest rate environment as well as the addition of correspondent lenders in select states in the Northeast. First Federal sells over 80% of its annual origination volume to the secondary market.
Generally, residential mortgage loans are sold and servicing rights are retained on qualifying fixed-rate mortgages. First Federal’s primary single-family product is the conventional mortgage loan. However, loans are also originated that are either fully guaranteed by the VA or partially insured by the FHA. First Federal also sells conventional whole loans to Fannie Mae and Freddie Mac, which are sold on a non-recourse basis and foreclosure losses are generally the responsibility of the purchaser and not First Federal. The level of loan sale activity and its contribution to First Federal’s profitability depends on maintaining a sufficient volume of loan originations. Changes in the level of interest rates and the local economy affect the number of loans originated by First Federal and the amount of loan sales and loan fees earned.
The following table presents loan originations and proceeds from residential mortgage securitizations and sales.
After selling originated mortgage loans, First Federal receives fees from a variety of institutional investors in return for performing the traditional services of collecting individual loan payments and otherwise servicing the sold mortgage loans. At December 31, 2012, First Federal was servicing $1.9 billion of loans for others, an increase from $1.4 billion at both December 31, 2011 and September 30, 2011. Loan servicing includes processing payments, accounting for loan funds and collecting and paying real estate taxes, hazard insurance and other loan-related items such as private mortgage insurance. After First Federal receives the gross mortgage payment from individual borrowers, it remits to the investor a predetermined net amount based on the loan sale agreement for that mortgage.
Servicing assets are amortized in proportion to, and over the period of, the estimated net servicing income and are carried at fair value. The fair value of servicing assets is determined by calculating the present value of the estimated net future cash flows consistent with contractually specified servicing fees. This valuation is performed on a disaggregated basis, based on loan type and interest rate. Generally, loan servicing becomes more valuable when interest rates rise (as prepayments typically decrease) and less valuable when interest rates decline (as prepayments typically increase). As discussed in Note 5 to the Consolidated Financial Statements, First Federal uses a weighted average constant prepayment rate, discount rate and other defined assumptions to model the respective cash flows and determine the fair value of the servicing asset at each balance sheet date. In aggregate, servicing assets had a fair value of $13.9 million, $10.7 million and $10.6 million at December 31, 2012, December 31, 2011 and September 30, 2011, respectively. See Notes 1, 5, 16 and 17 to the Consolidated Financial Statements for additional details.
Asset Quality
Because lending activities comprise such a significant source of revenue, First Federal adheres to sound lending practices. In addition to the underwriting practices described in the “Loans” section above, First Federal’s Management Loan Committee, which consists of the Chief Credit Officer and senior lending personnel, is authorized to approve loans to one borrower or a group of related borrowers up to $5.0 million in the aggregate. Loan requests for relationships in excess of $5.0 million in aggregate credit exposure are presented to the Loan Committee of First Federal’s Board for review and approval.
First Federal monitors the loan portfolio regularly to determine where risk mitigation efforts can be utilized to assist in preventing or mitigating future losses. An element of the credit risk management process is monthly loan reviews to determine risk levels and exposure to loss. The monthly loan review process evaluates all commercial loans greater than $200,000 that are more than 30 days past due and all criticized and classified loans over $500,000. The depth of review varies by asset type, depending on the nature of the assets and their risk characteristics. While certain assets may represent a substantial investment and warrant individual reviews, other assets may have less risk because the asset size is small, the risk is spread over a large number of obligors or the obligations are well collateralized and further analysis of individual assets would expand the review process without measurable advantage to risk assessment. Asset types with these characteristics may be reviewed as a total homogenous portfolio (as is the case with residential and consumer loans) on the basis of risk indicators such as delinquency or credit rating. In addition, a formal review process may be conducted on individual assets within the homogenous pool that represent potential risk. For the larger credits, action plans to address the credit weaknesses are presented and approved plans are monitored. Loan reviews emphasize the borrower’s and guarantor’s global cash flow analysis as a key determinant in the credit quality risk rating and to identify deterioration in the financial condition of the borrowers that may limit their ability to continue to service their debt or to carry their obligations to contractual term. In addition, reviews may include evaluations of collateral values as determined necessary based on credit policies and credit risk rating. First Federal’s policy is to update real estate collateral appraisals on problem loans at least annually or more frequently if deterioration in market value is observed.
In addition to monitoring individual loans during the monthly loan review process, First Federal management meets on a monthly basis to review historical portfolio performance and discuss emerging trends for delinquency, nonperforming and charge-off levels. The monthly credit quality meeting is comprised of senior credit, lending and accounting personnel who discuss current loss mitigation efforts as well as strategies to improve the success of ongoing efforts.
During 2011, First Federal identified loans for a bulk loan sale as part of a strategy to reduce its level of delinquent and nonperforming loans, as well as to minimize further negative migration and reduce the inherent risk in the overall loan portfolio. Certain nonperforming and performing loans considered to have a high risk of further credit deterioration, the resolution of which could likely extend over a protracted period of several years, were selected to create a bulk loan pool for sale. First Federal identified loans totaling $202.2 million in contractual principal balance ($155.3 million book value) to reclassify to loans held for sale as of June 30, 2011 and these loans were written-down to an estimated fair value of $60.3 million at that time. The bulk loan sale was completed in the fourth quarter of 2011, with a $20.8 million gain on the sale recorded. The bulk loan sale was a primary driver for the improvement in credit metrics and the level of nonperforming loans since the sale.
Measuring Asset Quality for Acquired Loans
Acquired loans are carried at fair value in accordance with Accounting Standards Codification (“ASC”) 805, Business Combinations. In addition, loans that displayed deteriorated credit quality at acquisition are accounted for in accordance with ASC 310-30, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, are deemed to be performing loans, and are not included in First Federal’s delinquent and nonperforming credit metrics. Acquired loans that were considered performing at acquisition but have subsequently become delinquent, impaired or nonperforming (as defined below) are included in the appropriate
credit metric. As discussed in Note 6 to the Consolidated Financial Statements, some of the acquired loans are considered to be covered and, as such, have a lower risk of loss if they are deemed uncollectible as First Federal will file a loss claim with the FDIC to be reimbursed in accordance with their agreement. The outstanding loan balance and credit metrics as of December 31, 2012 for the acquired loan portfolios are displayed in two tables in the “Loans” section above.
Delinquent Loans
The following table presents loans that were past due 30-89 days which were not otherwise on nonaccrual status.
Note: percentage calculations represent each loan category as a percentage of total loans.
Total delinquent loans at December 31, 2012 decreased $1.3 million or 7.0% from December 31, 2011 and increased $2.3 million or 15.4% over September 30, 2011. The decrease from December 31, 2011 was primarily the result of continued collection efforts as well as a stabilization of general economic conditions in most of First Federal’s markets. The increase over September 30, 2011 was driven by higher delinquent residential, home equity, and manufactured housing levels due primarily to normal seasonal fluctuations. The decrease between September 30, 2010 and September 30, 2011 was primarily the result of the bulk loan sale in 2011.
Nonperforming Assets
Nonperforming assets include nonaccrual loans, loans delinquent 90 days or more and still accruing, restructured loans still accruing, and other repossessed assets acquired through foreclosure. With the exception of the credit card portfolio, loans are placed on nonaccrual status when they become 90 days delinquent. In addition, loans that were not delinquent in excess of 90 days but exhibited doubt as to First Federal’s ability to collect all contractual principal and interest have been classified as impaired under ASC 310-10, as discussed further below, and placed on nonaccrual status. The following table presents the composition of nonperforming assets.
While total nonperforming assets were essentially unchanged from December 31, 2011 to December 31, 2012, decreases in other repossessed assets acquired and nonperforming commercial loans due to focused loss mitigation efforts were substantially offset by increases in nonperforming residential mortgage, home equity and accruing restructured loans. The increases in nonperforming residential mortgage and home equity loans were due to the prolonged economic downturn as well as the lengthy cycle to resolve foreclosed residential mortgages in South Carolina. The increase in accruing restructured loans was due to proactive modification arrangements to help customers through the prolonged economic downturn. The decrease in nonperforming assets from September 30, 2011 and prior periods was primarily the result of the bulk loan sale completed in the fourth quarter of 2011, as well as a general stabilization in credit trends since the bulk loan sale. Acquired covered nonperforming assets continue to be reduced through resolution or loss claims with the FDIC.
The following table provides a breakdown of nonaccrual loans by geographic location. Geographic data is presented by MSA where available, or by county as a proxy.
Impaired Loans and Troubled Debt Restructuring
In accordance with ASC 310-10-35, a loan is considered impaired when First Federal determines it is probable that the principal and interest due under the contractual terms of the loan will not be collected. Loans classified as impaired are placed on nonaccrual status and are included in the tables above as nonaccrual loans. First Federal accounts for certain loan modifications or restructuring as a troubled debt restructuring (“TDR”). In general, the modification or restructuring of a debt is considered a TDR if First Federal, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that First Federal would not otherwise consider. TDRs are included in the tables above, with nonaccruing TDRs incorporated into their respective loan category and accruing TDRs are identified separately. See Note 4 to the Consolidated Financial Statements for additional details on impaired loans and TDRs.
Other Repossessed Assets Acquired
Other repossessed assets acquired is comprised of OREO and other consumer assets. OREO is acquired as a result of foreclosure or by deed-in-lieu of foreclosure and is recorded at the lower of its cost or the fair value of the property at acquisition, less selling costs. New appraisals are obtained periodically on aged properties, with further reductions to fair value recorded through the Consolidated Statements of Operations in OREO expenses, net. Other repossessed consumer collateral, including automobiles, manufactured homes and boats are also recorded at the lower of cost or fair value. Other repossessed assets at December 31, 2012 decreased $2.1 million or 10.5% from December 31, 2011 and $7.9 million or 30.0% from September 30, 2011. The decreases were due to property sales and writedowns outpacing foreclosures, partially offset by the addition of $8.7 million as part of the Plantation acquisition. See Note 4 to the Consolidated Financial Statements for additional details on OREO.
Classified Assets
Federal regulations provide for the classification of lower quality loans as substandard, doubtful or loss. The commercial banking officers are responsible for monitoring borrower performance and recommending the loan risk rating, including classified grades. First Federal has a committee, comprised of the Chief Credit Officer, credit risk management officers and other senior lending personnel, that evaluates the risk rating recommendations of when to classify loans as either substandard, doubtful or loss. Residential mortgage and consumer loans are generally classified based on delinquency. However, if there are residential mortgage and consumer loans that are part of a commercial relationship that has classified loans, they may also be deemed as classified loans if there is a common source of repayment. A specific allowance may be established on an impaired classified loan if determined necessary based on the classification and circumstances, or the potential loss may be addressed in the general allowance. When problem loans are classified as a loss, they are charged-off in the period in which they are deemed uncollectible. First Federal's determination as to the classification of its loans and the amount of their valuation allowances is subject to review by its regulators, which can order changes to classifications and the establishment of additional loan loss allowances. See Note 4 to the Consolidated Financial Statements for additional details on criticized and classified loans.
The following table details classified assets, which includes classified loans, classified loans held for sale, and other repossessed assets acquired, by category.
Classified loans at December 31, 2012 increased $9.9 million or 8.7% over December 31, 2011 and increased $16.2 million or 14.9% over September 30, 2011. The increases were driven by higher levels of non-covered classified residential loans and consumer loans due to the prolonged economic downturn as well as the lengthy cycle to resolve foreclosed residential mortgages in South Carolina, partially offset by lower classified commercial loans. Acquired covered classified loans continue to be reduced through resolution or loss claims with the FDIC. The classified loans held for sale as of September 30, 2011 were related to the pool of loans selected for the bulk loan sale completed in the fourth quarter of 2011. See "Other Repossessed Assets Acquired" above for additional details on those assets.
Allowance for Loan Losses
First Federal maintains an allowance for loan losses (the “allowance”), which is management’s best estimate of probable losses inherent in the loan portfolio. The allowance is decreased by actual loan charge-offs, net of recoveries, and is increased by charges to current period operating results through the provision for loan losses. During the monthly loan review process, losses are identified and addressed as they are incurred. In addition, First Federal utilizes an external firm to review loan quality and it reports the results of its reviews to executive management and the Board on a quarterly basis. Such reviews also assist management in validating the accuracy of the risk rating process and establishing the level of the allowance.
A committee consisting of members of lending management, credit risk management, executive management and accounting meets at least quarterly to review the credit quality of the loan portfolios and to evaluate the allowance. The portfolio evaluation and allowance calculation process determines specific reserves for impaired loans and general reserves for pools of homogeneous loans to arrive at the required allowance. In addition to being used to categorize risk, First Federal's internal risk rating system is used as one of the factors to determine the allocated allowance for the loan portfolio. Loans are segmented into categories for analysis based in part on the risk profile inherent in each category. Loans are further segmented into risk rating pools within each category to appropriately recognize changes in inherent risk. While allocations of the allowance may be made for specific loans, the entire allowance is available for any loan that, in management's judgment, should be charged-off. In addition, an unallocated or non-specific reserve may be deemed necessary based on the committee's judgment. As of December 31, 2012, there was no unallocated portion of the allowance for loan losses.
A primary component of determining the reserve factors utilized in the allowance calculation is the actual loss history tracked by major loan category. First Federal currently estimates the losses inherent in the loan portfolio based on a rolling eighteen month historical loss period to evaluate the allowance. The loss history is reviewed by loan sector along with more recent trends, such as one-year and the most recent quarter historical loss ratios, to determine probable losses inherent in the portfolio. First Federal’s policy is to adjust the loss history with internal and external qualitative factors at each period end, as appropriate, given the facts available at the time. The following qualitative factors that are likely to cause estimated credit losses in First Federal’s existing portfolio to differ from historical loss experience include, but are not limited to:
·changes in lending policies and procedures;
·changes in economic conditions;
·changes in the nature and volume of the loan portfolios;
·experience, ability and depth of management;
·past due, nonaccrual, and classified loan trends;
·quality of the loan review process;
·collateral value changes for collateral dependent loans;
·changes in credit concentrations; and
·the competitive, legal and regulatory environment.
Upon completion of the qualitative adjustments, the allowance is allocated to the components of the portfolio based on the adjusted loss rates. The specific reserve associated with impaired loans is primarily determined by estimating loss inherent in each problem credit based on the value of the underlying collateral or by utilizing a discounted cash flow methodology.
The following tables summarize the changes in the allowance.
Note: percentage calculations represent each loan category as a percentage of total loans.
The allowance for loan losses at December 31, 2012 represented 1.77% of total loans, compared with 2.24% at December 31, 2011 and 2.31% at September 30, 2011. The decrease in the allowance ratio was primarily the result of acquiring loans that are carried at fair value and do not currently have an associated allowance. As of December 31, 2012, the acquired loans that were excluded from the allowance calculation totaled $252.5 million, compared with $14.6 million and $17.9 million at December 31, 2011 and September 30, 2011, respectively. Excluding the effect of the excluded acquired loans, the allowance was 1.97% at December 31, 2012, compared with 2.26% and 2.32% at December 30, 2011 and September 30, 2011, respectively. The decreases were driven by continued improvement in historical loss factors and stable credit metrics since the bulk loan sale in late 2011. See Note 4 to the Consolidated Financial Statements for additional details on the allowance for loan losses.
First Federal believes that it uses relevant information available to make determinations about the allowance and that it has established its allowance in accordance with GAAP. Management and the Board have implemented policies surrounding loan loss identification, loan monitoring and allowance for loan loss methodologies, have consistently applied its processes, and have determined that the controls in place are adequate to ensure that the allowance is appropriate as of each balance sheet date. Management believes that the allowance is adequate and sufficient for the risk inherent in the portfolio as of each balance sheet date. If circumstances differ substantially from the assumptions used in determining the allowance, future adjustments to the allowance may be necessary and results of operations could be affected. Because events affecting borrowers and collateral charge-offs cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate.
FDIC Indemnification Asset
The FDIC indemnification asset, net at December 31, 2012 totaled $80.3 million, an increase of $29.2 million or 57.3% over December 31, 2011 and an increase of $29.8 million or 59.1% over September 30, 2011. The increases were the result of establishing a $35.9 million indemnification asset during 2012 to recognize the loss share agreement associated with the Plantation transaction, combined with subsequent adjustments to the asset for actual losses in excess of original projections, as well as normal accretion of the existing indemnification asset. These additions were partially offset by the receipt of claims reimbursement from the FDIC and $4.0 million in potential impairment on the FDIC indemnification asset related to the Cape Fear transaction as the performance of an underlying loan pool has been better than originally projected and may result in lower future reimbursements under the loss share agreement. See Notes 1 and 6 to the Consolidated Financial Statements for additional details.
Bank Owned Life Insurance
Bank owned life insurance totaled $50.6 million at December 31, 2012, an increase of $50.6 million over December 31, and September 30, 2011. The increases were the result of establishing a bank owned life insurance program on certain corporate officers as part of a strategy to offset the costs of existing employee benefit plans.
Other Assets
Other assets totaled $77.2 million at December 31, 2012, a decrease of $18.8 million or 19.6% from December 31, 2011, and a decrease of $41.4 million or 34.9% from September 30, 2011. The decreases from both prior periods were principally due to current tax adjustments recorded, federal tax refunds received during the twelve month period ended December 31, 2012 and a $1.2 million net write-down of the state deferred tax asset due to First Federal’s conversion to a South Carolina state-chartered commercial bank. In addition, the decrease from September 30, 2011 was caused by additional federal tax refunds received and lower levels of OREO as property sales and writedowns outpaced foreclosures. See Notes 4 and 13 to the Consolidated Financial Statements for additional details.
Deposits
Deposits, particularly core deposits, are a primary source of funding for First Federal and provide the ability to successfully meet both short-term and long-term liquidity needs. First Federal offers a variety of deposit accounts with a range of interest rates and terms. While retail deposits have traditionally been the primary source of funding and provide a customer base for cross-selling additional products and services, First Federal also emphasizes business accounts as an opportunity for growth and offers products focused on business customers’ needs. Deposits as a percent of total funding were 90.3% at December 31, 2012, compared with 78.6% at December 31, 2011 and 79.2% at September 30, 2011. The increases reflect a focus to shift from wholesale funding sources to core deposits, which was accomplished through a combination of organic growth and acquisitions.
Interest paid on deposits represents the largest component of First Federal's interest expense. Interest rates offered on interest-bearing deposits are determined based on a number of factors, including, but not limited to: (1) interest rates offered with respect to comparable products in the local markets by competitors, (2) current and expected economic conditions, (3) anticipated future short-term and long-term interest rates, (4) the expected amount and timing of funding needs and (5) the availability and cost of alternative funding sources. Deposit flows are controlled by First Federal primarily through pricing, and to a lesser extent, through promotional activities. Management believes that the rates it offers, which are posted weekly on deposit accounts, are generally competitive with other financial institutions in First Federal's respective market areas. Customer deposits are attractive sources of funding because of their relative stability and cost. In addition, customer deposits are regarded as an important part of the overall customer relationship and provide opportunities to cross-sell other services.
The average cost of deposits for the year ended December 31, 2012 was 0.51%, compared with 0.76% for the quarter ended December 31, 2011 and 1.20% for the year ended September 30, 2011. The decreases in the average cost of deposits from both prior periods were due in large part to the low cost core deposits acquired in the Plantation and Liberty transactions as well as the continued planned reductions in maturing high rate time deposits.
The following table presents major deposit categories.
Core deposits at December 31, 2012 increased $412.2 million or 33.5% over December 31, 2011, and $419.3 million or 34.2% over September 30, 2011. The increases were primarily the result of acquiring $272.9 million in core deposit as part of the Plantation and Liberty transactions, as well as the introduction of new retail deposit products and sales processes during 2012. Time deposits at December 31, 2012 decreased $56.0 million or 5.6% from December 31, 2011, and decreased $126.8 million or 11.8% from September 30, 2011. The decreases were primarily the result of a planned reduction in maturing high rate retail and wholesale time deposits and lower funding needs relative to asset growth during 2012, partially offset by $260.0 million in time deposits acquired as a result of the Plantation and Liberty transactions. See Notes 2 and 9 to the Consolidated Financial Statements for additional information on deposits.
Borrowed Funds
Borrowed funds, which are comprised of advances from the FHLB and long-term debt, are used to complement deposit generation as a funding source for asset growth as well as for asset/liability management. Total borrowings at December 31, 2012 were $280.2 million, a decrease of $328.0 million or 53.9% from December 31, 2011, and a decrease of $325.0 million or 53.7% from September 30, 2011. The decreases were the result of shifting the funding mix to core deposits and the balance sheet repositioning strategy during 2012, which included prepaying $125.0 million in long-term FHLB advances with an average rate of 3.15%. As a result of this action, First Federal paid a prepayment termination charge of $8.5 million.
Shareholders’ Equity
Shareholders’ equity at December 31, 2012 totaled $299.6 million, an increase of $22.5 million or 8.1% over December 31, 2011 and an increase of $31.1 million or 11.6% over September 30, 2011. The increases were primarily the result of net income, partially offset by a reduction in accumulated other comprehensive income related to investment securities valuations. Both First Financial’s and First Federal’s regulatory capital ratios continue to be above “well-capitalized” minimums, as presented in the following table.
1 Effective in 2012, First Financial was required to file the FR Y-9C, Consolidated Financial Statements for Bank Holding Companies, with the Federal Reserve. Periods prior to first quarter 2012 were not applicable to such regulatory filings. Bank holding companies are not subject to the prompt corrective action provisions of the Federal Deposit Insurance Act.
2 Beginning in 2012, capital ratios for First Federal are based on reporting requirements for financial institutions filing FFIEC 041, FDIC Consolidated Reports of Condition and Income. Prior period ratios are reported based on superseded regulatory requirements previously issued by the Office of Thrift Supervision.
As a result of First Federal’s charter conversion and Federal Reserve membership in February 2012, First Federal is subject to Federal Reserve Supervisory Letter SR 91-17, which provides guidance that de novo state member banks and converting thrifts maintain a Tier 1 leverage ratio of 9.00% for the first three years as a member bank unless an exception is granted.
On March 29, 2012, the US Treasury completed the sale of its $65.0 million preferred stock investment in First Financial to private investors through a registered public offering. There was no impact to First Financial’s financial condition or operating results due to the transaction. On January 24, 2013, First Financial declared a quarterly cash dividend of $12.50 per preferred share payable on February 15, 2013 to shareholders of record as of February 5, 2013.
On January 24, 2013, First Financial declared a quarterly cash dividend of $0.05 per common share, payable on February 22, 203 to shareholders of record as of February 8, 2013.
Liquidity
First Federal Liquidity
An important component of First Federal’s asset/liability structure is the level of liquidity available to meet the needs of its customers and creditors. First Federal’s primary sources of funds consist of retail and commercial deposits, borrowings from the FHLB and Federal Reserve, other short-term borrowings, principal repayments on loans and cash flows on investment securities, the sale of loans and securities and brokered deposits. First Federal’s desired level of liquidity is determined by management in conjunction with the Asset/Liability Committee (“ALCO”) of First Federal. The level of liquidity is based on management’s strategic
direction, commitments to make loans and the ALCO’s assessment of First Federal’s ability to generate funds. Management believes First Federal has sufficient liquidity to meet future funding needs.
As of December 31, 2012, First Federal had the capacity to borrow a total of $717.7 million from the FHLB, the Federal Reserve of Richmond, and through federal funds lines with unaffiliated banks. Neither the line with the Federal Reserve nor the federal funds lines had outstanding balances at December 31, 2012.
First Financial Liquidity
As a bank holding company, First Financial conducts its business through its subsidiaries and is not subject to any regulatory liquidity requirements. Potential sources for First Financial’s payment of principal and interest on its borrowings, preferred and common stock dividends and future funding needs include dividends from First Federal and other subsidiaries, payments from existing cash reserves, sales of marketable securities and additional borrowings or stock offerings. First Federal’s ability to pay dividends to First Financial is subject to regulatory requirements as discussed in Note 12 to the Consolidated Financial Statements. Potential uses of First Financial’s cash and cash equivalents include dividend and interest payments, operating expenses or capital contributions to its subsidiaries, including First Federal. As of December 31, 2012, First Financial had cash and cash equivalents of $18.1 million, as compared with $39.0 million and $43.9 million at December 31, 2011 and September 30, 2011, respectively. The decrease was primarily the result of quarterly dividend payments to preferred and common shareholders as well as a $12.0 million of capital downstreamed to First Federal during 2012 to support acquisition activities. First Financial’s interest and preferred dividend payment obligations total $6.6 million annually.
Asset and Liability Management
First Federal’s treasury function manages the wholesale segments of the balance sheet, including investments, purchased funds, long-term debt and derivatives. Management’s objective is to achieve the maximum level of stable earnings over the long term, while controlling the level of interest rate risk, credit risk, market risk and liquidity risk, and optimizing capital utilization. Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. First Federal’s market risk arises primarily from interest rate risk inherent in lending, deposit-gathering and other funding activities. The structure of its loan, investment, deposit and borrowing portfolios is such that a significant change in interest rates may adversely impact net market values and net interest income. In managing the investment portfolio to achieve its stated objective, First Federal invests predominately in agency securities, agency and private label mortgage-backed securities, asset-backed and collateralized debt securities including trust preferred securities, corporate bonds and municipal bonds. Treasury strategies and activities are overseen by First Federal’s ALCO and the Investment Committee. ALCO activities are summarized and reviewed quarterly with the Board.
Interest Rate Risk
The nature of the banking business, which involves paying interest on deposits at varying rates and terms and charging interest on loans at other rates and terms, creates interest rate risk. As a result, net interest margin, earnings and the market value of assets and liabilities are subject to fluctuations arising from the movement of interest rates. First Federal manages several forms of interest rate risk, including asset/liability mismatch, basis risk and prepayment risk. An objective of First Federal’s asset/liability management policy is to maintain a balanced risk profile so that variations to net interest income stay within policy limits. A sudden and substantial increase or decrease in interest rates may adversely impact earnings to the extent that the interest rates on interest-earning assets and interest-bearing liabilities do not change at the same speed, to the same degree or on the same basis. Asset/liability management is the process by which First Federal evaluates and changes, when appropriate, the mix, maturity and pricing of assets and liabilities in an attempt to reduce a materially adverse impact on earnings resulting from the direction, frequency and magnitude of change in market interest rates. Although the net interest income of any financial institution is perceived as being vulnerable to fluctuations in interest rates, management has attempted to minimize this vulnerability within policy limits.
First Federal’s prepayment risk arises from the loans originated and investment securities purchased in which the underlying assets are real estate secured mortgage loans and may payoff prior to their contractual maturities. Both of these types of assets are subject to principal reduction due to principal prepayments resulting from borrowers’ elections to refinance the underlying mortgages based on market and other conditions. Prepayment rate projections utilize actual prepayment speed experience and available market information on similar instruments. The prepayment rates form the basis for income recognition of premiums or discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored and updated monthly to reflect actual activity and the most recent market projections.
First Federal’s ALCO has established policies and monitors results to manage interest rate risk. The dynamic repricing gap analysis provides a measurement of repricing risk as of a point in time by allocating rate sensitive assets and liabilities to repricing periods. The sum of assets and liabilities maturing or repricing in each of these periods is compared for mismatches within each period. Core deposits lacking contractual maturities or repricing frequencies are placed into repricing and maturity periods based on the historical price sensitivity of such liabilities to interest rate movements. Repricing periods for assets include the effects of expected prepayments on cash flows. Particular assets and liabilities, such as ARMs, are also evaluated for the manner in which
changes in interest rates or selected indices may affect their repricing. Other measurements include asset/liability modeling and interest income simulations, which assess varying interest rate and balance sheet mix assumptions. First Federal utilizes various balance sheet strategies to adjust its interest rate sensitivity position as necessary, including decisions on the pricing, maturity and marketing of particular loan or deposit products and to make decisions regarding the structure of maturities for borrowings or wholesale funding options.
Based on the dynamic gap analysis, First Federal is slightly liability-sensitive within one year, with rate-sensitive liabilities exceeding rate-sensitive assets by $119.8 million or 3.73% of total assets as of December 31, 2012. This is compared with a liability-sensitive position of $201.4 million or 6.40% of total assets as of December 31, 2011 and a liability-sensitive position of $281.9 million or 8.79% as of September 30, 2011. The decreases were primarily the result of the shift in funding mix with the reduction in certificates of deposit and the increase of immediately repricing core deposits.
Repricing gap analysis is limited in its ability to measure interest rate sensitivity. The repricing characteristics of assets, liabilities, and off-balance sheet derivatives can change in different interest rate scenarios, thereby changing the repricing position from that outlined above. Further, basis risk is not captured by repricing gap analysis. Basis risk is the risk that changes in interest rates will reprice interest-bearing liabilities differently from interest-earning assets, thus causing an asset/liability mismatch. This analysis does not take into consideration the repricing dynamics in adjustable-rate loans, such as minimum and maximum annual and lifetime interest rate adjustments and also the index utilized and whether the index is a current or lagging index. Included in the analysis are estimates of prepayments on fixed-rate loans and mortgage-backed securities in a one-year period and expectations that under current interest rates, certain advances from the FHLB will not be called and loans will not reprice due to floors. Also included in the analysis are estimates of core deposit decay rates, based on recent studies and regression analysis of core deposits.
An institution which is liability-sensitive would normally have a negative effect on net interest income in a rising rate environment. The opposite would generally occur when an institution has a positive gap position, or is asset-sensitive. Net interest income simulations were performed as of December 31, 2012 to evaluate the impact of market rate changes on net interest income over the subsequent 12 months assuming a static balance sheet composition. Based on the simulations, while First Federal is slightly liability-sensitivity, net interest income would be expected to decrease from what it would be if rates were to remain at December 31, 2012 levels by 1.07% if market interest rates were to increase immediately by 100 basis points in a parallel shift, while the increase in net interest income would be expected to be approximately 1.95% if market interest rates were to increase immediately by 200 basis points in a parallel shift. While the anticipated increase in net interest income is contrary for an institution with a negative gap, the movement is primarily related to the lag matrix on the repricing of liabilities and the timing and magnitude of asset repricing relative to liabilities. There are fewer assets adjusting immediately, however loans generally move fully with the related index or yield curve change, while deposits may not change on a one-to-one correlation with the index or yield curve. The difference in the rate of change for assets relative to liabilities and the lagged timing of the liability changes has resulted in the projected increase in net interest income in a rising rate environment.
Net interest income simulation for 100 and 200 basis point declines in market rates were not performed at December 31, 2012 as the results would not have been meaningful given the current levels of short-term market interest rates. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, pricing spreads in relation to market rates, balance sheet growth, the mix of different types of assets and liabilities and the timing of changes in these variables. Another test measures the economic value of equity at risk by analyzing the impact of an immediate change in interest rates on the market value of portfolio equity. If market interest rates were to increase immediately by 100 or 200 basis points (a parallel and immediate shift in the yield curve), the economic value of equity would increase by 1.83% and increase by 3.11%, respectively, from where it would be if rates were to remain at December 31, 2012 levels. The increases are primarily the result of the core deposit intangibles, which increase in value as interest rates rise. Scenarios different from those outlined above, whether different by timing, level or a combination of factors, could produce different results.
Computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions that may be taken in response to changes in interest rates.
Impact of Inflation and Changing Prices
The Consolidated Financial Statements and related data contained in Item 8 have been prepared in accordance with GAAP, which requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time because of inflation.
Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary. As a result, interest rates have a more significant impact on a financial institution’s performance than the effect of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the price of goods and services since such prices are affected by inflation.
Off-Balance Sheet Arrangements and Contractual Obligations
First Financial is party to financial instruments with off-balance sheet risk in the normal course of its business in order to meet the financing needs of its customers and in connection with its overall interest rate risk management strategies. These instruments involve, to varying degrees, elements of credit, interest rate, and liquidity risk. The primary instruments are described below.
Derivatives
Derivative transactions are used to manage interest rate sensitivity and to reduce risks associated with First Federal’s lending, deposit taking and borrowing activities. First Federal recognizes derivatives as either assets or liabilities on the Consolidated Balance Sheets and reports these instruments at fair value with realized and unrealized gains and losses included in earnings. The fair values of derivative financial instruments are determined based on quoted market prices, dealer quotes and internal pricing models that are primarily sensitive to market observable data.
By using derivative instruments, First Federal is exposed to credit and market risk. Credit risk is the risk due to uncertainty in counterparty’s ability to meet its obligations. Credit risk in derivative instruments is minimized by entering into transactions with high-quality counterparties who are subject to credit reviews and approvals similar to those used in making loans and other extensions of credit. In addition, certain counterparties are required to provide collateral to First Federal when their unsecured loss positions exceed certain negotiated limits.
Market risk is the adverse effect on the value of a financial instrument from a change in interest rates or implied volatility of interest rates. Market risk associated with mortgage origination activities with the secondary market and net interest income is managed through the use of various derivative products such as forward sales contracts. The market risk associated with derivatives used for interest rate risk management activity is incorporated in interest rate sensitivity analysis. See Notes 1, 5 and 17 to the Consolidated Financial Statements for additional information.
First Federal issues commitments for approved residential mortgage loans subject to the occurrence of certain events. Such commitments are made with specified terms and conditions. Interest rate locks are generally offered to prospective borrowers for up to a 60-day period, during which time the borrower may lock in the rate. First Federal’s outstanding commitments to originate loans to be held for sale are discussed further in Note 16 to the Consolidated Financial Statements.
When First Federal issues a loan commitment to a borrower, there is a risk that a rise in interest rates will reduce the value of the mortgage before it can be closed and sold. This type of risk occurs when First Federal commits to an interest rate lock on a borrower’s application during the origination process and interest rates increase before the loan can be sold. Such interest rate risk also arises when mortgages are placed in the warehouse (i.e., held for sale) without locking in an interest rate for their eventual sale in the secondary market. To control the interest rate risk caused by mortgage activities, First Federal uses forward security sales, loan sale commitments and mortgage-backed securities to offset the risk in the mortgage origination pipeline, futures contracts, and the purchase of over-the-counter put and call option contracts related to the ten-year Treasury security. At various times, depending on loan origination volume, interest rate direction, growth of the servicing asset and management’s assessment of projected loan fallout, First Federal may reduce or increase its derivative positions. See Notes 5, 16 and 17 to the Consolidated Financial Statements for additional information.
The activities described above are managed continually as markets change; however, there can be no assurance that First Federal will be successful in its effort to reduce the risk of interest rate fluctuations between the time commitments are issued and the ultimate sale of the loan. First Federal completes an analysis which reports First Federal’s interest rate risk position with respect to its loan origination and sale activities. First Federal’s interest rate risk management activities are conducted in accordance with a written policy which covers objectives, functions, instruments to be used, monitoring and internal controls. First Federal does not enter into option positions for trading or speculative purposes. First Federal does not apply hedge accounting to its derivative financial instruments; therefore, all changes in fair value are recorded in earnings. For 2012, First Federal had a net loss of $3.9 million attributable to the underlying derivative financial instruments used to mitigate the interest rate risk of its mortgage activities.
Off-Balance Sheet Arrangements
In the normal course of operations, First Financial engages in a variety of financial transactions that, in accordance with GAAP, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used for general corporate purposes or for customer needs. Corporate purpose transactions are used to help manage credit, interest rate and liquidity risk or to optimize capital. Customer transactions are used to manage their requests for funding.
Lending Commitments
Lending commitments include loan commitments, outstanding commitments on residential mortgage loans not yet closed, unused business and consumer credit card lines and documentary letters of credit. Commitments to extend credit are agreements to lend to borrowers as long as there is no violation of any condition established by the commitment letter. Commitments generally have fixed expiration dates or other termination clauses. The majority of the commitments will be funded within a twelve month period, and are evaluated for creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary
upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral varies but primarily consists of residential or income producing commercial properties. These instruments are not recorded in the Consolidated Balance Sheets until funds are advanced under the commitments. For commercial customers, loan commitments generally take the form of revolving credit arrangements to finance customers’ working capital requirements. See Note 16 to the Consolidated Financial Statements for additional information regarding lending commitments.
Standby Letters of Credit
Standby letters of credit represent First Federal’s obligation to a third party contingent upon the failure of its customer to perform under the terms of an underlying contract with the third party or obligate First Federal to guarantee or stand as surety for the benefit of the third party. The underlying contract may entail either financial or non-financial obligations and may involve such things as the customer’s delivery of merchandise, completion of a construction contract, release of a lien or repayment of an obligation. Under the terms of a standby letter, drafts will generally be drawn only when the underlying event fails to occur as intended. First Federal can seek recovery from the borrower of the amounts paid. In addition, some of these standby letters of credit are collateralized. Commitments under standby letters of credit are usually for one year or less. As of December 31, 2012, there was no current liability associated with these standby letters of credit. The maximum potential amount of undiscounted future payments related to standby letters of credit at December 31, 2012 was $10.8 million.
Representations and Warranties
First Federal issues standard representations and warranties related to mortgage loan sales to government sponsored entities. Although these agreements often do not specify limitations, First Federal does not believe that any payment related to these warranties would materially change its financial condition or results of operations. During 2012, First Federal repurchased $541 thousand of loans previously sold.
Contractual Obligations
The table below summarizes the fixed and determinable contractual cash obligations by payment due date.
1Given the nature of these deposits, deposits without stated maturities were included within the one year or less category.
In the banking industry, interest-bearing obligations are principally utilized to fund interest-bearing assets. As such, interest charges on related contractual obligations were excluded from reported amounts in the table above as the potential cash outflows would have corresponding cash inflows from interest-bearing assets. In addition to the commitments specifically noted in the table above, First Federal enters into a number of contractual commitments in the ordinary course of business. These include software licensing and maintenance, telecommunication services, facility maintenance and equipment servicing, supplies purchasing and other goods and services used in daily operations. Generally, these contracts are renewable or cancelable at least annually, with many having provisions to be terminated with a sixty or ninety day notice; although, in some cases to secure favorable pricing concessions, First Federal has committed to contracts that may extend to several years.
Critical Accounting Policies and Estimates
First Financial’s Consolidated Financial Statements are prepared in accordance with GAAP and follow general practices within the financial institutions industry. Application of these principles requires management to make estimates, assumptions and complex judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from these estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses; fair value measurements; income taxes; and business combinations, including the method of accounting for loans acquired and estimating the FDIC indemnification asset. First Financial believes that these estimates and the related policies discussed below are important to
the portrayal of its financial condition and results of operations. Therefore, management considers them to be critical accounting policies and discusses them directly with the Audit Committee of the Board. First Financial’s accounting policies are more fully described in Note 1 to the Consolidated Financial Statements.
Allowance for Loan Losses
The allowance for loan losses represents First Federal’s estimate of probable losses inherent in the loan portfolio, the largest asset category on the Consolidated Balance Sheets. Determining the amount of the allowance for loan losses is considered a critical accounting policy because it requires significant judgment and the evaluation of several factors: ongoing loan reviews, the credit risk ratings of loans, consideration of First Federal’s loan loss experience, trends in delinquent and nonperforming loans, risk characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, the size and diversity of individual large credits as well as other qualitative and quantitative factors which could affect probable credit losses. Other considerations include the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on First Federal’s historical loss experience and additional qualitative adjustments for internal and external factors. Additionally, an allocation of reserves may be established for special situations that are unique to the measurement period with consideration of current economic trends and conditions. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly.
First Federal’s allowance for loan loss methodology is based on regulatory, GAAP and SEC guidance. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond its control, including the performance of the loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications. See “Allowance for Loan Losses” for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
Continuous credit monitoring processes and the analysis of loss components are the principal methods relied upon by management to ensure that changes in estimated credit loss levels are reflected in the allowance for loan losses on a timely basis. First Federal utilizes regulatory guidance and its own experience in this analysis. In addition, federal banking regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require an increase in the allowance for loan losses through an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.
Actual loss ratios experienced in the future may vary from those projected. In the event that management overestimates future cash flows or underestimates losses on loan pools, First Federal adjusts the allowance for loan losses through the provision for loan losses, which will impact results of operations in the period where the variance is identified. Management believes that the allowance for loan losses at each balance sheet date is adequate and appropriate in accordance with GAAP. See Notes 1 and 4 to the Consolidated Financial Statements for additional information.
Fair Value Measurements
A number of valuation techniques are used to determine the fair value of assets and liabilities in First Financial’s Consolidated Financial Statements. These include quoted market prices for securities, interest rate swap valuations based on the modeling of termination values adjusted for credit spreads with counterparties and appraisals of real estate from independent licensed appraisers, among other valuation techniques. Fair value measures for assets and liabilities where there exists limited or no observable market data are based primarily on estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets or liabilities required to be measured at fair value or for impairment will be recognized in the financial statements as appropriate. See Notes 1 and 17 to the Consolidated Financial Statements for additional information.
Income Taxes
Income tax liabilities or assets are established for the amount of taxes payable or refundable for the current year. Deferred tax liabilities and assets are also established for the future tax consequences of events that have been recognized in First Financial’s Consolidated Financial Statements or tax returns. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and deductions that can be carried forward (used) in future years. First Financial assesses whether a valuation allowance should be established against its deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. For example, a cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable and also restricts the amount of evidence on projections of future taxable income to support the recovery of deferred tax assets.
The valuation of current and deferred tax liabilities and assets is considered critical as it requires management to make estimates based on enacted tax laws and other future events. The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. First Financial believes its tax assets and liabilities are adequate and are properly recorded in the Consolidated Financial Statements. See Notes 1 and 13 to the Consolidated Financial Statements for additional information.
Business Combinations, Including the Method of Accounting for Loans Acquired and Estimating the FDIC Indemnification Asset
Acquisitions are accounted for in accordance with GAAP and assets acquired and liabilities assumed are recorded at their estimated fair value as of acquisition date. Determining the fair value of the assets and liabilities, especially the loan portfolio and OREO, is a complex process involving significant judgment regarding the methods and assumptions used to calculate estimated fair values. The fair value of loans acquired is estimated based on discounted cash flows, which take into consideration current portfolio interest rates and repricing characteristics as well as assumptions related to prepayment speeds. Loans acquired with credit deterioration are considered to be impaired and are accounted for in accordance with GAAP. The estimated fair value of impaired loans is based on projected cash flows, the type of loan and related collateral, risk rating classification status and current market interest rates. When First Federal assumes the deposits, assets and liabilities of a failed financial institution from the FDIC, it establishes a FDIC indemnification asset. The FDIC indemnification asset represents the fair value of the losses for which First Federal expects to be reimbursed by the FDIC, in accordance with the loss share agreement entered into on the date of acquisition. The fair value is estimated based on projected cash flows and is discounted to reflect the uncertainty of the timing and receipt of the loss sharing agreement with the FDIC.
Actual cash flows received on acquired loans may vary from those projected. As a result, First Federal monitors the actual performance on a quarterly basis and adjusts the amortization of loan accretion and recognizes potential impairment in the FDIC indemnification asset or incremental loan impairment in the acquired loan pool accordingly. The adjustments are recognized in interest income (loan accretion), the provision for loan losses (additional credit deterioration) or noninterest expense (potential FDIC indemnification asset impairment) as appropriate. See Notes 1, 2, 4 and 6 to the Consolidated Financial Statements for additional information.
Recent Accounting Pronouncements
Note 1 to the Consolidated Financial Statements discusses new accounting policies adopted by First Financial as well as the expected impact of accounting policies recently issued or proposed but not yet required to be adopted. To the extent the adoption of new accounting standards materially affects First Financial’s financial condition, results of operations or liquidity, the impact is discussed elsewhere in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
Use of Non-GAAP Financial Measures
In addition to results presented in accordance with GAAP, this report includes non-GAAP financial measures such as the efficiency ratio, tangible common equity (“TCE”) to tangible assets ratio, tangible common book value (“TBV”) per share, pre-tax pre-provision earnings and adjusted net interest margin. First Financial believes these non-GAAP financial measures provide additional information that is useful to investors in understanding its underlying performance, business and performance trends, and such measures help facilitate performance comparisons with others in the banking industry. Non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited. Readers should be aware of these limitations and should be cautious in their use of such measures. To mitigate these limitations, First Financial has procedures in place to ensure that these measures are calculated using the appropriate GAAP or regulatory components in their entirety and to ensure that its performance is properly reflected to facilitate consistent period-to-period comparisons. Although First Financial believes the above non-GAAP financial measures enhance readers’ understanding of its business and performance, these non-GAAP measures should not be considered in isolation, or as a substitute for GAAP basis financial measures. Readers should consider First Financial’s performance and financial condition as reported under GAAP and all other relevant information when assessing First Financial’s performance or financial condition.
The efficiency ratio measures the amount of revenue (defined as the sum of net interest income on a fully tax-equivalent basis and noninterest income) needed to cover noninterest expenses. In accordance with industry standards, First Financial believes that presenting net interest income on a taxable equivalent basis when calculating the efficiency ratio, using a 35% federal tax rate, allows comparability with industry peers by eliminating the effect of the differences in portfolios attributable to the proportion represented by both taxable and tax-exempt investments.
First Financial believes that the exclusion of goodwill and other intangible assets facilitates the comparison of results for ongoing business operations. The TCE ratio and TBV have become a focus of some investors, analysts and banking regulators. Management believes these measures may assist in analyzing First Financial’s capital position absent the effects of intangible assets and preferred stock. Because TCE and TBV are not formally defined by GAAP or codified in federal banking regulations, these measures are considered to be non-GAAP financial measures. However, analysts and banking regulators may assess First
Financial’s capital adequacy using TCE or TBV and, therefore, management believes that it is useful to provide investors the ability to assess its capital adequacy on the same basis.
First Financial believes that pre-tax pre-provision earnings is a useful measure in assessing its core operating performance, particularly during times of economic stress. This measurement, as defined by management, represents total revenue (net interest income plus noninterest income) less noninterest expense. As recent results for the banking industry demonstrate, credit write-downs, loan charge-offs and related provisions for loan losses can vary significantly from period to period, making a measure that helps isolate the impact of credit costs on profitability important to investors.
The performance of the Cape Fear loans acquired from the FDIC in April 2009 has been better than originally projected. During 2012, cash payments received exceeded First Federal’s initial investment in the pool and, in accordance with GAAP, First Federal began recognizing the cash payments in net interest income. As the amount and frequency of cash payments for the Cape Fear loan pool are not predictable, this creates volatility in net interest margin. First Financial believes that adjusting net interest margin to remove the effect of the incremental loan accretion and interest income associated with the Cape Fear loan pool provides a more consistent trend to compare First Federal’s historical performance against itself as well as its net interest margin with its peers.
The following table presents the calculation of these non-GAAP measures.
1Goodwill includes goodwill from Continuing Operations and goodwill from Discontinued Operations of $27,630, $27,395 and $27,262 for the years ended September 30, 2010, 2009 and 2008, respectively.
2Intangible assets includes intangible assets for Continuing Operations, as shown on the Consolidated Balance Sheets, and includes intangible assets for Discontinued Operations of $6,938, $7,568, and $8,304 for the years ended September 30, 2010, 2009, and 2008, respectively.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management.”
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
First Financial Holdings, Inc.
We have audited the accompanying consolidated balance sheets of First Financial Holdings, Inc. (a Delaware corporation) and subsidiaries (the “Company”) as of December 31, 2012 and 2011 and September 30, 2011, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity, and cash flows for the year ended December 31, 2012, the quarter ended December 31, 2011, and the years ended September 30, 2011 and 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Financial Holdings, Inc. and subsidiaries as of December 31, 2012 and 2011 and September 30, 2011, and the results of their operations and their cash flows for the year ended December 31, 2012, the quarter ended December 31, 2011, and the years ended September 30, 2011 and 2010 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’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), and our report dated March 18, 2013 expressed an unqualified opinion.
/s/ GRANT THORNTON LLP
Charlotte, North Carolina
March 18, 2013
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
First Financial Holdings, Inc.
We have audited the internal control over financial reporting of First Financial Holdings, Inc. (a Delaware corporation) and subsidiaries (the “Company”) 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). The Company’s management is responsible 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 the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
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 Company 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 COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company as of and for the year ended December 31, 2012, and our report dated March 18, 2013 expressed an unqualified opinion on those financial statements.
/s/ GRANT THORNTON LLP
Charlotte, North Carolina
March 18, 2013
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (continued)
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
See accompanying notes to consolidated financial statements.
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2012, and 2011 and September 30, 2011 and 2010
NOTE 1. Summary of Significant Accounting Policies
First Financial Holdings, Inc. (“First Financial”) is incorporated under the laws of the State of Delaware and is a bank and financial holding company. First Financial is headquartered in Charleston, South Carolina and conducts its operations principally in South and North Carolina. The commercial bank subsidiary, First Federal Bank (“First Federal”), offers a full range of financial services designed to meet financial needs of individuals and businesses. First Federal provides residential mortgage, commercial and consumer loan products, consumer and business deposit products, ATM and debit cards, cash management services, safe deposit boxes, trust and fiduciary services, reinsurance of private mortgage insurance and premium financing activities. Other subsidiaries of First Financial include First Southeast Investor Services, Inc. (“First Southeast Investors”), which is a registered broker-dealer, and First Southeast 401(k) Fiduciaries, Inc. (“First Southeast 401(k)”), which is a registered investment advisor. First Financial is not dependent on any single or limited number of customers, the loss of which would have a material adverse effect. No material portion of the business is seasonal.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of First Financial, First Federal, First Southeast Investors and First Southeast 401(k). The consolidated financial statements also include the assets and liabilities of the variable interest entities (“VIE”) where First Financial is the primary beneficiary. All significant intercompany accounts and transactions have been eliminated in consolidation. First Financial operates as one business segment.
Accounting Estimates and Assumptions
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates and assumptions. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, impaired loan valuations, other real estate owned (“OREO”) valuations, estimates of fair value associated with acquisitions, pension and post-retirement benefits, asset prepayment rates, goodwill and intangible assets, share-based payments, derivative financial instruments, litigation, income taxes, mortgage servicing rights and other-than-temporary impairment (“OTTI”) of investment securities.
Reclassifications
Certain amounts have been reclassified to conform to the presentation for the year ended December 31, 2012.
Change in Fiscal Year
On December 20, 2011, First Financial’s Board of Directors (“Board”) approved an amendment to Article VIII of First Financial’s bylaws to change the fiscal year end from September 30th to December 31st of each year. The change was effective December 31, 2011 and the current fiscal year began on January 1, 2012 and ended on December 31, 2012. The change in fiscal year end resulted in a three-month transition period which began on October 1, 2011 and ended on December 31, 2011. As a result of its change in fiscal year, First Financial filed a Transition Report on Form 10-Q with the SEC on February 9, 2012 which covered the transition period from October 1, 2011 to December 31, 2011. The separate audited financial statements required for the transition period are included in the Consolidated Financial Statements and accompanying notes.
Discontinued Operations
As a result of First Financial’s sale of its insurance agency subsidiary, First Southeast Insurance Services, Inc. (“First Southeast”), which was completed on June 1, 2011, and its managing general insurance agency subsidiary, Kimbrell Insurance Group, Inc. (“Kimbrell”), which was completed on September 30, 2011, the financial condition, operating results, and the gain or loss on the sales, net of transaction costs and taxes, for these subsidiaries have been segregated from the financial condition and operating results of First Financial’s continuing operations throughout this document and, as such, are presented as discontinued operations. While all prior periods have been revised retrospectively to align with this treatment, these changes do not affect First Financial’s reported consolidated financial condition or operating results for any of the prior periods.
Controlling Financial Interest
First Financial determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a VIE under GAAP. Voting interest entities are entities in which the total equity investment at risk is
sufficient to enable each entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. First Financial consolidates voting interest entities in which it has all, or at least a majority of, the voting interest. As defined in applicable accounting standards, VIEs are entities that lack one or more of the characteristics of a voting interest entity described above. A controlling financial interest in an entity is present when an enterprise has a variable interest, or combination of variable interests, that will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. North Central Apartments, LP qualifies as a VIE of First Federal as First Federal is the primary beneficiary, therefore, North Central Apartments, LP is combined into the accounts of First Federal. The wholly-owned trust subsidiary, formed to issue trust preferred securities, First Financial Capital Trust I (“Capital Trust I”), is a VIE for which First Financial is not the primary beneficiary. Accordingly, the accounts of Capital Trust I are not included in the Consolidated Financial Statements.
Business Combinations
Acquisitions are accounted for in accordance with Accounting Standards Codification Topic (“ASC”) 805, Business Combinations, and assets acquired and liabilities assumed are recorded at their estimated fair value as of acquisition date. Accordingly, the assets acquired and liabilities assumed are presented at their fair values as required by that statement. Fair values are determined in accordance with ASC 820, Fair Value Measurements and Disclosures. In many cases, the determination of these fair values required management to make estimates about discount rates, future expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change. Determining the fair value of the assets and liabilities, especially the loan portfolio and OREO, is a complex process involving significant judgment regarding the methods and assumptions used to calculate estimated fair values. The fair value of loans acquired is estimated based on discounted cash flows, which take into consideration current portfolio interest rates and repricing characteristics as well as assumptions related to prepayment speeds. Loans acquired with credit deterioration are considered to be impaired and are accounted for in accordance with GAAP. The estimated fair value of impaired loans is based on projected cash flows, the type of loan and related collateral, risk rating classification status and current market interest rates. When First Federal assumes the deposits, assets and liabilities of a failed financial institution from the Federal Deposit Insurance Corporation (“FDIC”), it establishes a FDIC indemnification asset. The FDIC indemnification asset represents the fair value of the losses for which First Federal expects to be reimbursed by the FDIC, in accordance with the loss share agreement entered into with the FDIC. The fair value is estimated based on projected cash flows and is discounted to reflect the uncertainty of the timing and receipt of the loss sharing agreement with the FDIC. Acquisition-related costs are recognized as expenses in the period they are incurred.
Actual cash flows received on acquired loans may vary from those projected. As a result, First Federal monitors the actual performance on a quarterly basis and adjusts the amortization of loan accretion and recognizes potential impairment in the FDIC indemnification asset or incremental loan impairment in the acquired loan pool accordingly. The adjustments are recognized in interest income (loan accretion), the provision for loan losses (additional credit deterioration), or noninterest expense (potential FDIC indemnification asset impairment) as appropriate. See Note 2 to the Consolidated Financial Statements for additional information.
Cash and Cash Equivalents
First Financial considers federal funds sold and highly liquid debt instruments with an original maturity date of three months or less to be cash equivalents.
Investment Securities
First Financial’s investments in debt securities principally consist of United States (“US”) agency securities, corporate securities, state and municipal obligations and agency and private-label mortgage-backed securities. Investments in debt securities are classified as available for sale or held to maturity.
First Financial classifies debt and equity securities as available for sale when at the time of purchase it is determined that such securities may be sold at a future date or if First Financial does not have the intent or ability to hold such securities to maturity. Securities designated as available for sale are recorded at fair value. Changes in the fair value of debt and equity securities available for sale are included in shareholders’ equity as unrealized gains or losses, net of the related tax effect. Unrealized losses on available for sale securities reflecting a decline in value judged to be other-than-temporary are charged to income in the Consolidated Statements of Operations. Realized gains or losses on available for sale securities are computed on the specific identification basis.
Securities are designated as held to maturity if First Financial has the intent and the ability to hold the securities to maturity. Held to maturity securities are carried at amortized cost, adjusted for the amortization of any related premiums or the accretion of any related discounts into interest income using a methodology which approximates a level yield of interest over the estimated remaining period until maturity. Unrealized losses on held to maturity securities, reflecting a decline in value considered to be other-than-temporary, are charged to income in the Consolidated Statements of Operations.
Fair values of investment securities may be based on quoted market prices in an active market when available, or through a combination of prices determined by an income valuation technique using fair value models and quoted prices. When market
observable data is not available, which generally occurs due to the lack of liquidity for certain investment securities, the valuation of the security is subjective and may involve substantial judgment.
To determine which individual securities are at risk for OTTI, First Financial considers various characteristics of each security including, but not limited to, the credit rating, the duration and amount of the unrealized loss credit quality factors affecting the issuer or the underlying collateral and any credit enhancements. The relative importance of this information varies based on the facts and circumstances surrounding each security, as well as the economic environment at the time of assessment. For securities identified as at risk for OTTI, additional evaluation techniques are applied which includes estimating projected cash flows based on the structure of the security and certain assumptions such as prepayments, default rate, and loss severity to determine whether First Financial expects to receive all of the contractual cash flows as scheduled. First Financial recognizes an OTTI credit loss when the present value of the investment security’s cash flows expected to be collected are less than the amortized cost basis. OTTI attributed to credit is recorded as a charge against current earnings, while OTTI attributed to noncredit factors is recorded as a charge against Other Comprehensive Income. The detail of the components of OTTI is presented in Note 3 to the Consolidated Financial Statements.
Loans and Loans Held for Sale
The residential mortgage loan portfolio consists primarily of long-term loans secured by first mortgages on single-family residences, homes in the construction phase and land. The commercial loan portfolio is comprised of loans that are secured by various types of real estate (including owner occupied, non-owner occupied buildings in the construction phase and raw land) as well as loans used for general business purposes, which may be secured by working capital, equipment financing or other business assets or unsecured. Consumer loans include home equity lines of credit, auto loans, marine loans, manufactured housing loans, credit card receivables and loans on various other types of consumer products.
Fees are charged for originating loans at the time the loan is granted. Loan origination fees received, if any, are deferred and offset by the deferral of certain direct expenses associated with loans originated. The net deferred fees or costs are recognized as yield adjustments by applying the effective interest method. Interest on loans is accrued and credited to income based on the principal amount and contract rate on the loan. The accrual of interest is discontinued when, in the opinion of management, there is an indication that the borrower may be unable to meet future payments as they become due, generally when a loan is 90 days past the contractual due date. A loan will also be placed on nonaccrual status when it is determined to be impaired, even if prior to 90 days past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. While a loan is on nonaccrual status, no interest is recognized. Loans are returned to accrual status only when the loan is brought current and ultimate collectability of principal and interest is no longer in doubt.
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are provided for by charges to the Consolidated Statements of Operations in mortgage and other loan income. For these loans, the fair value is primarily based on quoted market prices for securities backed by similar types of loans. The changes in fair value of these assets are largely a result of changes in interest rates subsequent to loan funding and changes in the fair value of servicing associated with the mortgage loan held for sale. First Financial uses various derivative instruments to mitigate the effect of changes in fair value of the underlying loans on its Consolidated Statements of Operations.
Certain nonperforming and performing loans held for bulk sale are carried at the lower of cost or estimated market value, less estimated selling costs, based on indicative market pricing. As the loans are paid off or other resolutions are agreed upon, or upon the ultimate execution of the bulk loan pool sale, subsequent gains or losses are recorded in the Consolidated Statements of Operations in mortgage and other loan income.
Allowance for Loan Losses
Management recognizes that losses may occur over the life of a loan and that the allowance for loan losses must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio. As part of its quarterly allowance assessment, management takes into consideration various qualitative factors, including economic conditions, unemployment, the composition of the loan portfolio, deterioration of the loan portfolio and specific sector stress, trends in delinquent and nonperforming loans and historical loss experience by categories of loans, concentrations of credit, changes in underwriting standards, regulatory examination results, value of underlying collateral and other factors indicative of potential losses remaining in the portfolio. Management evaluates the carrying value of loans periodically and the allowance is adjusted accordingly. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. The allowance for loan losses is subject to periodic evaluation by various regulatory authorities and may be subject to adjustment upon their examination.
First Financial’s methodology for analyzing the allowance for loan losses consists of specific allocations on significant individual credits and a general allowance amount. The specific allowance component is determined when management believes that the collectability of an individually reviewed loan has been impaired and a loss is probable. The fair value of loans with probable losses may be determined based upon the present value of expected cash flows, market prices of the loans, if available, or the value of the underlying collateral. Expected cash flows are required to be discounted at the loans’ effective interest rates. The general allowance component takes into consideration probable, incurred losses that are inherent within the loan portfolio but have
not been specifically identified. Loans are segmented into categories for analysis based in part on the risk profile inherent in each category. Loans are further segmented into risk rating pools within each category to appropriately recognize changes in inherent risk. A primary component of determining the general allowance for performing and classified loans not analyzed specifically is the actual loss history for an eighteen month period, tracked by main loan category. The loss history is adjusted by internal and external qualitative factors as considered necessary at each period end given the facts at the time.
A loan is considered to be impaired under ASC 310-10, Receivables when, based upon current information and events, it is probable that First Federal will be unable to collect all amounts due according to the contractual terms of the loan. Loans classified as impaired are placed on nonaccrual status. Commercial loans greater than $500,000 are reviewed for potential impairment on a regular basis as a part of the monthly problem loan review process. In addition, homogeneous loans greater than $200,000 which have been modified are reviewed for potential impairment. In assessing the impairment of a loan and the related reserve requirement for that loan, various methodologies are employed. Impairment on loans that are not collateral dependent is determined primarily using the present value of expected future cash flows discounted at the loans’ effective interest rates. In assessing the impairment of a loan and the related reserve requirement for that loan, various methodologies are employed. Specific valuation allowances are established or partial charge-offs are recorded on impaired loans for the difference between the loan amount and the estimated net realizable value. With respect to most real estate loans, and specifically if the loan is considered to be a probable foreclosure, a fair value of collateral approach is generally used. The underlying collateral is appraised and market value, appropriately adjusted for an assessment of the sales and marketing costs as well as the total hold period, is used to calculate an anticipated realizable value.
Increases to the allowance for loan losses are charged by recording a provision for loan losses. Charge-offs to the allowance are made when all, or a portion, of the loan is deemed to be a loss based upon management’s review of the loan through possession of the underlying collateral or through a troubled debt restructuring transaction. Recoveries are credited to the allowance. Management believes that the allowance for loan losses is appropriate according to GAAP and is adequate and sufficient for the risk inherent in the portfolio as of each balance sheet date.
Loans Acquired with Deteriorated Credit Quality
ASC 310-30 Accounting for Certain Loans or Debt Securities Acquired in a Transfer applies to a loan with evidence of deterioration of credit quality since its origination, and for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. For loans accounted for under ASC 310-30, First Federal’s management determines the value of the loan portfolio based, in part, on work provided by an appraiser. Factors considered in the valuation are projected cash flows for the loans, type of loan and related collateral, classification status and current discount rates. Loans are grouped together according to similar characteristics and are treated in the aggregate when applying various valuation techniques. Once acquired loans are determined to be within the scope of ASC 310-30, First Federal evaluates such loans for common risk characteristics and aggregation into one or more pools. Common risk characteristics for pooling acquired loans include similar credit risk or risk ratings; similar risk characteristics, including collateral, loan purpose or type of borrower; and similar anticipated risk of default and loss given default. Management also estimates the amount of credit losses that are expected to be realized for the loan portfolio primarily by estimating the liquidation value of collateral securing loans on nonaccrual status or classified as substandard or doubtful. These estimates are highly subjective. The accretion of the fair value discount on the acquired loans is recorded in net interest income on the Consolidated Statements of Operations. The accretion of the fair value discount on the acquired OREO is recorded in noninterest expense on the Consolidated Statements of Operations.
Adjustments to loan values in future periods may occur based on management’s expectation of future cash flows to be collected over the lives of the loans. Estimating cash flows incorporates analysis of historical cash flows, delinquencies, and charge-offs as well as assumptions about future cash flows. Performance can vary from period to period, causing changes in estimates of the expected cash flows. If based on the review, it is probable that a significant increase or improvement in cash flows previously expected to be collected or if actual cash flows are significantly greater than cash flows previously expected, the remaining valuation allowance established for the loans is reduced for the increase in the present value of cash flows expected to be collected and the accretable yield is increased and is recognized over the remaining life of the loan. If based on the review, it is probable that a significant decrease or impairment in cash flows previously expected to be collected or if actual cash flows are significantly less than cash flows previously expected, the allowance for loan losses is increased for the decrease in the present value of the cash flows expected to be collected. The accretable yield for the loans is recalculated based on the decrease of the revised cash flows expected and is recognized over the remaining life of the loan.
For acquired assets covered under the loss sharing agreement with the FDIC described below, loans are considered in the calculation of the allowance for loan losses as previously discussed. Loans determined to be impaired and related credit losses incurred subsequent to the initial measurement of the loan valuation and FDIC indemnification asset appropriately affect the provision for loan losses and the allowance in that period. Related changes to the FDIC indemnification asset are presented net in the provision for loan losses.
Transfer of Financial Assets
Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over the transferred assets is deemed to be surrendered when: (1) the assets have been isolated from First Federal, (2) 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 (3) First Federal does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. First Federal reviews all sales of loans by evaluating specific terms in the sales documents and
believes that the criteria discussed above to qualify for sales treatment have been met as loans have been transferred for cash and the notes and mortgages for all loans in each sale are endorsed and assigned to the transferee. As stated in the commitment document, First Federal has no recourse with these loans except in the case of fraud. In certain sales, mortgage servicing rights may be retained and in other programs potential loss exposure from the credit enhancement obligation may be retained, both of which are evaluated and appropriately measured at the date of sale.
First Federal packages mortgage loans as securities to investors and currently securitizes most of the 30-year fixed-rate conforming mortgage loans originated, converting them into mortgage-backed securities issued through Fannie Mae and selling the resulting securities to third-party investors. First Federal records loan securitizations as a sale when the transferred loans are legally isolated from its creditors and the accounting criteria for a sale are met. Gains or losses recorded on loan securitizations depend in part on the net carrying amount of the loans sold, which is allocated between the loans sold and retained interests based on their relative fair values at the date of sale. First Federal generally retains mortgage servicing rights on residential mortgage loans sold in the secondary market. Loans transferred to held for sale with the intention of disposal through a bulk loan sale will be sold with servicing released. Since quoted market prices are not typically available, the fair value of retained interests is estimated through the services of a third-party service provider to determine the net present value of expected future cash flows. Such models incorporate management’s best estimates of key variables, such as prepayment speeds and discount rates that would be used by market participants and are appropriate for the risks involved. Gains and losses incurred on loans sold to third-party investors are included in mortgage and other loan income in the Consolidated Statements of Operations.
FDIC Indemnification Asset
First Federal has entered into two purchase and assumption agreements (the “Agreements”) with loss share with the FDIC to acquire certain assets and assume certain liabilities of a failed financial institution. The loans and OREO purchased under the Agreements are covered by a loss share agreement between the FDIC and First Federal, which affords First Federal significant protection. These Agreements cover realized losses on loans and foreclosed real estate purchased from the FDIC for the time period specified in the agreement. Realized losses covered by the loss share agreements include loan contractual balances (and related unfunded commitments that were acquired), accrued interest on loans for up to 90 days, the book value of foreclosed real estate acquired and certain direct costs, less cash or other consideration received by First Federal. The Agreements extend for ten years for one-to-four family real estate loans and for five years for other loans. First Federal cannot submit claims of loss until certain events occur, as defined under the Agreements.
The determination of the initial fair value of loans and OREO acquired, and the initial fair value of the related FDIC indemnification asset involve a high degree of judgment and complexity. The fair value of the FDIC indemnification asset is estimated using projected cash flows related to the loss sharing agreement, based on the expected reimbursement for losses and the applicable loss sharing percentages for each loss tranche. The expected cash flows are discounted to reflect the uncertainty of the timing and receipt of the loss sharing reimbursement from the FDIC. The amount that First Federal realizes on these assets could differ materially from the carrying value reflected in these financial statements, based on the timing and amount of collections on the acquired assets in future periods. To the extent the actual values realized are different from the estimate, the indemnification asset will generally be affected in an offsetting manner due to the loss share support from the FDIC. There is no contractual interest rate associated with the FDIC indemnification asset; however, a present value discount is recorded against the initial balance of the FDIC indemnification asset and this discount is accreted into net interest income on the Consolidated Statement of Operations. A liability for a potential true-up payment which may be owed to the FDIC related to the indemnification asset is also established, net of present value discount, and is recorded in other liabilities on the Consolidated Balance Sheets, with the amortization of the fair value discount recorded in other noninterest expense on the Consolidated Statements of Operations.
Premises and Equipment
Office properties and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is determined generally on the straight-line method over the estimated life of the related asset for financial reporting purposes. Estimated lives range up to 39 years for buildings and improvements and up to 10 years for furniture, fixtures and equipment. Maintenance and repairs are charged to expense as incurred. Improvements, which extend the useful lives of the respective assets, are capitalized.
Bank Owned Life Insurance
Bank owned life insurance (“BOLI”) represents life insurance on the lives of certain current employees who have provided positive consent allowing First Federal to be the beneficiary of such policies. First Federal purchases BOLI in order to use its earnings to help offset the costs of benefit expenses including pre- and post-retirement employee benefits. Increases in the cash surrender value (“CSV”) of the policies, as well as death benefits received net of any CSV, are included in other income in the Consolidated Statements of Operations, and are not subject to income taxes. The CSV of the policies are recorded as other assets in the Consolidated Balance Sheets. First Federal reviews the financial strength of the insurance carriers prior to the purchase of BOLI and annually thereafter. BOLI with any individual carrier is limited to 15% of Tier 1 capital and BOLI in total is limited, at purchase, to 25% of Tier 1 capital based on policies established by First Financial’s Board.
Goodwill and Intangible Assets
First Financial accounts for acquisitions using the purchase method of accounting. Under purchase accounting, if the purchase price of an acquired company exceeds the fair value of its net assets, the excess is carried on the acquirer’s balance sheet as goodwill. An intangible asset is recognized as an asset apart from goodwill if it arises from contractual or other legal rights or if it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged. Intangible assets are identifiable assets, such as customer lists and core deposits resulting from acquisitions. Customer list intangibles are amortized on a straight-line basis over an estimated useful life of seven to fifteen years and evaluated for impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be recoverable. For core deposit intangible assets, First Financial uses the double declining accelerated method of amortization. Acceleration is required because the core deposit value calculations are generally based on a declining deposit base with correspondingly declining earnings.
Goodwill is not amortized but is evaluated at least annually for impairment or more frequently if events occur or circumstances change that may trigger a decline in the value of the reporting unit or otherwise indicate that a potential impairment exists. Examples of such events or circumstances include adverse change in legal factors, business climate, unanticipated competition, change in regulatory environment or loss of key personnel. The evaluation of goodwill is based on a variety of factors, including common stock trading multiples, discounted cash flows and data from comparable acquisitions. Potential impairment of goodwill exists when the carrying amount of a reporting unit exceeds its fair value. In accordance with ASC 350 Intangibles-Goodwill and Other, the fair value for each reporting unit is computed using one or a combination of the income, market value or cost methods.
To the extent a reporting unit’s carrying amount exceeds its fair value, an indication exists that the reporting unit’s goodwill may be impaired, and a second step of impairment testing will be performed. In the second step, the implied fair value of the reporting unit’s goodwill is determined by allocating the reporting unit’s fair value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair value of the reporting unit’s goodwill is lower than its carrying amount, goodwill is impaired and is written down to the implied fair value. The loss recognized is limited to the carrying amount of goodwill. Once an impairment loss is recognized, future increases in fair value will not result in the reversal of previously recognized losses.
Other Real Estate Owned
OREO properties acquired through, or in lieu of, foreclosure are initially recorded at the lower of cost or fair value as of the date of foreclosure, adjusted for estimated selling costs. Valuation adjustments required at the time of foreclosure are charged to the allowance for loan losses. Fair values of OREO are reviewed regularly and any subsequent valuation adjustments, operating expenses or income, as well as any gains or losses on the disposition of such properties are recognized in noninterest expense.
Mortgage Servicing Rights
First Federal has a mortgage loan servicing portfolio with related mortgage servicing rights. Mortgage servicing rights (“MSRs”) represent the present value of the future net servicing fees from servicing mortgage loans. Servicing assets and servicing liabilities must be initially measured at fair value, if practicable. For subsequent measurements, an entity can choose to measure servicing assets and liabilities either based on fair value or lower of cost or market. First Federal uses the fair value measurement option for MSRs.
The methodology used to determine the fair value of MSRs is subjective and requires the development of a number of assumptions, including anticipated prepayments of loan principal. Fair value is determined by estimating the present value of the asset’s future cash flows utilizing market-based prepayment rates, discount rates and other assumptions validated through comparison to trade information, industry surveys and with the use of independent third party appraisals. Risks inherent in the MSRs valuation include higher than expected prepayment rates and/or delayed receipt of cash flows. The value of MSRs is significantly affected by mortgage interest rates available in the marketplace, which influence mortgage loan prepayment speeds. In general, during periods of declining interest rates, the value of mortgage servicing rights declines due to increasing prepayments attributable to increased mortgage refinance activity. Conversely, during periods of rising interest rates, the value of servicing rights generally increases due to reduced refinance activity. MSRs are carried at fair value with changes in fair value recorded as a component of mortgage and other loan income each period.
Derivative Financial Instruments
Derivatives are used as part of First Federal’s interest rate management activities associated with mortgage activities. Entities are required to recognize derivatives as either assets or liabilities in the balance sheet and to measure those instruments at fair value. Changes in the fair value of those derivatives are reported in current earnings. First Federal does not currently engage in any activities that qualify for hedge accounting. All changes in the fair value of derivative instruments are recorded as noninterest income in the Consolidated Statements of Operations.
Comprehensive Income
Comprehensive income consists of net income and Other Comprehensive Income (“OCI”), which includes net unrealized gains (losses) on securities and the cumulative effect of other post-retirement benefits. Comprehensive income (loss) is presented in the Consolidated Statement of Comprehensive Income.
Earnings Per Share
Basic earnings (loss) per share (“EPS”) excludes the dilutive effect of options and other convertible securities, and is computed by dividing income (loss) available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
Income Taxes
Deferred income taxes are reported for temporary differences between items of income or expense reported in the financial statements and those reported for income tax purposes. Deferred taxes are computed using the asset and liability approach as prescribed in ASC 740, Income Taxes. Under this method, a deferred tax asset or liability is determined based on the currently enacted tax rates applicable to the period in which the differences between the financial statement carrying amounts and tax basis of existing assets and liabilities are expected to be reported in First Financial’s income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.
Fair Value of Financial Instruments
Disclosures about the fair value of all financial instruments whether or not recognized in the balance sheet for which it is practicable to estimate that value are required. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized through immediate settlement of the instrument. Accordingly, the aggregate fair value amounts presented do not represent the underlying value to First Financial.
Recently Issued Accounting Pronouncements
FASB ASU 2013-02. “Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”
The objective of this Accounting Standards Update (“ASU”) is to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments require First Financial to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required by GAAP to be reclassified in its entirety to net income. For other amounts that are not required under US GAAP to be reclassified in their entirety to net income in the same reporting period, First Financial is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is reclassified to a balance sheet account instead of directly to income or expense in the same reporting period. The amendments are effective prospectively for reporting periods beginning after December 15, 2012. First Financial previously accounted for its accumulated other comprehensive income in accordance with this guidance and does not expect the adoption to have an impact on its financial position, results of operations or cash flows.
FASB ASU 2013-01. “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities”
This ASU addresses implementation issues about the scope of ASU 2011-11, Balance Sheet Topic 210: Disclosures about Offsetting Assets and Liabilities, which requires First Financial to disclose both gross information and net information about instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The scope includes derivatives, sale and repurchase agreements and reverse sales and repurchase agreements, as well as securities borrowing and securities lending arrangements. An entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented. First Financial does not expect the adoption of ASU 2013-01 to have a material impact on its financial condition or results of operations.
FASB ASU 2012-06. “Business Combinations (Topic 805) - Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution”
This ASU addresses the diversity in practice about how to interpret the terms on the same basis and contractual limitations when subsequently measuring an indemnification asset recognized in a government-assisted (FDIC) acquisition of a financial institution that includes a loss sharing agreement (indemnification agreement). When First Federal recognizes an indemnification asset (in accordance with Subtopic 805-20) as a result of a government-assisted acquisition of a financial institution and subsequently a change in the cash flows expected to be collected on the indemnification asset occurs (as a result of a change in cash flows expected to be collected on the assets subject to indemnification), First Federal should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement (that is, the lesser
of the term of the indemnification agreement and the remaining life of the indemnified assets). This guidance was effective for annual periods beginning on or after December 15, 2012 and interim periods within those annual periods. First Federal previously accounted for its indemnification asset in accordance with this guidance, as presented in Note 6 to the Consolidated Financial Statements.
FASB ASU 2012-02, “Intangibles - Goodwill and Other (Topic 350) - Testing Indefinite-Lived Assets for Impairment.”
This ASU simplifies the guidance for testing the decline in the realizable value (impairment) of indefinite-lived intangible assets other than goodwill. The amendments allows First Financial to make a qualitative evaluation about the likelihood of impairment of an indefinite-lived intangible asset to determine whether it should apply the quantitative test and calculate the fair value of the indefinite-lived intangible asset. Specifically, First Financial has the option to first assess qualitative factors (events and circumstances) that could have affected the significant inputs used in determining the fair value of the indefinite-lived intangible asset to determine whether it is more likely than not that the indefinite-lived intangible asset is impaired. If, after considering all relevant events and circumstances, First Financial concludes that it is more likely than not that the indefinite-lived intangible asset is impaired then First Financial is required to determine the fair value of the indefinite-lived intangible asset and compare the fair value with the carrying amount to determine the amount of impairment loss, if any. However, if First Financial concludes otherwise, then it is not required to take any further action. Under the amended guidance, First Financial may choose to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to calculate its fair value. The amendments do not change how an impairment loss is measured. ASU 2012-02 was effective for annual and interim impairment tests performed after September 15, 2012 and did not have a material impact on First Financial’s financial condition or results of operations.
FASB ASU 2011-11, “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities.”
This ASU addresses the differences in reporting between GAAP and International Financial Reporting Standards (“IFRS”) regarding offsetting (netting) assets and liabilities and enhances current disclosures. ASU 2011-11 requires First Financial to disclose both gross information and net information about instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The scope includes derivatives, sale and repurchase agreements and reverse sales and repurchase agreements, as well as securities borrowing and securities lending arrangements. ASU 2011-11 will be effective for annual reporting periods beginning on or after January 1, 2013 and interim periods within those annual periods. First Financial does not expect the adoption of ASU 2011-11 to have a material impact on its financial condition or results of operations.
FASB ASU 2011-08, “Intangibles-Goodwill and Other (Topic 350) -Testing Goodwill for Impairment”
This ASU provides an entity with the option to first assess 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 the totality of events or circumstances, an entity determines 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. However, if an entity concludes otherwise, then it is required to perform the first of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit. If the carrying amount of a reporting unit exceeds its fair value, then the entity is required to perform the second step of the goodwill impairment test to measure the amount of the impairment loss, if any. The amendments in this ASU allow an entity the option of by-passing the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step goodwill impairment test. An entity may resume performing the qualitative assessment in any subsequent period. The ASU was effective for the interim or annual goodwill impairment test performed for fiscal years beginning after December 15, 2011 and did not have a material impact on First Financial’s financial condition or results of operations.
FASB ASU 2011-05, “Comprehensive Income (Topic 220) - Presentation of Comprehensive Income”
This ASU increases the prominence of OCI in financial statements and provides two options for presenting OCI. The ASU eliminates the current placement near the statement of shareholders’ equity or detailed in the Consolidated Statement of Changes in Shareholders' Equity and provides for an OCI statement to be included with the net income statement, and together the two will make a statement of total comprehensive income. Alternatively, businesses can have an OCI statement separate from a net income statement, but the two statements have to appear consecutively within a financial report. The ASU does not affect the calculation of earnings per share. The ASU was effective for the first interim or annual period beginning on or after December 15, 2011. First Financial elected to present a separate OCI statement, which is located immediately following its Consolidated Statements of Operations.
FASB ASU 2011-04, “Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRSs”
This ASU amends the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. The ASU clarifies the application of existing fair value measurement requirements and changes the principles or requirements for measuring fair value or for disclosing information about fair value measurements. The ASU requires new disclosures for any transfers between Levels 1 and 2 of the fair value hierarchy, not just significant transfers, and further expands focus on Level 3 measurements, including quantitative information about the significant unobservable inputs
used for all Level 3 measurements, a qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs disclosed and a description of the valuation processes. The ASU was effective for reporting periods beginning on or after December 15, 2011 and is included in Note 16 to the Consolidated Financial Statements.
FASB ASU 2011-03, “Transfer and Servicing (Topic 860) - Reconsideration of Effective Control of Repurchase Agreements”
This ASU improves the accounting for repurchase agreements and other agreements that entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. The ASU removes from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation related to that criterion. Other criterion applicable to the assessment of effective control are not changed by the amendments in this ASU. The ASU was effective for the first interim or annual period beginning on or after December 15, 2011 and did not have a material impact on First Financial’s financial condition or results of operations.
FASB ASU 2011-02, “Receivables (Topic 310) - A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring”
This ASU provides additional guidance or clarification in determining whether a creditor has granted a concession and whether the debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring (“TDR”). This ASU clarifies that in order for a restructuring to constitute a TDR, a creditor must separately conclude that two conditions exist (1) the restructuring constitutes a concession and (2) the debtor is experiencing financial difficulties. The ASU clarifies guidance on a creditor’s evaluation of whether it has granted a concession. Additionally, the ASU clarifies guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulties. The ASU was effective for interim or annual periods beginning on or after June 15, 2011 and its adoption did not have a material impact on First Financial’s financial condition or results of operations.
FASB ASU 2010-29, “Business Combinations (Topic 805) - Disclosure of Supplementary Pro Forma Information for Business Combinations”
This ASU requires new pro forma revenue and earnings disclosures for business combinations occurring during the year to be presented as if the business combination occurred as of the beginning of the current fiscal year, or if comparative statements are presented, as if the business combination occurred as of the beginning of the comparative year. In addition, this ASU requires disclosure of the nature and amount of any material nonrecurring adjustments directly attributable to the business combination to be included in the pro forma revenue and earnings. The amended disclosure was effective for business combinations consummated on or after December 15, 2010 and its adoption did not have a material impact on First Financial’s consolidated financial condition or results of operations.
FASB ASU 2010-28, “Intangibles-Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts”
This ASU requires a Step 2 impairment test to be performed even if the carrying amount of goodwill is zero or negative for a reporting unit. Additionally, in considering whether it is more likely than not that an impairment exists, an evaluation must be made to determine whether any adverse qualitative factors exist that require goodwill to be tested for impairment more often than annually if an event occurs or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. The amended disclosure was effective for fiscal years beginning on or after December 15, 2010 and its adoption did not have a material impact on First Financial’s consolidated financial condition or results of operations
NOTE 2. Acquisitions
Liberty Savings Bank Branch Acquisition
On April 20, 2012, First Federal acquired five branches from Liberty Savings Bank (“Liberty”) in the Hilton Head, South Carolina market and the transaction included $22.2 million of performing loans and $113.2 million of deposits, as of the transaction date. First Federal consolidated three of the acquired branches with existing First Federal financial centers, adding a net of two new financial centers in the Hilton Head market. As part of the branch acquisition, First Federal acquired $1.0 million in buildings, $500 thousand in land, as well as $500 thousand in cash. The acquired loans and time deposits were recorded at their estimated fair value based on expected contractual cash flows, which were discounted at market rates as of the acquisition date. The estimated fair value for the loans did not include a discount for credit quality as they were all performing loans as of the acquisition date. First Federal also recorded an intangible asset totaling $5.2 million, which represented the estimated fair value of the assumed core deposits (noninterest-bearing checking, interest-bearing checking, savings and money market accounts) as well as the estimated value of a non-compete agreement between First Federal and Liberty. The amortization of the purchase accounting adjustments for the loans and time deposits is recorded in net interest income while the amortization of the intangible asset is recorded in noninterest expense on the Consolidated Statements of Operations.
Plantation Federal Bank FDIC-Assisted Acquisition
On April 27, 2012, First Federal assumed all deposits and substantially all assets and certain other liabilities of Plantation Federal Bank (“Plantation”), a full-service community bank headquartered in Pawleys Island, South Carolina, from the FDIC, as receiver for Plantation (the “Acquisition”). Plantation operated three branches along the coast of South Carolina under the name of Plantation Federal and three branches in the Greenville, South Carolina market under the name of First Savers Bank. The Acquisition was made pursuant to a purchase and assumption agreement, in the FDIC’s customary form, entered into by First Federal and the FDIC as of April 27, 2012 (a “P&A Agreement”).
In connection with the Acquisition, the FDIC made a cash payment to First Federal of $45.9 million, and First Federal did not pay the FDIC a premium to assume the customer deposits. The P&A Agreement includes a customary loss sharing agreement with the FDIC, which covers $216.4 million at carrying value of acquired commercial loans and commercial OREO ($168.6 million at estimated fair value). First Federal will share in the losses and the FDIC is obligated to reimburse First Federal for 80% of all eligible losses, beginning with the first dollar of loss incurred through $55.0 million in losses. First Federal absorbs losses greater than $55.0 million up to $65.0 million. The FDIC will reimburse First Federal for 60% of all eligible losses in excess of $65.0 million. First Federal has a corresponding obligation to reimburse the FDIC according to the same arrangement for eligible recoveries. The loss share agreement provides for FDIC loss sharing for five years and First Federal to reimburse the FDIC for recoveries for eight years.
In accordance with ASC 805, the Plantation loans were recorded at estimated fair value based on discounted cash flows, which considered current portfolio interest rates and repricing characteristics as well as assumptions related to prepayment speeds, The Plantation loans were also assessed to determine which loans met the scope of ASC 310-30. Some of the primary factors used to determine the projected collectability of the contractual cash flows included: type of loan and related collateral, default rate, loss severity rates assuming default, prepayment speeds and estimated collateral values. Generally, commercial loans rated substandard or worse and nonrated residential and consumer loans past due at least 90 days or with a history of past due occurrences over the life of the loan were considered to be have a high risk of default or likelihood of loss and were classified as credit impaired loans. In addition, there were several specifically identified loans that were considered credit impaired by proxy as they displayed uncertainty as to the source of repayment, underlying cash flows, or current financial information. The acquired credit impaired loans were grouped into eight pools based on loan type or purpose, collateral, risk ratings, repayment terms and other similar characteristics, with no distinction for geography as all of the loans were within the state of South Carolina. Certain amounts related to these loans were estimates, such as “as-is” and liquidation collateral values provided for by appraisers, and are highly subjective. The discount rates used to estimate the fair value take into consideration the market interest rate environment as of the acquisition date and a credit risk component based on the credit characteristics of each loan pool.
The fair value of the FDIC indemnification asset associated with the covered assets was estimated using projected cash flows related to the loss sharing agreement, based on the expected reimbursement for losses and the applicable loss sharing percentages for each loss tranche. The expected cash flows were discounted to reflect the uncertainty of the timing and receipt of the loss sharing reimbursement from the FDIC. A liability for a potential true-up payment which may be owed to the FDIC related to the indemnification asset was established net of present value discount.
For the other assets acquired and liabilities assumed, First Federal used various methods to estimate fair value as of the acquisition date. For the investment securities and advances from the Federal Home Loan Bank (“FHLB”), the fair value was estimated using quoted or current market prices, including applicable prepayment termination charges. The fair value of time deposits was estimated based on expected contractual cash flows, which were discounted at current market rates. The accretion of the discount on the time deposits is recorded in net interest income on the Consolidated Statements of Operations. First Federal recorded a core deposit intangible representing the fair value of the assumed core deposits and the amortization of this intangible is recorded in noninterest expense on the Consolidated Statements of Operations.
Subsequent to the Acquisition, First Federal exercised an option under the P&A Agreement to acquire Plantation’s Pawleys Island branch location at fair market value for $2.8 million. First Federal consolidated an existing financial center into this location and consolidated Plantation’s remaining two coastal locations into First Federal’s existing financial centers during the fourth quarter of 2012, for no net increases in financial centers along the South Carolina coast. First Federal also assumed the leases associated with the three locations in the Greenville, South Carolina market and acquired certain fixed assets totaling $625 thousand associated with the former Plantation locations during the third quarter of 2012.
A bargain purchase gain of $13.9 million was recorded in noninterest income on the Consolidated Statements of Operations. A deferred tax liability, representing the difference between the financial statement and tax bases of the assets acquired and liabilities assumed, was recorded in other liabilities on the Consolidated Balance Sheets. The bargain purchase gain represents the amount by which the estimated fair value of the assets acquired exceeded the estimated fair value of the liabilities assumed, adjusted for the discount bid cash payment received from the FDIC as well as the establishment of the FDIC indemnification asset and its associated potential true-up liability.
In accordance with the relief granted in a letter dated May 21, 2012 from the staff of the Division of Corporate Finance of the Securities and Exchange Commission to First Financial and the guidance provided in Staff Accounting Bulletin Topic 1:K, Financial Statements of Acquired Troubled Financial Institutions (“SAB 1:K”), First Financial has omitted certain financial information of Plantation required by Rule 3-05 of Regulation S-X. SAB 1:K provides relief from the requirements of Rule 3-05 of Regulation S-X under certain circumstances, including the Acquisition, in which the registrant engages in an acquisition of a troubled financial institution for which historical financial statements are not reasonably available and in which federal assistance is an essential and significant part of the transaction. Instead, as permitted by the relief letter, First Financial has provided a Statement of Assets Acquired and Liabilities Assumed pursuant to the Acquisition. Due to the significant amount of fair value adjustments, the resulting accretion and amortization of those adjustments and the protection from the FDIC loss share agreement, historical operating results for Plantation are not relevant to First Federal’s ongoing results of operations. The fair value assigned to loans and OREO is preliminary and subject to refinement for the earlier of up to one year after the closing date of the acquisition or as additional information becomes available. The following table presents the assets acquired and liabilities assumed as of April 27, 2012, including the purchase accounting adjustments.
Statement of Assets Acquired and Liabilities Assumed
As of April 27, 2012
Explanation of fair value adjustments
Reflects the fair value adjustments based on First Federal's evaluation of the acquired loan portfolio.
Reflects the estimated fair value of payments First Federal anticipates receiving from the FDIC under the loss share agreement.
Reflects estimated OREO losses based on First Federal's evaluation of the acquired OREO.
Reflects recording the core deposit intangible on the acquired core deposits.
Adjusts for interest rates that are higher than rates available on similar deposits as of the acquistion date.
Reflects the fair value as quoted by FHLB.
Establishes a deferred tax liability related to the gain on acquisition.
Establishes the true-up liability that may be owed to the FDIC at the end of the loss share agreement.
NOTE 3. Investment Securities
The investment securities portfolio is comprised of securities that, at purchase, are rated in one of the four highest rating categories by at least one nationally recognized investment rating service, and where available, are rated by two rating services. The following table presents amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value of investment securities available for sale and securities held to maturity and nonmarketable securities.
Nonmarketable securities include FHLB and Federal Reserve Bank (“Federal Reserve”) stock. Ownership of FHLB and Federal Reserve stock is required for membership in these two systems. The carrying amount of FHLB and Federal Reserve stock is used to approximate the fair value of these securities as they are not readily marketable and are recorded at cost (par value).
The following table provides the names of issuers for whom First Financial has investment securities totaling in excess of 10% of shareholders’ equity and the fair value and amortized cost of these investments as of December 31, 2012. Securities issued by Bank of America Corp. are, for the most part, collateralized mortgage obligations (“CMOs”) and not backed by Bank of America Corp. All of these securities are available for sale.
The amortized cost and fair value of investments held to maturity and investments available for sale, exclusive of mortgage-backed securities and CMOs, at December 31, 2012, by contractual maturity are shown below. Expected maturities may differ from contractual maturities, as borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Securities with a fair market value of $123.7 million at December 31, 2012, $237.8 million at December 31, 2011 and $217.2 million at September 30, 2011 were pledged to secure public and certain customer deposits, repurchase agreements and advances from the FHLB and the Federal Reserve.
During 2012, mortgage-backed securities totaling $203.6 million with an average yield of 1.79% were sold as part of a balance sheet repositioning initiative, generating a $3.5 million gain. All of the sold investment securities were classified as Level 2 fair value financial instruments and had not previously recorded an OTTI charge. During the year ended September 30, 2011, a previously impaired other security with was sold. The security had a carrying value of zero at the time of sale due to a $1.1 million OTTI charge recorded in a prior year. The proceeds from the sale of $1.4 million were recognized as a gain.
The following table presents gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position. No investment held to maturity was in a loss position at December 31, 2012 or 2011 or at September 30, 2011.
Other-Than-Temporary Impairment
Management evaluates securities for OTTI on at least a quarterly basis. In determining OTTI, investment securities are evaluated according to ASC 320 Investments - Debt and Equity Securities and management considers many factors including: (1) the length of time and extent to which the fair value has been less than cost; (2) the financial condition and near-term prospects of the issuer; (3) whether the market decline was affected by macroeconomic conditions; and (4) whether First Financial has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether OTTI exists involves a high degree of subjectivity and is based on information available to management on the assessment date. In assessing the recovery of value, the key factors reviewed include the length of time and the extent the fair value has been less than the carrying cost, adverse conditions, if any, specifically related to the security, industry or geographic area, historical and implied volatility of the fair value of the security, credit quality factors affecting the issuer or the underlying collateral, payment structure of the security, payment history of the security, changes to the credit rating of the security, recoveries or declines in value subsequent to the balance sheet date or any other relevant factors. Evaluations are performed on a more frequent basis as the degree to which fair value is below carrying cost or the length of time that the fair value has been continuously below carrying cost increases.
At December 31, 2012, the majority of unrealized losses were related to trust preferred collateralized debt obligations (“CDOs”) and private-label CMOs as discussed below. For the year ended December 31, 2012, credit-related OTTI of $503 thousand was recorded in net impairment losses recognized in earnings in the Consolidated Statements of Operations. The components of the OTTI were: $41 thousand on CDOs and $462 thousand on CMOs. The total carrying value of securities affected by credit-related OTTI represent 8.8% of the carrying value of First Financial’s investment portfolio at December 31, 2012, and are not considered to have a significant impact on First Financial’s liquidity and capital positions.
Collateralized Debt Obligations
The CDO portfolio is collateralized primarily with trust preferred securities issued by other financial institutions in pooled issuances. To determine the fair value, cash flow models for trust preferred CDOs provided by a third-party pricing service are utilized. The models estimate default vectors for the underlying issuers within each CDO security, estimate expected bank failures across the entire banking system to determine the impact on each CDO, and assign a risk rating to each individual issuer in the collateral pool. The individual risk ratings for the underlying securities in the pools were determined by a number of factors including Tier 1 capital ratio, return on assets, percent of nonperforming loans, percent of commercial and construction loans and level of brokered deposits for each underlying issuer. The risk ratings were used to determine an expected default vector for each CDO. The model assigns assumptions for constant default rate, loss severity, recovery lags and prepayment assumptions, which
were reviewed for reasonableness and consistency by management. The resulting projected cash flows were compared to book value to determine the amount of OTTI, if any. See Note 17 to the Consolidated Financial Statements for additional information on fair value.
The following table provides information regarding the CDO portfolio as of December 31, 2012, all of which are pooled.
1Recognized in impairment losses on investment securities on the Consolidated Statements of Operations
2Represents percentage of the underlying trust preferred collateral not currently making dividend payments or issued by financial institutions that have been placed into receivership by the FDIC
3Fair market value discount margin to LIBOR
The OTTI noted in the table above was related to two CDO securities with credit-related deterioration evidenced by the following metrics:
The estimated fair value of these CDOs continues to be adversely affected by the elevated credit losses within the financial industry caused by the recent recession, continued uncertain economic conditions, high unemployment rates and the weak national housing market, all of which have severely impacted the creditworthiness of the underlying issuers. As of December 31, 2012, management does not intend to sell these securities, nor is it more likely than not that it will be required to sell the securities before the amortized cost basis is recovered as First Financial has adequate other sources of liquidity.
Collateralized Mortgage Obligations
The CMO portfolio, which is comprised of agency and non-agency securities, was priced using discounted cash flow models. In making the determination of each CMO’s fair value, consideration was given to recent transaction volumes, price quotations and related price volatility, available broker information and market conditions. A pricing model is utilized to estimate each security’s cash flow and adjusted price based on coupon, credit rating, estimated default rate, constant prepayment rate and required yields or spreads. A cash flow analysis is performed on each security in the CMO portfolio, regardless of the credit rating, to determine if the security has any OTTI. See Note 17 to the Consolidated Financial Statements for additional information on fair value.
The following table presents the investment grades assigned by the rating agencies for CMO securities which were in a loss position at December 31, 2012 along with OTTI losses recorded during the year ended December 31, 2012.
The OTTI in the table above was related to three private-label securities with credit-related deterioration evidenced by the following metrics.
Based on First Financial’s policy, the credit rating displayed in the above table reflects the lowest credit rating by the major rating agencies. As of December 31, 2012, management does not intend to sell these securities, nor is it more likely than not that it will be required to sell the security before the amortized cost basis is recovered as First Financial has adequate other sources of liquidity.
The following table presents the cumulative credit-related losses recognized in earnings.
NOTE 4. Loans and Other Repossessed Assets Acquired
The following table presents the loan portfolio by major category. Loans are grouped by purpose versus underlying collateral.
As of the balance sheet dates, loans to related parties did not exceed five percent of shareholders equity.
In April 2009 and April 2012, First Federal entered into purchase and assumption agreements with the FDIC to acquire certain assets and liabilities of the former Cape Fear Bank (“Cape Fear”) and Plantation, respectively, under which all Cape Fear loans and certain Plantation commercial loans and OREO were covered under loss share agreements with the FDIC (“acquired covered loans” or “acquired covered assets”). In addition, First Federal acquired five branches from Liberty in April 2012. The Plantation loans and OREO not covered under its loss share agreement and all of the Liberty loans are considered “acquired non-covered loans” or “acquired non-covered assets.” Loans that were originated through First Federal’s normal origination channels (i.e., not acquired in an acquisition) that are part of the loan portfolio or have subsequently migrated to OREO are considered “legacy loans” or “legacy assets.”
The carrying amount of the loans acquired from Plantation is detailed in the following table.
The following is a summary of changes in the accretable yields of acquired loans during the respective periods.
First Federal monitors the expected cash flows for each ASC 310-30 pool on a quarterly basis. During 2011 and again in 2012, First Federal determined that the projected cash flows of a Cape Fear loan pool are expected to exceed the value estimated at acquisition. As a result, First Federal reclassified the expected improvement.
Delinquent Loans and Nonperforming Assets
The following table presents the loan portfolio by age of delinquency.
Nonperforming assets include nonaccrual loans, loans delinquent 90 days or more and still accruing, restructured loans still accruing, and other repossessed assets acquired through foreclosure. With the exception of the credit card portfolio, loans are placed on nonaccrual status when they become 90 days delinquent. In addition, loans that were not delinquent in excess of 90
days but exhibited doubt as to First Federal’s ability to collect all contractual principal and interest have been classified as impaired under ASC 310-10, and placed on nonaccrual status. The following table presents the composition of nonperforming assets.
Interest income related to nonaccrual and renegotiated loans that would have been recorded if such loans had been current in accordance with their original terms amounted to $9.8 million at December 31, 2012, $0.9 million at the quarter ended December 31, 2011 and $12.1 million for the year ended September 30, 2011 and $11.2 million for the year ended September 30, 2010. Recorded interest income on these loans was $1.1 million for year ended December 31, 2012, $(0.1) million for the quarter ended December 31, 2011, $979 thousand for the year ended September 30, 2011, and $1.1 million for the year ended September 30, 2010.
Loans acquired from Cape Fear and Plantation that were performing at the time of acquisition, but have subsequently become nonaccrual are included in the tables above. Nonperforming loans acquired at acquisition are not included since these loans were adjusted to fair value at the acquisition date and accounted for under ASC 310-30.
Impaired Loans
In accordance with ASC 310-10, a loan is considered impaired when First Federal determines it is probable that the principal and interest due under the contractual terms of the loan will not be collected. Criticized and classified commercial loans (as defined in the “Criticized Loans, Classified Loans and Other Risk Characteristics” section of this Note) greater than $500,000 are reviewed for potential impairment as part of a monthly problem loan review process. In addition, homogeneous loans which have been modified are reviewed for potential impairment.
In assessing the impairment of a loan and the related reserve required for that loan, various methodologies are employed. Impairment measurement on loans that are not collateral dependent is determined primarily using the present value of expected future cash flows discounted at the loan’s effective interest rate. With respect to most real estate loans, and specifically if the loan is considered to be collected through a probable foreclosure, an approach that estimates the fair value of the underlying collateral is used. The collateral is appraised to reflect estimated realizable value (usually “as is” or liquidation value), with the market value being adjusted for estimated selling costs. First Federal’s policy is to update collateral appraisals on impaired loans at least annually, and more frequently if deemed necessary based on market conditions or specific circumstances. Significant downward trends in the real estate market can adversely affect First Federal’s collateral position. For larger credits or loans that are classified “substandard” or worse that rely primarily on real estate collateral for repayment, re-appraisal would occur earlier than the stated policy if management believes the market conditions have changed such that the existing appraisal may no longer reflect the current market value of the property. At a minimum, at the time a loan with a principal balance of over $500,000 is downgraded to “substandard” or worse, or if the loan is determined to be impaired, the property securing the loan is re-appraised to update the value. In addition to updated appraisals, market bids or current offers may be utilized to estimate current value.
First Federal maintains a valuation reserve for impaired loans as part of the allowance for loan losses. Cash collected on impaired nonaccrual loans is applied to outstanding principal. A summary of impaired loans, related valuation reserves and their effect on interest income follows.
The total recorded investment in acquired covered impaired loans was $3.5 million, $11.6 million and $14.3 million as of December 31, 2012, December 31, 2011 and September 30, 2011, respectively. These loans had a specific allowance of less than $100 thousand as of each balance sheet date. There were no acquired non-covered impaired loans as of each balance sheet date.
Troubled Debt Restructuring
First Federal accounts for certain loan modifications or restructurings as a TDR. In general, a loan is considered a TDR if, for economic or legal reasons related to a borrower’s financial difficulties, a concession is granted to the borrower that First Federal would not otherwise consider. While commercial loan modifications vary depending on circumstances, the most common types of modifications for residential and consumer loans include below market rate reductions and/or maturity extensions, and generally do not include forgiveness of principal balances. Modified terms are dependent on the financial position and needs of the individual borrower.
First Federal classifies TDRs as nonaccruing loans unless the loan qualified for accruing status at the time of the restructure, or the loan has performed according to the new contractual terms for at least six months. To qualify for accruing status at the time of the restructure, the original loan must have been less than 90 days past due at the time of the restructure and the modification must not have resulted in an impairment loss. As of December 31, 2012, First Federal had 54 TDRs with an aggregate balance of $16.7 million classified as impaired and included in the appropriate nonperforming loan category in the tables above. Included in the impaired total were nine TDRs that were considered performing in accordance with modified terms and still accruing interest.
The following table provides a summary of TDRs that continue to accrue interest under restructured terms and TDRs that have been placed in nonaccrual status.
1 There were no accruing or non-accruing acquired non-covered TDRs in the above noted periods.
The following table provides a summary of the primary reason loan modifications were classified as TDRs and their estimated impact on the allowance for loan losses.
1 There were no rate or structure modifications for acquired non-covered TDRs in the above noted periods.
The following table provides a summary of the pre-default balance for TDRs that experienced a payment default during the respective period, that were classified as TDRs during the previous twelve months.
1 There were no restructured modifications for acquired non-covered TDRs in the above noted periods.
Criticized Loans, Classified Loans and Other Risk Characteristics
Federal regulations provide for the designation of lower quality loans as special mention, substandard, doubtful or loss. Loans designated as special mention are considered “criticized” by regulatory definitions and possess characteristics of weakness which may not necessarily manifest into future loss. Loans designated as substandard, doubtful or loss are considered “classified” by regulatory definitions. Substandard loans have a well-defined weakness and are inadequately protected by the current net worth, liquidity and paying capacity of the borrower or any collateral pledged, and include loans characterized by the distinct possibility that some loss will occur if the deficiencies are not corrected. Loans classified as doubtful have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable on the basis of currently existing facts, conditions and values. Loans classified as loss are those considered uncollectible and of such little value that their continuance without the establishment of a specific loss reserve is not warranted. When First Federal classifies problem loans as a loss, they are charged-off in the period in which they are deemed uncollectible. First Federal evaluates its commercial loans regularly to determine whether they are appropriately risk rated in accordance with applicable regulations and internal policies.
The following tables presents the risk profiles for the commercial loan portfolio by the primary categories monitored.
For residential and consumer loans, First Federal evaluates credit quality based on payment activity, accrual status and if a loan was modified from its original contractual terms.
The following tables present the risk indicators for the residential and consumer loan portfolios.
An analysis of changes in the allowance for loan losses follows.
Other Repossessed Assets Acquired
The following table presents the components of other repossessed assets acquired, which is comprised of OREO and other consumer-related repossessed items, such as manufactured houses and boats, and is included in other assets on the Consolidated Balance Sheets.
The following table presents the components of OREO expenses, net.
NOTE 5. Loans Held for Sale, Loan Servicing and Mortgage Origination
The portfolio of residential mortgages serviced for others was $1.9 billion at December 31, 2012, and $1.4 billion at both December 31 and September 30, 2011. The amount of contractually specified servicing fees earned by First Federal during 2012 was $4.3 million, compared with $933 thousand for the quarter ended December 31, 2011, and $3.5 million and $3.2 million for the years ended September 30, 2011 and 2010, respectively. Servicing fees are recorded in mortgage and other loan income in the Consolidated Statements of Operations.
Mortgage servicing rights are recorded on the Consolidated Balance Sheets at fair value with changes in fair value recorded as a component of mortgage and other loan income in the Consolidated Statements of Operations. First Federal uses various free standing derivative instruments to mitigate the income statement effect of changes in fair value due to changes in valuation inputs and residential mortgage servicing rights assumptions. The following table presents the changes in the fair value of MSRs and its offsetting hedge.
The following table is an analysis of the activity in the MSRs.
The fair value of MSRs is highly sensitive to changes in assumptions and fair value is determined by estimating the present value of the asset’s future cash flows utilizing market-based prepayment rates, discount rates and other assumptions validated through comparison to trade information, industry surveys and with the use of independent third party appraisals. Changes in prepayment speed assumptions have the most significant impact on the fair value of MSRs. Generally, as interest rates decline, mortgage loan prepayments accelerate due to increased refinance activity, which results in a decrease in the fair value of the MSR. Measurement of fair value is limited to the conditions existing and the assumptions utilized as of a particular point in time, and those assumptions may not be appropriate if they are applied at a different time.
The characteristics and sensitivity analysis of the MSR are included in the following table as of December 31, 2012.
The sensitivity calculations above are hypothetical and should not be considered to be predictive of future performance. Changes in fair value based on adverse changes in assumptions generally cannot be extrapolated because the relationship of the changes in assumptions to fair value may not be linear. Also, in this table, the effects of an adverse variation in a particular assumption on the fair value of the MSRs is calculated without changing any other assumptions, while in reality, changes in one factor may result in changing another, which may magnify or contract the effect of the change.
The following table displays mortgage loan securitizations and whole loan sales during the respective periods.
Loans held for sale have historically been comprised of residential mortgage loans awaiting sale in the secondary market, which generally settle in 15 to 45 days. Loans held for sale, which consists of residential mortgage loans to be sold in the secondary market, was $55.2 million at December 31, 2012, compared with $48.3 million and $94.9 million at December 31, 2011 and September 30, 2011, respectively. Loans held for sale at September 30, 2011 was comprised of $40.8 million in residential mortgage loans awaiting sale in the secondary market and $54.1 million of loans in the bulk loan sale pool.
NOTE 6. FDIC Indemnification Asset
First Federal has loss sharing agreements with the FDIC related to the Cape Fear and Plantation acquisitions which afford First Federal significant protection regarding certain acquired assets. Under the loss sharing agreement for Cape Fear, First Federal assumes the first $32.4 million of losses and the FDIC reimburses First Federal for 80% of the losses greater than $32.4 million and up to $110.0 million. On losses exceeding $110.0 million, the FDIC will reimburse First Federal for 95% of the losses. The expected reimbursements under the loss sharing agreement were recorded as an indemnification asset at the time of the Cape Fear acquisition in April 2009.
Under the loss sharing agreement for Plantation, First Federal shares in the losses on certain commercial loans and commercial OREO in three tranches. On losses up to $55.0 million, the FDIC reimburses First Federal for 80% of all eligible losses; First Federal absorbs losses greater than $55.0 million up to $65.0 million; and the FDIC reimburses First Federal for 60% of all eligible losses in excess of $65.0 million.
The following table presents the change in the FDIC indemnification asset.
During 2012, First Federal began recognizing a potential impairment on the indemnification asset. The performance of an underlying Cape Fear loan pool has been better than originally projected and cumulative payments received exceeded First Federal’s initial investment in the pool. As a result, First Federal may claim lower future reimbursements than projected at the time of the Cape Fear acquisition in 2009. The impairment was recorded in noninterest expense on the Consolidated Statement of Operations. Additional expected losses related to Plantation increased the FDIC indemnification asset by approximately $9.5 million during the year ended December 31, 2012.
During the year ended December 31, 2012, First Federal received payments totaling $15.5 million from the FDIC, of which $2.0 million was credited to OREO expenses and other loan expense on the Consolidated Statement of Operations. These payments satisfied all claims through June 30, 2012. During the quarter ended December 31, 2011, First Federal received payments totaling $14 thousand from the FDIC. During the year ended September 30, 2011, First Federal received payments totaling $20.5 million from the FDIC, of which $1.3 million was credited to OREO expenses and other loan expense.
As of the December 31, 2012 quarterly reporting period, First Federal filed a $19.2 million claim with the FDIC under the terms of the loss share agreement, and payment is expected during the first quarter of 2013.
NOTE 7. Premises and Equipment
The following table presents premises and equipment by major category.
Depreciation expense was $6.2 million, $1.4 million, $6.4 million and $6.1 million for the year ended December 31, 2012, quarter ended December 31, 2011 and years ended September 30, 2011 and 2010, respectively. During the year ended December 31, 2012 First Financial disposed of four in-store financial centers, resulting in a decreases in leasehold improvements and the associated accumulated depreciation of $795 thousand. In addition, First Financial disposed of fully depreciated assets no longer
in service, resulting in decreases to assets and accumulated depreciation in the amounts of $3.1 million and $285 thousand for furniture and equipment and leasehold improvements, respectively. Increases in fixed assets from the Plantation acquisition were $1.1 million, $1.7 million, and $480 thousand for land, buildings, and furniture and equipment, respectively.
At December 31, 2012, First Financial held various non-cancelable operating leases with contract terms extending through 2034 on buildings and land used for office space and banking purposes. Some of these leases contain escalation clauses which provide for higher rental expense based on increases in common area maintenance expenses and automatic escalation at predetermined lease anniversary or renewal dates. The following table presents minimum rental commitments as of December 31, 2012.
Rental expenses under operating leases were $2.4 million for the year ended December 31, 2012, compared with $570 thousand, $3.6 million, and $3.0 million for the quarter ended December 31, 2012, and the years ended September 30, 2011 and 2010, respectively.
NOTE 8. Goodwill and Intangible Assets
During the year ended September 30, 2011, First Financial performed its annual goodwill impairment test. The Step 1 analysis indicated that the carrying amount exceeded estimated fair value for Atlantic Acceptance (“Atlantic”), a former subsidiary of First Federal, and for Kimbrell; therefore, Step 2 testing was required. As a result of the Step 2 analysis, First Financial determined that the goodwill associated with both entities was impaired due to updated discounted cash flow projections, and a change in business strategy. First Financial recorded a non-cash, non-tax-deductible goodwill impairment charge of $630 thousand for Atlantic, which is included in the results for continuing operations, and $1.9 million for Kimbrell, which is included in the results from discontinued operations.
The following table summarizes the carrying amount of intangible assets.
During the year ended December 31, 2012, new intangible assets were established to include the value of core deposit and non-compete contract intangibles related to the acquisition of Liberty and Plantation.
The weighted average amortization period for intangible assets is approximately ten years as of December 31, 2012. Expected amortization expense related to intangible assets for future years is shown in the table below.
NOTE 9. Deposit Accounts
Deposit accounts with overdraft balances are classified as consumer loans in the Consolidated Balance Sheets. Overdrafts totaled $1.5 million, $1.4 million and $903 thousand at December 31, 2012, December 31, 2011 and September 30, 2011, respectively.
The following table presents scheduled maturities of time deposits as of December 31, 2012.
Brokered time deposits totaled $71.2 million at December 31, 2012, compared to $140.5 million at December 31, 2011 and $162.6 million at September 30, 2011. The aggregate amount of time deposits with balances equal to or greater than $100,000 totaled $495.3 million, $552.2 million and $599.8 million at December 31, 2012, December 31, 2011 and September 30, 2011, respectively.
The following table presents scheduled maturities for time deposits equal to or greater than $100,000 as of December 31, 2012.
Related party deposits are those deposits held by First Federal that are owned by executives and certain other key officers of First Federal. Related party deposits totaled $982 thousand, $715 thousand and $668 thousand at December 31, 2012, December 31, 2011 and September 30, 2011, respectively.
NOTE 10. Advances From Federal Home Loan Bank
During 2012, FHLB advances totaling $125.0 million with an average yield of 3.15% were prepaid as part of a balance sheet repositioning initiative, resulting in an early termination charge of $8.5 million. The following table presents the contractual maturity
schedule for the outstanding FHLB advances as of December 31, 2012. Expected maturities may differ from contractual maturities, as the FHLB has the right to call certain advances.
At December 31, 2012, callable advances totaled $175.0 million, with a weighted average rate of 3.93%. The FHLB did not exercise any of its call provisions during the period from October 1, 2010 to December 31, 2012.
Advances from the FHLB, which mature on various dates through 2018, are collateralized by a blanket lien on certain residential and commercial real estate loans with an aggregate balance at December 31, 2012, December 31, 2011 and September 30, 2011 of $590.9 million, $730.8 million and $692.7 million, respectively. In addition, First Federal had pledged investment securities totaling $28.2 million as of December 31, 2012, as compared with $104.6 million at December 31, 2011 and $126.8 million at September 30, 2011 to secure borrowings. At December 31, 2012, First Federal had excess borrowing capacity of $348.2 million compared to $267.2 million at December 31, 2011 and $254.5 million at September 30, 2011, based on assets pledged. The maximum borrowings permitted under the agreement are 40% of total eligible assets subject to the presentment of sufficient qualifying collateral. At December 31, 2012, December 31, 2011 and September 30, 2011, total maximum availability was $619.1 million, $834.9 million and $819.5 million, respectively. Advances are subject to prepayment penalties and certain advances may be subject to conversion to floating rates at the option of the FHLB.
NOTE 11. Short-Term Borrowings and Long-Term Debt
First Federal has unsecured federal funds lines with various unaffiliated banks. These lines totaled $70.0 million as of December 31, 2012, $40.0 million as of December 30, 2011 and $35.0 million as of September 30, 2011. Borrowings from the federal funds lines and the Federal Reserve, which is secured by a portion of the manufactured housing loan portfolio, would be included in other short-term borrowings on the Consolidated Balance Sheets, if drawn, and are used to supplement other liquidity sources as needed. As of December 31, 2012, First Financial had borrowing availability of $257.7 million from these sources, as compared with $252.9 million as of December 31, 2011 and $249.7 million as of September 30, 2011. There were currently no funds drawn from these lines at the respective period end dates.
On March 19, 2004, First Financial issued $46.4 million of 30-year trust preferred securities through Capital Trust I, an unconsolidated special purpose trust, to unrelated institutional investors. The trust preferred securities qualify as Tier 1 capital under risk-based capital guidelines. Gross proceeds from the issuance were used by Capital Trust I to purchase junior subordinated deferred interest debt issued by First Financial. The subordinated debt is the only asset of Capital Trust I. The debt matures in thirty years and is an unsecured obligation of First Financial that ranks junior to First Financial’s other outstanding debt. Distributions on the trust preferred securities, which represent undivided beneficial interests in the assets of Capital Trust I, are payable quarterly in arrears at an annual rate of 7.00%, beginning July 7, 2004. The securities are callable and mature on April 6, 2034. Debt issuance costs, net of amortization, totaled $974 thousand at December 31, 2012 and $1.2 million at December 31, 2011 and September 30, 2011, and are included in other assets on the Consolidated Balance Sheets.
Other long-term debt consists of notes payable to several South Carolina non-profit organizations. These loans are part of a strategy to leverage low-income housing tax credits.
The following table presents long term debt and their related weighted average interest rates.
First Financial’s federal funds lines of credit are generally only utilized once a year, unless there is a liquidity need, and the balances as of period ends noted below are unutilized. As of or for the year ended December 31, 2012, quarter ended December 31, 2011, and year ended September 30, 2011 the outstanding balance, maximum amount outstanding at any month end, daily average and the weighted average rate were all nominal. The following table presents information related to the various forms of borrowings utilized.
Note 12. Shareholders’ Equity, Dividend Restrictions and Other Regulatory Matters
Stock Issuances
On December 5, 2008, pursuant to the US Department of the Treasury’s (the “Treasury”) Troubled Asset Relief Program (“TARP”) Capital Purchase Program (“CPP”), First Financial issued and sold to the Treasury for an aggregate purchase price of $65.0 million in cash (1) 65,000 shares of its Fixed Rate Cumulative Perpetual Preferred Stock Series A (the “Series A Preferred Stock”), and (2) a ten-year warrant to purchase up to 483,391 shares of First Financial’s common stock (the “Warrant”). On September 29, 2009, First Financial completed a qualified equity offering as defined in the Purchase Agreement and the number of shares exercisable under the warrant was adjusted to 241,696 shares of common stock. The Series A Preferred Stock has $0.01 par value, carries a liquidation price of $1,000 per share, pays cumulative dividends at a rate of 5.00% per annum for the first five years and 9.00% per annum thereafter, and qualifies as Tier 1 capital. The Warrant has a par value of $.01 per share and an initial exercise price of $20.17 per share, subject to certain anti-dilution and other adjustments. First Financial used relative fair value as the basis for allocating the proceeds from the issuance of the Series A Preferred Stock and warrants. The assumptions incorporated into the Black-Scholes fair value model include a dividend yield of 4.85%, volatility of 35.4% and a risk-free interest rate of 2.5%. First Financial could not redeem the Series A Preferred Stock during the first three years after issuance except with the proceeds from an offering of perpetual preferred or common stock that qualifies as and may be included in Tier 1 capital. However, because three years have passed since the issuance of the Series A Preferred Stock, First Financial may redeem the Series A Preferred Stock at the liquidation price plus accrued and unpaid dividends. First Financial is accreting the book value of the Series A Preferred Stock using the effective interest method up to the par value of $65.0 million. The preferred shares are non-voting, other than class voting rights on matters that could adversely affect the shares. The warrant is immediately exercisable and expires ten years from the issuance date. It provides for an adjustment to the exercise price and to the number of shares of common stock issuable upon exercise pursuant to customary anti-dilution provisions.
On March 29, 2012, the Treasury completed the sale of its $65.0 million Series A Preferred Stock investment in First Financial to private investors through a registered public offering at $873.51 per share. There was no impact to First Financial’s financial condition or operating results due to the transaction. On January 24, 2013, First Financial declared a quarterly cash dividend of $12.50 per share on its Series A Preferred Stock payable on February 15, 2013 to preferred shareholders of record as of February 5, 2013.
On January 24, 2013, First Financial declared a quarterly cash dividend of $0.05 per common share, payable on February 22, 2013 to common shareholders of record as of February 8, 2013.
Earnings (Loss) Per Share
Basic earnings (loss) per common share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is calculated by applying the treasury stock method. Under the treasury stock method, the exercise of dilutive stock options is assumed. The sum of the assumed proceeds of (1) the stock option exercises, (2) the amount of any tax benefits that would be credited to additional paid-in capital assuming exercise of
the options, and (3) the unamortized compensation expense on in-the-money options not yet recognized pursuant to GAAP for share-based payments (see Note 14 to the Consolidated Financial Statements) are assumed to be used to purchase common stock at the average market price during the period. The incremental shares (the difference between the number of shares assumed issued and the number of shares assumed purchased), if any, are included in the denominator of the diluted earnings (loss) per share calculation.
Stock options and warrants which were not included in computing diluted earnings per share because the effects were antidilutive totaled 490,996 and 646,083 as of December 31, 2012 and 2011, respectively, compared to 743,333 and 962,547 as of September 30, 2011 and 2010, respectively.
Accumulated Other Comprehensive Income
The following table summarizes the components of accumulated other comprehensive income.
Dividend Restrictions and Other Regulatory Matters
Since First Financial is a bank holding company, its ability to declare and pay dividends is dependent on certain federal and state regulatory considerations, including the guidelines of the Board of Governors of the Federal Reserve. In accordance with a policy statement issued by the Federal Reserve regarding the payment of dividends by bank holding companies, the Federal Reserve may generally restrict or prohibit the payment of dividends if (1) First Financial’s net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (2) First Financial’s prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; (3) First Financial will not meet, or is in danger of not meeting, its minimum regulatory capital ratios; or (4) the Federal Reserve otherwise determines that the payment of dividends would constitute an unsafe or unsound practice. The Federal Reserve’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. Under the prompt corrective action regulations for a bank subsidiary, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of First Financial to pay dividends or otherwise engage in capital distributions. In addition, since First Financial is a legal entity separate and distinct from First Federal and does not conduct stand-alone operations, its ability to pay dividends depends on the ability of First Federal to pay dividends to it. As a South Carolina chartered bank, First Federal is subject to limitations on the amount of dividends that it is permitted to pay. Unless otherwise instructed by the State Board of Financial Institutions (the “SC Board”) or the Commissioner of Banking, First Federal is generally permitted under South Carolina state banking regulations to pay cash dividends of up to 100% of net income in any calendar year without obtaining the prior approval of the SC Board. Under Federal Reserve regulations, a dividend cannot be paid by First Federal if it would be less than well-capitalized after the dividend. The Federal Reserve may also prevent the payment of a dividend by First Federal if it determines that the payment would be an unsafe and unsound banking practice.
As a result of First Federal’s charter conversion and Federal Reserve membership in February 2012, First Federal is subject to Federal Reserve Supervisory Letter SR 91-17, which provides application and supervision standards for de novo state member banks and converting thrifts. The guidance includes standards for senior management and directors, policies, cash flows between the bank and the holding company, ongoing supervision and capital levels, among other things. With respect to capital levels, the guidance provides that de novo state member banks and converting thrifts maintain a Tier 1 leverage capital ratio of 9.00% for the first three years as a state member bank unless an exception is granted. First Federal had a Tier 1 leverage capital ratio of 9.97% at December 31, 2012.
Quantitative measures established by regulation to ensure capital adequacy require First Financial and First Federal to maintain minimum amounts and ratios (as defined in the regulations and set forth in the table below) of tangible and core capital to total assets, and of risk-based capital to risk-based assets. As of December 31, 2012, both First Financial and First Federal met all capital adequacy requirements to which they are subject and were categorized as well-capitalized under the regulatory framework for prompt corrective action.
Capital amounts and ratios are presented in the following table.
Effective in 2012, First Financial was required to file the FR Y-9C, Consolidated Financial Statements for Bank Holding Companies, with the Federal Reserve. Periods prior to first quarter 2012 were not applicable to such regulatory filings. Bank holding companies are not subject to the prompt corrective action provisions of the Federal Deposit Insurance Act.
Beginning in 2012, capital ratios for First Federal are based on reporting requirements for financial institutions filing FFIEC 041, FDIC Consolidated Reports of Condition and Income. Prior period ratios are reported based on superseded regulatory requirements previously issued by the Office of Thrift Supervision.
First Federal is required by regulatory agencies to maintain certain minimum balances of cash or noninterest-bearing deposits with the Federal Reserve. There was no required balance at December 31, 2012 compared with $5.0 million for both periods ended December 31, 2011 and September 30, 2011. During 2012, First Federal maintained higher balances in an interest-bearing account with the Federal Reserve and as a result, there was no required balance needed at December 31, 2012.
NOTE 13. Income Taxes
Income tax expense (benefit) is comprised of the following.
A reconciliation from expected federal tax expense (benefit) for continuing operations of 35% to consolidated effective income tax expense (benefit) for the periods indicated follows.
A reconciliation from expected federal tax expense for discontinued operations of 35% to consolidated effective income tax expense for the periods indicated follows.
The effective tax rate for the year ended September 30, 2011 is the result of a taxable gain on the sale of First Southeast.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of First Financial’s deferred tax assets and liabilities are presented below.
At December 31, 2012, First Federal had $7.5 million of state net operating loss carryforwards that will begin to expire in 2024.
The recognition of deferred tax assets (“DTA”) is based on management’s judgment that realization of the asset meets a “more likely than not” standard. If such determination is not made, a valuation allowance is established against the DTA to reduce its level to where it is more likely than not that the tax benefit will be realized. Management’s judgment is based on estimates concerning various future events and uncertainties, including future reversals of existing taxable temporary differences, the timing and amount of future income earned by First Financial and the implementation of various tax planning strategies to maximize realization of the DTA.
As a result of pre-tax losses, First Financial was in a three year cumulative loss position at December 31, 2012. A cumulative loss position is considered significant negative evidence in assessing the realizability of a DTA. Management has concluded that sufficient positive evidence exists to overcome this negative evidence, including that First Financial has both taxable and tax-deductible temporary differences at December 31, 2012 that are expected to reverse in the next 5-10 years. Further, the reversal of substantial taxable and tax-deductible temporary differences within the next 5-10 years are expected to closely mirror each other, and should further support the conclusion that the gross deferred tax benefits to be realized will be available to offset significant gross deferred tax liabilities.
Management believes that the combination of a strong history of taxable income, the projected current federal income tax receivables and projected pre-tax income in future years represents positive evidence that the tax benefit will be realized. While realization of the deferred tax benefits is not assured, it is management’s judgment, after review of all available evidence and based on the weight of such evidence, that a valuation allowance is not necessary, as realization of these benefits meets the “more likely than not” standard.
First Financial accounts for uncertain tax positions in accordance with the income taxes accounting guidance. The First Financial has analyzed filing positions in the federal and state jurisdictions where it is required to file tax returns, as well as the open tax years in these jurisdictions. The following tax years remain subject to examination as of December 31, 2012.
Jurisdiction Tax Years
Federal 2008-2011
State 2008-2011
First Financial believes that its federal income tax filing positions and deductions will be sustained on audit and does not anticipate any adjustments that will result in material change to its financial position. Therefore, no material reserves for uncertain federal income tax positions have been recorded. First Financial recognizes interest and penalties related to unrecognized tax
benefits as a component of the provision for income taxes. First Financial did not incur any federal income tax related interest income, interest expense or penalties for the year ended December 31, 2012, quarter ended December 31, 2011, and years ended September 30, 2011 and 2010.
The Consolidated Financial Statements at December 31, 2012, December 31, 2011 and September 30, 2011 did not include a tax liability of $8.5 million related to the base year bad debt reserve amounts since these reserves are not expected to reverse until indefinite future periods, and may never reverse. Circumstances that would require an accrual of a portion or all of this unrecorded tax liability include failure to meet the tax definition of a bank, dividend payments in excess of current year or accumulated tax earnings and profits, or other distributions in dissolution, liquidation or redemption of First Financial’s stock.
NOTE 14. Share-Based Payment Arrangements
At December 31, 2012, First Financial has one share-based compensation plan from which new awards may be granted. This plan may issue qualified and non-qualified options, restricted stock awards and stock appreciation rights to employees and nonemployee directors. Under the active plan, the Board may issue up to 900,000 options, stock appreciation rights and restricted stock in the aggregate. At December 31, 2012, First Financial had 529,104 shares related to options and stock appreciation rights and 225,000 shares related to restricted stock awards available for grants. Stock options currently granted under the plan generally expire five years from the date of grant. Restrictions on non-vested stock generally lapse in three annual installments beginning on the first anniversary of the grant date
First Financial also has four plans that currently have option grants outstanding, but no new issuances may be made since these plans have been abandoned or terminated. Forfeited or expired options under the abandoned or terminated plans may not be reissued. At December 31, 2012, there were 113,293 options which remained outstanding under the four abandoned or terminated plans.
Pursuant to the merger Agreement (as defined and described in Note 22), no new awards may be issued by First Financial from its share-based compensation plan noted above.
Compensation expense for stock options is recognized in salaries and employee benefits in the Consolidated Statements of Operations. For the year ended December 31, 2012, First Financial recorded an expense of $180 thousand. For the quarter ended December 31, 2011, First Financial recorded an expense of $59 thousand. First Financial recorded a share-based compensation expense of $432 thousand for the year ended September 30, 2011 and a benefit of $219 thousand for the year ended September 30, 2010. The net benefit in fiscal 2010 was primarily the result of actual forfeitures exceeding the estimated forfeiture rate. First Financial recognized an income tax benefit of less than $100 thousand in the year ended December 31, 2012; and, an income tax benefit of less than $100 thousand in the quarter ended December 31, 2011 related to share-based compensation. First Financial recorded an income tax benefit of approximately $100 thousand in the year ended September 30, 2011 compared to an income tax expense of less than $100 thousand in the year ended September 30, 2010 related share-based payments.
Compensation cost is measured using the Black-Scholes option pricing model. The determined cost is recognized on a straight line basis over the requisite service period of the award. The following table presents the assumptions used to determine the fair value of options granted in the year ended September 30, 2010. There were no options granted or exercised during the period from October 1, 2010 to December 31, 2012.
A summary of stock option activity is presented below.
Stock options outstanding and exercisable as of December 31, 2012 are as follows.
As of December 31, 2012, there was $39 thousand of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. That cost is expected to be recognized over a weighted-average period of approximately 0.4 years. The total original fair value of shares vested during the year ended December 31, 2012 was $174 thousand. For the quarter ended December 31, 2011, the original fair value of the shared vesting was $204 thousand. The total original fair value of shares vested during the years ended September 30, 2011 2010 was $678 thousand and $912 thousand respectively.
NOTE 15. Benefit Plans
Sharing Thrift Plan
First Financial offers a 401(k) Saving Plan (the “Plan”) that permits eligible participants to contribute amounts up to the limitations prescribed by law. The Plan provides for First Financial to match employee contribution in a discretionary match. In connection with other cost savings and capital preservation initiatives implemented in January 2009, First Financial suspended its match as of the quarter ended March 31, 2009. Effective January 1, 2013, First Financial reinstated its match of employee contributions up to one half of 6% of the employee salary.
The Plan provides that all employees who have completed a year of service with First Financial are entitled to receive a profit sharing contribution, if declared. Employees become vested in profit sharing contributions made to their accounts over a six-year period or upon their earlier death, disability or retirement at age 65 or over. Employees are able to direct the investment of profit sharing contributions made to their accounts to any of the available investment funds. As a result of the cost savings and capital preservation initiatives implemented in fiscal 2009, First Financial did not fund any profit sharing contributions for the periods ended December 31, 2012, December 31, 2011 or September 30, 2011.
Other Postretirement Benefits
In the past, First Financial sponsored postretirement benefit plans that provided health care, life insurance and other postretirement benefits to retired employees. The health care plans generally include participant contributions, co-insurance provisions, limitations on the obligation and service-related eligibility requirements. These benefits are paid as they are incurred. As it is a defined contribution plan, it is unfunded. Postretirement benefits for employees hired after January 1, 1989 and those electing early retirement or normal retirement after January 1, 1999, were substantially curtailed.
The following tables set forth the activity of the benefit plan’s projected benefit obligation and plan assets.
The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 3.25%, 4.30% and 4.30% for the year ended December 31, 2012, the quarter ended December 31, 2011 and the year ended September 30, 2011, respectively.
Components of Net Periodic Benefit Expense
The actuarially estimated net benefit cost includes the following components.
First Financial revises the rates applied in the determination of the actuarial present value of the projected benefit obligation to reflect the anticipated performance of the plan and changes in compensation levels.
Benefit Payments
Presented below are the estimated future benefit payments as of December 31, 2012.
NOTE 16. Commitments and Contingencies
Loan commitments
Commitments to extend credit are agreements to lend to borrowers as long as there is no violation of any condition established by the commitment letter. Commitments generally have fixed expiration dates or other termination clauses. The majority of the commitments will be funded within a twelve month period. First Federal evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies but primarily consists of residential or income producing commercial properties. Outstanding commitments on loans not yet closed include commitments issued to correspondent lenders and are principally commitments for loans on single-family residential and commercial property. Outstanding undisbursed closed construction loans primarily consists of permanent residential construction and commercial property construction loans.
Standby letters of credit
Standby letters of credit represent First Federal’s obligations to a third party contingent on the failure of its customer to perform under the terms of an underlying contract with the third party or obligate First Federal to stand as surety for the benefit of the third party. The underlying contract may entail either financial or non-financial obligations and may involve such things as the customer’s delivery of merchandise, completion of a construction contract, release of a lien or repayment of an obligation. Under the terms of a standby letter, drafts will generally be drawn only when the underlying event fails to occur as intended. First Federal can seek recovery from the borrower for the amounts paid. In addition, some of these standby letters of credit are collateralized. Commitments under standby letters of credit are usually for one year or less.
The following table presents First Federal’s loan and letter of credit commitments.
Derivative instruments
First Federal utilizes derivatives as part of its risk management strategy in conducting its mortgage activities. These instruments may consist of financial forward and future contracts, when-issued securities and options written and purchased. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. First Federal does not elect hedge accounting treatment for any of its derivative transactions; consequently, changes in fair value, both gains and losses, of the instrument are recorded in the Consolidated Statements of Operations in mortgage and other loan income.
Derivative contracts related to MSRs are used to offset changes in fair value and are written in amounts referred to as notional amounts. Notional amounts only provide the basis for calculating payments between counterparties and do not represent amounts to be exchanged between the parties, and are not a measure of financial risk. On December 31, 2012, First Federal had derivative financial instruments outstanding with notional amounts totaling $63.0 million compared with $48.0 million at December 31, 2011 and $46.5 million at September 30, 2011. The estimated net fair value of the open contracts related to the MSRs was a loss of $280 thousand at December 31, 2012 compared with a gain of $354 thousand at December 31, 2011 and a gain of $195 thousand at September 30, 2011.
The following table presents First Federal’s obligation under forward commitments, the fair value of those obligations along with the fair value of derivative instruments associated with forward commitments.
NOTE 17. Fair Value of Financial Instruments
Fair value estimates are intended to represent the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Where there is no active market for a financial instrument, First Financial has made estimates using discounted cash flows or other valuation techniques. Inputs to these valuation methods are subjective in nature, involve uncertainties and require significant judgment and cannot be determined with precision. Accordingly, the derived fair value estimates presented below are not necessarily indicative of the amounts First Financial could realize in a current market exchange.
Assets and liabilities are recorded at fair value according to a fair value hierarchy comprised of three levels. The levels are based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. The level of an asset or liability within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with Level 1 considered highest and Level 3 considered lowest). A brief description of each level follows.
·Level 1 - Valuation is based on quoted prices for identical instruments in active markets.
·Level 2 - Valuation is based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market.
·Level 3 - Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Valuation techniques include the use of discounted cash flow models and similar techniques.
The following table presents the carrying value and fair value of the financial instruments.
1 Included as part of other assets in the Consolidated Balance Sheets
2 Included as part of other liabilities in the Consolidated Balance Sheets
The methods and assumptions used to estimate the fair value of financial instruments are set forth below. There were no changes in the valuation methods used to estimate fair value for the year ended December 31, 2012.
Assets Recorded at Fair Value on a Recurring Basis
The following tables present the financial instruments measured at fair value on a recurring basis.
Securities Available for Sale
Securities available for sale include obligations of the US government agencies and corporations, state and municipal obligations, CDOs, mortgage-backed securities, CMOs and other securities. For securities classified as Level 2, valuation is based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques, such as cash flow models, for which all significant assumptions are observable in the market.
To determine the fair value of securities available for sale that are classified as level 2, cash flow models provided by a third-party pricing service and other observable inputs are utilized. The cash flow models incorporate market participant data and
knowledge of the structures of each security to develop cash flows specific to each security and apply appropriate discount rates. The discount rates are developed by determining credit spreads above a benchmark rate, such as LIBOR, and adding premiums based on a comparison of initial issuance spread to LIBOR versus a financial sector curve for recently issued debt to LIBOR. Specific securities that have increased uncertainty regarding the receipt of cash flows are discounted at higher rates due to the addition of a security-specific credit premium.
For private-label CMOs, the pricing model estimates each security’s cash flows and adjusted price based on coupon, constant prepayment rate, default rate, and required yields or spreads. A cash flow analysis is performed on each security within the CMO portfolio, regardless of the credit rating, to determine if the security has any OTTI.
The fair value of securities available for sale that are classified as Level 3 primarily include trust preferred CDOs. In the absence of observable or corroborated market data, estimates that incorporate market-based assumptions are used when such information is available. These values take into account recent market activity as well as other market observable data such as interest rate, spread and prepayment information. When market observable data is not available, the valuation of the security is subjective and may involve substantial judgment. For trust preferred CDOs, the models estimate default vectors for the underlying issuers within each CDO security, estimate expected bank failures across the entire banking system to determine the impact on each CDO and assign a risk rating to each individual issuer in the collateral pool. If a security is rated below investment grade by a credit agency, a stress test is performed to determine OTTI.
With respect to third party pricing services used to value both level 2 and level 3 securities, valuations are reviewed by management noting the extent to which the pricing service is gathering observable market information as opposed to using unobservable inputs. Review and oversight procedures are performed to ensure that securities available for sale are properly classified in the fair value hierarchy.
Residential mortgage servicing rights
The estimated fair value of residential MSRs is obtained through an independent third party analysis of future cash flows. The evaluation utilizes assumptions market participants would use in determining fair value including market discount rates, prepayment speeds, servicing income, servicing costs, default rates and other market driven data, as well as the market’s perception of future interest rate movements. MSRs are classified as Level 3.
With respect to third party pricing services used to value MSRs, valuations are reviewed by management noting the extent to which the pricing service is gathering observable market information as opposed to using unobservable inputs. Review and oversight procedures are performed to ensure that MSRs are properly classified in the fair value hierarchy.
Derivative financial instruments
The fair values of derivative financial instruments are determined based on quoted market prices, dealer quotes and internal pricing models that are primarily sensitive to market observable data.
The following table presents quantitative information regarding the assumptions used for valuing Level 3 assets.
1Other level 3 securities totaling $1.6 million are valued based on data provided by the issuer.
Changes in Fair Value Measurement Levels
The table below includes changes in Level 3 fair value measurements based on the hierarchy levels previously discussed. The gains (losses) in the following table may include changes to fair value due in part to observable factors that may be part of the valuation methodology.
1Level 3 impaired security with a cost basis of less that $100 thousand was sold during the year ended September 30, 2011 with a gain of $1.4 million recognized in earnings.
During the year ended December 31, 2012 and quarter ended December 31, 2011 First Financial transferred certain CMOs from Level 3 to Level 2 as the observable market activity increased. There were no gains or losses as a result of the transfers.
Assets Recorded at Fair Value on a Nonrecurring Basis
The table below presents the assets measured at fair value on a nonrecurring basis categorized by the level of inputs used in the valuation of each asset and the corresponding realized loss.
Loans held for sale
Loans held for sale is comprised of residential mortgage loans originated for sale in the secondary market. The fair value of residential mortgage loans originated for sale in the secondary market is based on purchase commitments or quoted prices for the same or similar loans and classified as nonrecurring Level 2.
Impaired loans, net of specific allowance
Impaired loans are evaluated and valued at the time the loan is identified as impaired, at the lower of cost or fair value. These loans are generally collateral dependent and their value is measured based on the value of the collateral securing these loans. Certain assumptions and unobservable inputs are currently being used by appraisers, therefore qualifying these assets as Level 3. Specific reserves for impaired loans were $1.0 million, $1.4 million and $1.5 million at December 31, 2012, December 31, 2011, and September 30, 2011, respectively.
Other repossessed assets acquired
Other repossessed assets acquired in settlement of loans are recorded at the lower of the principal balance of the loan or fair value of the property less estimated selling expenses. Certain assumptions and unobservable inputs are currently being used by appraisers, therefore qualifying these assets as Level 3.
Assets Not Recorded at Fair Value
Additionally, accounting standards require the disclosure of the estimated fair value of financial instruments that are not recorded at fair value. The following table presents the financial instruments not recorded at fair value categorized by the level of inputs.
1Excludes impaired loans
A financial instrument is defined as cash, evidence of an ownership interest in an entity or a contract that creates a contractual obligation or right to deliver or receive cash or another financial instrument from a second entity. For the financial instruments that
First Financial does not record at fair value, estimates of fair value are calculated based on the value of one trading unit without regard to any premium or discount that may result from concentrations of ownership of a financial instrument, possible tax ramifications, estimated transaction costs that may result from bulk sales or the relationship between various financial instruments. No readily available market exists for a significant portion of First Financial’s financial instruments. Fair value estimates for these instruments are based on current economic conditions, currency and interest rate characteristics, loss experience and other factors. Many of these estimates involve uncertainties and matters of significant judgment and cannot be determined with precision. Therefore, the calculated fair value estimates in many instances cannot be sustained by comparison to independent markets and, in many cases, may not be realizable in a current sale of the instrument. In addition, changes in assumptions could significantly affect these fair value estimates. The following methods and assumptions were used by First Financial in estimating the fair value of these financial instruments.
Cash and cash equivalents
For these short-term instruments, the carrying amounts are a reasonable estimate of their fair values.
Securities held to maturity
The fair value of securities classified as held to maturity is based on quoted prices for similar assets.
Nonmarketable securities
The carrying amount of FHLB and Federal Reserve stock is used to approximate the fair value of these securities as they are not readily marketable, are recorded at cost (par value) and are evaluated for impairment based on the ultimate recoverability of the par value. First Financial considers positive and negative evidence, including the profitability and asset quality of the issuer, dividend payment history and recent redemption experience, when determining the ultimate recoverability of the par value. First Financial believes its investments in FHLB and Federal Reserve stock are ultimately recoverable at par.
Net loans
The fair value of net loans is estimated based on discounted cash flows. The cash flows take into consideration current portfolio interest rates and repricing characteristics as well as assumptions relating to prepayment speeds. The discount rates take into consideration the current market interest rate environment, a credit risk component based on the credit characteristics of each loan portfolio and a liquidity premium reflecting the liquidity or illiquidity of the market. The carrying amount of accrued interest receivable approximates fair value.
FDIC indemnification asset, net
The fair value is determined by the projected cash flows from the FDIC loss-share agreements based on expected reimbursements for losses at the applicable loss sharing percentages pursuant to the terms of the loss-share agreements. Cash flows are discounted to reflect the timing and receipt of the loss-sharing reimbursements from the FDIC.
Deposits
The fair value of core deposits, which include checking, savings and money market accounts, are, by definition, equal to the amount payable on demand as of the valuation date (i.e. their carrying amounts). Fair values for time deposits are based on the discounted value of contractual cash flows at current interest rates. The estimated fair value of deposits does not take into account the value of First Financial’s long-term relationships with depositors, commonly known as core deposit intangibles, which are separate intangible assets and not considered financial instruments. The carrying amount of accrued interest payable approximates fair value.
Advances from FHLB and long-term debt
The fair value of these financial instruments is estimated using observable market prices and by discounting future cash flows using current interest rates for similar financial instruments.
FDIC true-up liability
The fair value of the FDIC true-up liability is determined by the projected cash flows based on expected payments for recoveries in accordance with the Plantation loss share agreement with the FDIC. Cash flows are discounted to reflect the timing and payment of recoveries due to the FDIC.
NOTE 18. Discontinued Operations
On May 26, 2011, First Financial entered into a definitive agreement with Hub International, LLC. (“Hub”) whereby Hub agreed to acquire all of the stock of First Southeast. On June 1, 2011, First Financial completed the stock sale in exchange for $38.0
million in cash. First Financial will receive no additional consideration from the sale of First Southeast. In addition, effective September 30, 2011, First Financial completed the sale of Kimbrell, its managing general insurance agency subsidiary, to Burns & Wilcox, Ltd., a Kaufman Financial Group company (“Burns & Wilcox”). Burns & Wilcox acquired substantially all of the assets of Kimbrell in exchange for cash. In addition, there is a provision for a potential earn-out payable over two years based on specific annual growth goals.
First Southeast and Kimbrell had experienced a decline in revenues and returns over the last several years, primarily the result of the recessionary economy and a generally soft insurance market, which negatively impacted insurance premium pricing. In addition, First Financial evaluated its future capital requirements in light of upcoming regulatory capital changes resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act and determined that re-deploying the capital supporting the insurance agencies to support the banking operations would increase overall value and returns to shareholders.
Both sales were completed prior to, or effective as of, September 30, 2011. As a result, there were no assets or liabilities for the insurance operations in the Consolidated Balance Sheets presented in the Financial Statements.
The operating results of discontinued operations for the years ended September 30, 2011 and 2010 were as follows.
The income tax expense in 2011 includes $4.5 million related to the recognition of deferred tax liabilities due to the sale of First Southeast.
NOTE 19. First Financial Holdings, Inc. (Parent Company Only) Condensed Financial Information
NOTE 20. Quarterly Results (Unaudited)
The following table presents summarized quarterly financial data.
NOTE 21. Selected Financial Data for Transition Period
FIRST FINANCIAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
The reclassifications noted above were the result of corrections of an immaterial misstatement related to the bulk sale of a pool of loans and OREO, which was executed during the quarter ended December 31, 2011. The original presentation did not correctly report the migration of loans converting to OREO in the bulk loan pool prior to sale execution. The correction in classifications between components of the cash flow statement resulted in the following adjustments:
·Cash from other operating activities decreased $3.8 million from $(5.1) million cash used as originally presented.
·Net cash used in operating activities was $(0.7) million as originally presented and increased $3.8 million to net cash provided by operating activities of $3.1 million.
·Cash from the net increase in loans & leases increased $4.1 million from $(34.3) million as originally presented.
·Cash from sales and payoffs of other real estate increased $0.3 million from $6.0 million, as originally presented.
·Net cash provided by investing activities decreased $3.8 million from $53.7 cash provided as originally presented.
The effects of the correction to appropriately classify activity on the Consolidated Statements of Cash Flows had no impact to the Consolidated Balance Sheets, Statements of Operations, Statements of Comprehensive Income or Statements of Changes in Shareholders’ Equity as of and for the quarter ended December 31, 2011.
NOTE 22. Subsequent Events
On February 19, 2013, First Financial entered into an Agreement and Plan of Merger (the “Agreement”) with SCBT Financial Corporation, a South Carolina corporation (“SCBT”). Subject to the terms and conditions set forth in the Agreement, First Financial plans to merge with and into SCBT (the “Merger”), with SCBT continuing as the surviving corporation in the Merger. The Agreement also provides that, immediately following the closing of the Merger, First Federal will merge with and into SCBT, a South Carolina banking corporation and a wholly owned subsidiary of SCBT (“SCBT Bank”), with SCBT Bank continuing as the surviving bank in the merger (the “Bank Merger”). At the closing, the holding company name will be First Financial Holdings, Inc. The Agreement was unanimously approved by the Board of each of First Financial and SCBT.
Subject to the terms and conditions of the merger Agreement, at the closing of the Merger, each outstanding share of First Financial common stock will be converted into the right to receive 0.4237 shares of common stock of SCBT, subject to the payment of cash in lieu of fractional shares. Each outstanding share of Series A Preferred Stock, will be converted into the right to receive one share of preferred stock of SCBT, to be designated Series A Fixed Rate Cumulative Perpetual Preferred Stock and having such rights, preferences and privileges as are not materially less favorable than the rights, preferences and privileges of First Financial’s Series A Preferred Stock.
Pursuant to the Agreement, at the closing SCBT, will designate five members of First Financial’s Board to join the Boards of SCBT and SCBT Bank.
The Agreement contains customary representations and warranties from First Financial and SCBT, and each party has agreed to customary covenants, including, among others, covenants relating to (1) the conduct of First Financial’s businesses during the interim period between the execution of the Agreement and the closing, (2) each party’s obligations to facilitate its shareholders’ consideration of, and voting upon, the Agreement and the Merger, (3) the recommendation by the board of directors of each party in favor of approval of the Agreement and the Merger by its shareholders, (4) each party’s non-solicitation obligations relating to alternative business combination transactions, and (5) SCBT’s obligation to establish an advisory board consisting of, among others, the current directors of First Financial who will not serve on SCBT’s Board and who enter into advisory board member agreements with SCBT (the “Advisory Board Member Agreements”).
The Merger is expected to close in the third quarter of 2013, subject to certain customary conditions, including (1) approval of the Agreement by First Financial’s shareholders and by SCBT’s shareholders, (2) receipt of required regulatory approvals without the imposition of a condition that would have or be reasonably likely to have a material adverse effect on First Financial or SCBT, (3) the absence of any law or order prohibiting the consummation of the Merger, (4) approval of the listing on the NASDAQ Global Select Market of SCBT common stock to be issued in the Merger and (5) the effectiveness of the registration statement for SCBT common stock to be issued in the Merger. Each party’s obligation to complete the Merger is also subject to certain additional customary conditions, including (1) subject to certain exceptions, the accuracy of the representations and warranties of the other party, (2) performance in all material respects by the other party of its obligations under the Agreement, and (3) receipt by such party of an opinion from its counsel to the effect that the Merger will qualify as a reorganization within the meaning of the Internal Revenue Code of 1986, as amended. SCBT’s obligation to complete the Merger is further subject to additional customary conditions, including (1) the imminent occurrence of the Bank Merger, (2) the execution and delivery of an Advisory Board Member Agreement by each of the then-sitting members of the Board of First Financial who desires to join the advisory board, and (3) the transfer of First Financial’s loss share agreements with the FDIC from First Financial to SCBT without adverse modification or amendment to such contracts and without cost to SCBT.
The Agreement provides certain termination rights for both First Financial and SCBT and further provides that upon termination of the Agreement under certain circumstances, First Financial or SCBT, as applicable, will be obligated to pay the other party a termination fee of $14.9 million. The foregoing description of the Merger and the Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which is incorporated as Exhibit 2.3 to this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. An evaluation of First Financial’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Act”)) was carried out as of December 31, 2012 under the supervision and with the participation of its Chief Executive Officer, Chief Financial Officer and several other members of its senior management. The Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2012, the disclosure controls and procedures were effective in ensuring that the information First Financial is required to disclose in the reports it files or submits under the Act is (i) accumulated and communicated to management (including the Chief Executive Officer and Chief Financial Officer) to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
(b) Management’s Report on Internal Control Over Financial Reporting. First Financial’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. First Financial’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of published financial statements in accordance with generally accepted accounting principles.
First Financial’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, has assessed the effectiveness of internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has concluded that, as of December 31, 2012, First Financial’s internal controls over financial reporting were effective based on that framework.
First Financial does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent all errors and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within First Financial have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns in controls or procedures can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
Grant Thornton LLP, First Financial’s independent registered public accounting firm, issued a report on the effectiveness of First Financial’s internal control over financial reporting as of December 31, 2012, which is included herein.
Attestation Report of Independent Registered Public Accounting Firm.
The attestation report required under this Item 9A is contained in Item 8 of Part II of this Annual Report on Form 10-K under the heading “Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting.”
(c) Changes in Internal Control over Financial Reporting. There were no changes in First Financial’s internal controls over financial reporting that occurred during the quarter ended December 31, 2012, that have materially affected, or are reasonably likely to materially affect, First Financial’s internal controls over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Board of Directors
First Financial Holdings, Inc.’s (“First Financial’s”) Board of Directors (the “Board”) currently consists of 12 members. The Board is divided into three classes with terms of three years, with approximately one-third of the directors elected each year. The following provides information regarding each of our directors. Each of the directors is also a director of First Federal.
Directors With Terms Expiring at the Next Shareholders’ Meeting at which Directors are Elected
The following provides information regarding each of our directors whose term expires at the next shareholders’ meeting at which directors are elected, including business experience for the past five years. Each of these directors, except for Ronnie M. Givens, has been nominated for reelection. The nominees for election will serve for three-year terms or until their respective successors have been elected and qualified.
Mr. Givens, whose term expires at the next shareholders’ meeting at which directors are elected, has not been re-nominated because he has reached the mandatory retirement age based on First Financial’s Bylaws. As a result, Mr. Givens will cease to be a director after the next shareholders meeting at which directors are elected. Mr. Givens has served as a director of First Financial since 2004 and First Federal since 2010.
PAULA HARPER BETHEA, 57, has served as a director of First Financial and First Federal Bank (“First Federal”) since 1996 and has served as Chairman since 2010. She was one of nine South Carolinians chosen in 2001 to establish the South Carolina Education Lottery and now serves as its Executive Director.
PAUL G. CAMPBELL, JR., 66, has served as a director of First Financial and First Federal since 1991. Mr. Campbell is the retired President of the Southeast Region for Alcoa Primary Metals and continues to work for Alcoa as a consultant. He was initially elected to the South Carolina Senate in November 2007, continues to serve in the Senate and was recently re-elected in November 2012. He represents District 44 in Berkeley County.
SUSAN R. LEADEM, 48, has served as a director of First Financial and First Federal since February 2013. Ms. Leadem has been a Chartered Financial Analyst for twenty years and has devoted her business career to the analysis of financial institutions. She began her career in Atlanta in 1986 with the Robinson-Humphrey Company. In 1994, she re-located to London, England with Goldman Sachs International. In 1996, she became the first female outside of the United States to gain the title of Managing Director of Goldman Sachs. In 2004, she re-located to Charleston and was co-founding partner of Charleston-based Peninsula Capital Partners, LLC. If elected, First Financial anticipates that Ms. Leadem will join the Audit Committee and be designated as the “audit committee financial expert” upon Mr. Givens' retirement.
RONNIE M. GIVENS, 70, has served as a Director of First Financial since 2004 and First Federal since 2010. Mr. Givens is a Certified Public Accountant with approximately 40 years of professional experience. He is a director of Dixon Hughes Goodman LLP, a certified public accounting and business advisory firm.
Directors With Terms Ending in 2014
The following provides information regarding each of our directors whose term expires in 2014, including business experience for the past five years.
THOMAS J. JOHNSON, 62, is currently Vice Chairman and has served as a director of First Financial since 1998 and of First Federal since 2002. He previously served as a director of Peoples Federal Savings and Loan Association (“Peoples”), an institution acquired by First Financial and later merged into First Federal. He is President, Chief Executive Officer and Owner of F & J Associates, a company that owns and operates automobile dealerships in the southeastern United States and the U.S. Virgin Islands.
D. KENT SHARPLES, 69, has served as a director of First Financial since 1992 and of First Federal since 2009. He previously served as a director of Peoples. He has served as the President of CEO of the Business Alliance in Daytona Beach, Florida since February 2011. The Alliance is a privately funded economic development organization. Dr. Sharples is the past President of Daytona State College, Daytona Beach, Florida.
B. ED SHELLEY, JR., 60, has served as a director of First Financial since 2011 and First Federal since 2002. He previously served as director of Peoples. He is engaged in the private practice of medicine, specializing in radiology. Dr. Shelley is involved in several businesses outside of the practice of radiology, including real estate development and pharmaceutical and software sales.
HUGH L. WILLCOX, JR., 66, has served as a director of First Financial since 2010 and First Federal since 2002. He previously served as a director of Peoples. Mr. Willcox is a Senior Partner in the law firm of Willcox, Buyck, and Williams, PA, of Florence and Surfside Beach, South Carolina.
Directors With Terms Ending in 2015
The following provides information regarding each of our directors whose term expires at the 2015 Annual Meeting of Shareholders, including business experience for the past five years.
R. WAYNE HALL, 62, is President and Chief Executive Officer of First Financial and First Federal. He has served as a director of First Financial since 2011 and First Federal since 2009. Mr. Hall was initially employed by First Federal and First Financial on December 1, 2006 as Executive Vice President, Financial Management. He subsequently served as the Principal Financial and Accounting Officer and Chief Financial Officer of First Financial and as First Federal’s Chief Operating Officer. He is a certified public accountant. Mr. Hall has over 35 years of audit and financial institutions experience, having served in several senior financial positions, including Executive Vice President and Chief Risk Officer of Provident Bank, Baltimore, Maryland.
JAMES L. ROWE, 69, has served as a director of First Financial since 2001 and First Federal since 2012. From 2001 until its sale during 2011, he served as President of First Southeast Insurance Services, Inc. and Kinghorn Insurance Services, Inc., each former subsidiaries of First Financial.
RICHARD W. SALMONS, JR., 53, has served as a director of First Federal since 2001 and First Financial since 2011. Mr. Salmons is the President and Chief Executive Officer of Salmons Dredging Corporation, a marine construction company which also provides commercial diving and marine services in the southeastern United States.
HENRY M. SWINK, 67, is President of McCall Farms, Inc., a food processing company that manufactures and markets canned fruits and vegetables throughout the Southeast. Mr. Swink has served as a director of First Financial since 2002 and First Federal since 2010. From 1996 until 2002, he served as a director of Peoples Federal Savings and Loan Association, an institution acquired by First Financial and later merged into First Federal.
Executive Officers
Other than Mr. Hall, whose information appears above in the list of directors, the following information is provided for those officers currently designated as executive officers by the Board. Ages presented are as of December 31, 2012.
MARK R. ADELSON, 58, is Senior Vice President and Treasurer of First Financial and First Federal. He began his employment with First Federal in 1996 and served as a Senior Vice President of Investments until 2007.
JOSEPH W. AMY, 63, is Executive Vice President and Chief Credit Officer of First Financial and First Federal. He began his employment with First Financial and First Federal in September 2009. Prior to joining First Financial, Mr. Amy had 35 years of financial institution experience, having started his career in 1974 at Mellon Bank, N.A. and going on to serve in senior positions in a number of regional and community banks.
RICHARD A. ARTHUR, 40, is Executive Vice President, Retail Banking, of First Federal. He began his employment in January 2010. Prior to his employment with First Federal, he served as Senior Vice President with Bank of America from 1996 to 2009 where he oversaw sales, service and operations for 11 consumer markets and 335 branches in the Southeast.
SUSAN A. BAGWELL, 49, is Executive Vice President, Human Resources, of First Financial and First Federal. She began her employment with First Federal in 1985 as a Human Resources Associate.
BLAISE B. BETTENDORF, 50, is Executive Vice President and Chief Financial Officer of First Financial and First Federal. She began her employment with First Financial and First Federal in January 2010 and served as Executive Vice President, Chief Accounting Officer until her promotion to CFO in May 2010. Most recently, Ms. Bettendorf was Senior Vice President and Chief Financial Officer at Carolina Commerce Bank in Gastonia, North Carolina from August 2008 until its sale in October 2009. She is a licensed CPA in both South and North Carolina.
ROBERT L. DAVIS, 59, is Executive Vice President and General Counsel of First Financial and First Federal. He began his employment with First Financial and First Federal in July 2010. Prior to joining First Financial and First Federal, Mr. Davis was Managing Director and General Counsel of Provident Bankshares Corporation and Provident Bank in Baltimore, Maryland from 1991 through 2009. He has been engaged in the practice of law for a total of 34 years, with 30 of them in the financial services industry.
JOHN N. GOLDING, 45, is Executive Vice President, Commercial Banking, of First Federal. He began his employment with First Federal in March 2010. Prior to his employment, he served as Senior Vice President with Wachovia/Wells Fargo with responsibility as a Regional Commercial Banking Relationship Manager from 1990 to 2010.
J. DALE HALL, 64, is Executive Vice President and Chief Banking Officer of First Financial and First Federal. He began his employment with First Financial and First Federal in June 2009, having previously worked in the North Carolina region as an Executive Vice President. Prior to his employment, he was employed with Bank of America for 38 years where he led specialized sales teams in Commercial Middle Market, Government and Non-Profit Healthcare.
MICHAEL NEAL HELMUS, 46, is Executive Vice President and Chief Risk Officer of First Financial and First Federal. He began his employment with First Financial and First Federal in 2011. He has 16 years of financial institution experience, including serving as Audit Manager for U.S. Bancorp from 2009 to 2011. He served as Director of Internal Control and Risk Management for Provident Bank in Baltimore, Maryland from 2006 to 2009.
KELLEE S. MCGAHEY, 33, is Executive Vice President, Marketing, of First Federal. She began her employment in September 2010. She has 12 years of multi-dimensional marketing experience specifically, brand development, advertising, public relations, event organization and interactive media.
EARTHA C. MORRIS, 55, is Executive Vice President and Chief Operations Officer of First Federal. She began her employment with First Federal in March 2010. Prior to her employment with First Federal, she served as Executive Vice President and Chief Operating Officer at Congressional Bank in Bethesda, Maryland from 2007 to 2010.
SANDRA LEE PETROWSKI, 43, is Senior Vice President and Controller of First Financial and First Federal. She began her employment with First Financial and First Federal in August 2010. Prior to her employment with First Financial and First Federal, she had 24 years of financial institution experience, having started her career in 1986 at Citizens Republic Bancorp in Flint, Michigan.
Timothy B. Sease, 47, is Executive Vice President, Wealth Management, of First Financial and First Federal. He began his employment with First Financial in 1995. He is responsible for the Trust Division of First Federal and is President and CEO of First Southeast Investor Services, the broker/dealer subsidiary of First Financial.
DANIEL S. VROON, 44, is Executive Vice President, Wealth Management of First Financial and First Federal. He began his employment with First Federal in April 2009. He is responsible for the Premier Relationship Group and American Pension Division of First Federal, and is the President of the registered investment advisor subsidiary of First Financial. Previously, he served as Senior Vice President, Premier Banking and Investments Market Manager (South Carolina) for Bank of America.
Family Relationships
There are no family relationships among any of the directors of First Financial.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires that First Financial’s executive officers, directors and persons who own more than 10% of any registered class of First Financial’s equity securities file reports of ownership and changes in ownership with the Securities and Exchange Commission. Executive officers, directors and greater than 10% stockholders are required by regulation to furnish First Financial with copies of all Section 16(a) reports they file.
Based solely on First Financial’s review of copies of the reports it has received and written representations provided to it from the individuals required to file the reports, First Financial believes that each of its executive officers and directors has complied with applicable reporting requirements for transactions in First Financial common stock during the 2012 Calendar Year, with the exception of Executive Vice President Susan A. Bagwell, who made one late filing reporting a single transaction.
Code of Ethics
First Financial has adopted a Code of Business Conduct and Ethics that is designed to ensure that First Financial’s directors, officers and employees meet the highest standards of ethical conduct. The Code of Business Conduct and Ethics addresses conflicts of interest, the treatment of confidential information, general employee conduct and compliance with applicable laws, rules and regulations. In addition, the Code of Business Conduct and Ethics is designed to deter wrongdoing and promote honest and ethical conduct, the avoidance of conflicts of interest, full and accurate disclosure and compliance with all applicable laws, rules
and regulations. The Code of Business Conduct and Ethics is available on First Financial’s corporate website located at www.firstfinancialholdings.com. The information contained on the website is not incorporated by reference in, or considered to be a part of, this report.
Audit Committee Financial Expert
The Audit Committee is responsible for providing oversight of First Financial’s financial reporting process, systems of internal accounting and financial controls, internal audit function, annual independent audit and the compliance and ethics programs established by management and the Board. The Audit Committee selects the independent registered public accounting firm and meets with them to discuss the results of the annual audit and any related matters. The Board has determined that Mr. Givens, who currently serves as the chair of the Audit Committee, is an “audit committee financial expert.” Mr. Givens is independent under the listing standards of the NASDAQ Stock Market. As noted above, Mr. Givens’ term as a director expires at the next shareholders meeting at which directors are elected as a result of him reaching the mandatory retirement age under First Financial’s Bylaws. Therefore, after the Annual Meeting, Mr. Givens will cease to be a director and the Board will appoint a new chair of the Audit Committee and designate a new audit committee financial expert. If elected, First Financial anticipates that Ms. Leadem will join the Audit Committee and be designated as the “audit committee financial expert” upon Mr. Givens’ retirement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Report of the Compensation/Benefits Committee
The following report of the Compensation/Benefits Committee should not be deemed filed or incorporated by reference into any other document, including First Financial's filings under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent First Financial specifically incorporates this Report into any such filing by reference.
The Compensation/Benefits Committee has reviewed and discussed the following Compensation Discussion and Analysis with management and its advisors and, based on such review and discussions, the Compensation/Benefits Committee recommended to the Board that the Compensation Discussion and Analysis be included in this report.
All Senior Executive Officer compensation plans are measured by specific performance targets, reviewed and approved or disapproved by the Compensation/Benefits Committee of the Board. As a result of the current economic environment, the Compensation/Benefits Committee did not consider any specific performance targets for the 2012 Calendar Year and no payments were made to the Named Executive Officers during the 2012 Calendar Year under First Financial’s incentive compensation plans. However, on January 24, 2013, each of the Named Executive Officers (as defined in the “Compensation Discussion and Analysis” section below) received a $20,000 discretionary cash bonus based on performance from March 30, 2012 through December 31, 2012.
In addition, First Financial has in place agreements that contain a payback provision which requires the Named Executive Officer to return to First Financial any bonus amount if it is subsequently discovered that the bonus payment was calculated as a result of misstated financial information. Finally, all employee compensation plans are reviewed and approved or disapproved by executive management on an annual basis and, if appropriate, presented to the Compensation/Benefits Committee for its review and approval or disapproval. For plans that are submitted to the Compensation/Benefits Committee for review, the Committee attempts to identify and eliminate any material risk that it believes is detrimental to First Financial or that would cause intentional manipulation of earnings to First Financial.
Risk Policy Framework
First Financial’s adherence to appropriate risk tolerances is ensured by First Financial’s system of internal controls and validated by independent groups, including Internal Audit and Loan Review and, to some extent, the external auditors. All material business plans are reviewed for excessive risks. Incentive compensation plans and performance goals are tied to the risk-assessed business plans.
In addition, there are controls around employee incentive plans (including the senior Executive Officer plans) that are designed to effectively discourage and limit unnecessary and excessive risk-taking. All employee incentive plans allow for management discretion (or Compensation/Benefits Committee discretion in the case of the senior Executive Officer plans) to reduce or eliminate any award. Every incentive plan is documented using a standard template and is reviewed annually by a team that consists of representatives from the business segment, Finance, Human Resources, Risk Management and any other group deemed to be appropriate, with final approval by the appropriate executive officers. As further described below, the Compensation/Benefits Committee reviews and approves all senior Executive Officer plans, award opportunities and performance goals.
Senior Executive Officer Compensation Plans
The Senior Executive Officer compensation plans operated within the constraints of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program (the “CPP”) limits until March 29, 2012 when such limits ceased to be applicable to First Financial because the US Department of Treasury (the “Treasury”) sold all of its 65,000 shares of Fixed Rate Cumulative Perpetual
Preferred Stock, Series A (“Series A Preferred Stock”) of First Financial to private investors through a registered public offering at $873.51 per share. The CPP constraints included extensive restrictions on bonus or other incentive payments to executives. The Compensation/Benefits Committee believes, however, that First Financial’s standard compensation programs for executives do not encourage unnecessary and excessive risk even before application of the CPP limits. Annual incentive awards and long-term incentive awards are closely linked to First Financial’s financial performance compared with First Financial’s strategic plans for each plan year or plan cycle. The opportunity to earn annual incentive awards in cash and long-term awards in a combination of cash and stock provides a mix of variable compensation that integrates First Financial’s short-term and long-term goals and helps to attract and retain executive officers. Due to the impact of the CPP constraints until March 29, 2012, annual cash incentive awards for the senior Executive Officers under the Management Performance Compensation Plan have been severely limited or prohibited. Equity awards under the 2007 Equity Incentive Plan were also restricted.
Employee Compensation Plans
In addition to the incentive plans in which the senior Executive Officers participate, First Financial has multiple incentive plans which reward measurable performance across First Financial’s major business segments. The Compensation/Benefits Committee believes that the features of these incentive compensation plans, alone or combined with the systems of controls in place, do not encourage unnecessary or excessive risk and do not encourage the manipulation of reported earnings to enhance the compensation of any employee. In particular, there is a multi-level approval process before any amounts are paid out under any of these incentive plans. In addition, persons having compliance, risk, credit quality, quality assurance and finance roles are not compensated on the same results as the business teams they support. Instead, their incentives are tied to corporate goals under the Management Performance Compensation Plan. First Financial has integrated a recoupment policy into every incentive compensation plan pursuant to which First Financial can withhold or recoup all or a portion of any incentive payment if it is determined that an unnecessary or excessive risk was taken that, had it not, would have resulted in a smaller or no payout. First Financial has had a recoupment policy for senior Executive Officer incentive plans in effect since 2009.
Finally, the Compensation/Benefits Committee certifies that, as required pursuant to its participation in the Treasury’s TARP, with respect to the period from October 1, 2011 through March 29, 2012 (the “TARP Period”), it has reviewed with First Financial’s Chief Risk Officer the senior Executive Officers’ incentive compensation arrangements and made reasonable efforts to ensure that any such arrangements do not encourage the senior Executive Officers to take unnecessary and excessive risks that threaten the value of First Financial. In addition, with respect to the TARP Period, the Compensation/Benefits Committee has reviewed with First Financial’s Chief Risk Officer all compensation plans for all levels of employees, has made reasonable efforts to ensure that such arrangements do not encourage any employee to take unnecessary or excessive risks that threaten the value of First Financial and has made reasonable efforts to eliminate all features that would encourage the manipulation of reported earnings of First Financial to enhance the compensation of any employee.
THE COMPENSATION/BENEFITS COMMITTEE
D. Kent Sharples, Chairman
Paula Harper Bethea
Paul G. Campbell, Jr.
Thomas J. Johnson
B. Ed Shelley, Jr.
Hugh L. Willcox, Jr.
Compensation Discussion and Analysis
The following Compensation Discussion and Analysis may contain statements regarding future individual and First Financial performance targets or goals. First Financial has disclosed these targets or goals in the limited context of its compensation programs and, therefore, readers should not take these statements to be statements of management’s expectations or estimates of results or other guidance. First Financial specifically caution investors not to apply such statements to other contexts.
As noted above, on December 20, 2011, First Financial’s Board approved an amendment to Article VIII of First Financial’s Bylaws to change its fiscal year-end from September 30th to December 31st of each year. The change was effective December 31, 2011 and, the current fiscal year began on January 1, 2012 and ended on December 31, 2012. As a result of the change in fiscal year end, there was a three-month transition period which began on October 1, 2011 and ended on December 31, 2011. In this report, the period from January 1, 2012 to December 31, 2012 is referred to as the “2012 Calendar Year” and the three-month transition period from October 1, 2011 to December 31, 2011 as the “Transition Period.”
This Compensation Discussion and Analysis is intended to assist readers to understand First Financial’s compensation programs. This section presents and explains the philosophy underlying First Financial’s compensation strategy and fundamental elements of compensation paid to its chief executive officer (“CEO”), chief financial officer (“CFO”) and other individuals included in the Summary Compensation Table (collectively, the “Named Executive Officers”) for the 2012 Calendar Year. This Compensation Discussion and Analysis addresses the following:
·Compensation philosophy and the objectives of the compensation programs;
·What the compensation programs are designed to reward;
·Process for determining executive officer compensation, including:
·the role and responsibility of the Compensation/Benefits Committee;
·the role of the CEO and other Named Executive Officers;
·the role of compensation consultants;
·benchmarking and other market analyses; and
·Elements of compensation provided to the executive officers, including a discussion of;
·the purpose of each element of compensation;
·why First Financial elects to pay each element of compensation;
·how First Financial determines the levels or payout opportunities for each element; and
·decisions on final payments for each element and how these align with performance; and
·Other compensation and benefit policies affecting the executive officers, including the impact of compensation plans on First Financial’s risks.
Compensation Philosophy and the Objective of the Compensation Programs
First Financial seeks a compensation foundation rubric that embraces best practices including, but not limited to, the following:
·Since 2009, First Financial has had a payback policy to help address the risk to First Financial associated with incentive compensation. Pursuant to this policy, if payouts from any incentive plan are made based on inaccurate measurements of results, First Financial will attempt to recover the awards from the employee.
·First Financial maintains a policy that prohibits our directors, Named Executive Officers and other key Executive Officers from hedging the economic interest in First Financial securities that they hold.
·First Financial engages an independent compensation consultant that does not provide any services to management and that had no prior relationship with management prior to their engagement.
·First Financial maintains a strong risk management program, which includes its Compensation/Benefits Committee’s significant oversight of the ongoing evaluation of the relationship between our compensation programs and risk.
In following such best practices, First Financial has designed a compensation program to accomplish the following objectives:
·attract and retain highly qualified executive officers and management team members;
·align the interests of the employees with First Financial’s strategic goals; and
·motivate performance toward the achievement of short-term and long-term goals.
To meet these objectives, the Compensation/Benefits Committee, with final approval from the Board, has structured the compensation programs in the following manner:
·an appropriate balance between base pay, short-term incentives, long-term incentives and benefits that provides total compensation within the range of the market median;
·base compensation levels comparable and competitive within the range of the market median of a peer group;
·annual incentive compensation that varies in a manner consistent with the achievement of individual performance objectives, where appropriate, and a broad set of corporate objectives related to the risk-adjusted financial results of First Financial;
·long-term compensation (equity) based on the achievement of longer-term financial and strategic performance goals; and
·executive benefits that are meaningful, competitive and comparable to those offered by similar organizations.
What The Compensation Programs Are Designed To Reward
In designing and administering executive compensation programs, the Board strives to maintain an appropriate balance across all of the various compensation elements, realizing that some objectives may from time-to-time come into conflict with others. In addition, external factors, such as the unanticipated downturn in the economy occurring during 2008 and economic insecurities continuing into 2012 or legislative changes impacting executive compensation programs, may impact the effectiveness of existing approaches to executive compensation. Such events require a careful reconsideration of existing approaches and, on an annual basis, the Compensation/Benefits Committee, with final approval from the Board, may make decisions and adjustments to future compensation programs to maintain the strategic objectives of executive compensation.
Key elements of compensation for the executive officers typically include base salary, 401(k) plan participation, profit sharing, annual cash incentive awards, equity-based awards and other fringe benefits. Our compensation program uses different components to reward different performance considerations. Base salary is provided to retain the executive and to reward the executive for basic job-related contributions and the application of his or her knowledge, experience and talent to the success of First Financial. Base salary is also a reflection of the executive’s external value in the job market and the internal value of the assigned roles and responsibilities to the success and ongoing viability of First Financial, as well as the Board’s assessment of the executive’s personal performance.
Annual incentives are provided to focus performance on key strategic short-term objectives defined and established on an annual basis emanating from First Financial’s strategic plan. These incentives are strongly linked to the success of achieving annual goals and provide the executive with cash and stock rewards commensurate with First Financial’s annual performance.
Long-term incentives reward executives for the longer-term success of First Financial. This equity-based compensation rewards executives for the long-term performance of First Financial and maintains the alignment between executive compensation levels and stockholder value. As the value of the stock held by shareholders increases, the value of the equity-based long-term incentives provided to each executive also increases.
Benefits provided to each executive officer are in line with First Financial’s broad based employee benefits which meet basic health and welfare needs. Perquisites for First Financial’s executives remain conservative as part of its plan to conserve capital.
Process for Determining Executive Officer Compensation
Role of the Compensation/Benefits Committee
The Compensation/Benefits Committee of the Board reviews First Financial’s compensation policies and benefit plans, grants equity compensation, reviews the performance of and recommends compensation for the CEO, and reviews the compensation for all members of executive management, including the Named Executive Officers. During the 2012 Calendar Year, the Compensation/Benefits Committee consisted of the following individuals: D. Kent Sharples, Paula Harper Bethea, Paul G. Campbell, Jr., Henry M. Swink, and Hugh L. Willcox, Jr. The members of the Compensation/Benefits Committee all qualify as independent, outside members of the Board in accordance with the requirements of The NASDAQ Stock Market, current SEC regulations, and Section 162(m) of the Internal Revenue Code of 1986.
The Compensation/Benefits Committee decides all compensation issues for the CEO and reviews the compensation of the other Named Executive Officers. The Compensation/Benefits Committee annually reviews the levels of compensation along with the performance results on goals and objectives relating to compensation for the Named Executive Officers. Based on this evaluation, the Compensation/Benefits Committee makes decisions related to executive compensation programs with final approval by the Board.
Additionally, the Compensation/Benefits Committee annually reviews the incentive plans and other equity-based plans. The Compensation/Benefits Committee reviews, adopts and submits to the Board any proposed arrangement or plan and any amendment to an existing arrangement or plan that provides or will provide benefits to the executive officers collectively or to an individual executive officer. The Compensation/Benefits Committee has sole authority to retain and terminate a compensation consultant or other advisor as it deems appropriate. A d etailed description of all of the Compensation/Benefits Committee’s duties and responsibilities may be found in its charter on First Financial’s website at: www.firstfinancialholdings.com.
Role of the Executive Officers
The CEO annually reviews the performance of the other Named Executive Officers, after which the CEO presents his conclusions to the Compensation/Benefits Committee. The CEO, CFO and other senior officers may also work with the Compensation/Benefits Committee to gather and compile data needed for benchmarking purposes or for other analysis conducted by the Compensation/Benefits Committee’s independent consultants and advisors. However, all decisions regarding compensation of Named Executive Officers are ultimately made by the Compensation/Benefits Committee.
Role of the Compensation Consultant
The Compensation/Benefits Committee periodically engages a compensation consultant to conduct a thorough review of the compensation for First Financial’s executive officers and to assist the Committee in making compensation decisions. In late 2010, the Compensation/Benefits Committee engaged Pearl Meyer & Partners LLC (“PM&P”) to evaluate the competitiveness of the compensation paid to First Financial’s executive officers and make recommendations for managing executive compensation in the 2011 fiscal year. For benchmarking purposes, PM&P created a peer group of 21 banks located in the Southeast and Mid-Atlantic United States with total assets of between $2.5 billion and $8 billion. Based on its review, PM&P evaluated the competitiveness of pay for First Financial’s executive officers and made recommendations for managing executive compensation in the 2011 fiscal year.
The Compensation/Benefits Committee also engaged PM&P during the 2011 fiscal year and the 2012 Calendar Year to perform certain compensation services, including conducting a risk assessment on six non-executive incentive plans, advising on outside director compensation, reviewing First Financial’s 2012 management incentive plan and 2013 Equity Incentive Plan as well as other non-compensation services, including advising the Compensation/Benefits Committee on its roles and responsibilities, corporate governance, and current compensation trends and reviewing the Compensation/Benefits Committee’s charter. PM&P did not conduct a benchmarking and peer review similar to 2010 or make recommendations for managing executive compensation in the 2012 Calendar Year. PM&P reported directly to the Compensation/Benefits Committee on all work conducted, and all services were only provided at the direction of the Compensation/Benefits Committee.
Assessment of Compensation Consultant Conflicts
In accordance with the rules and regulation of the SEC, including Item 407(e)(3)(iv) of Regulation S-K, First Financial and the Compensation/Benefits Committee recently conducted an assessment to determine whether the role of PM&P raises any conflict of interest. First Financial and the Compensation/Benefits Committee determined that no conflicts of interest exist.
Elements of Compensation
Total direct compensation includes cash, in the form of base salary and annual incentives, and long-term equity incentives. The Compensation/Benefits Committee evaluates the mix between these elements based on the pay practices of comparable companies. The Compensation/Benefits Committee strives to be fully informed in its determination of the appropriate compensation mix and award levels for the Named Executive Officers, including consideration of publicly available information and the retention of compensation consultants when deemed appropriate. With respect to the Named Executive Officers, the elements of compensation available to compensate the executive officers include the following:
·base salary;
·annual incentives;
·long-term equity awards;
·401(k);
·profit sharing;
·health and insurance benefits; and
·perquisites.
The following is a discussion of each element of compensation listed above, including the purpose of each element of compensation, why First Financial elects to pay or not to pay each element of compensation, how each element of compensation was determined by the Compensation/Benefits Committee and how each element and decisions regarding the payment of each element relates to its goals.
Base Salary
First Financial’s philosophy is to pay a base salary that is competitive with the salaries paid by comparable organizations based on each employee’s experience, duties and scope of responsibility. Generally, First Financial has chosen to position cash compensation at market median levels in order to remain competitive in attracting and retaining executive talent. First Financial does not benchmark the compensation of its named executive officers to comparable organizations, and the Compensation/Benefits Committee uses its understanding of comparable companies’ compensation only as a starting point for its decision-making.
Base salary levels are also used to determine the target amount of incentive awards and for computing 401(k) and profit sharing contributions.
The Compensation/Benefits Committee took the following factors into account when setting base salaries for First Financial’s executive officers:
·progress in meeting return on equity and other financial goals in 2012;
·the performance of First Financial’s common stock;
·mergers and acquisitions generally;
·an assessment of individual performance;
·public representation of First Financial by virtue of community and industry stature; and
·the Consumer Price Index that would otherwise be applicable for the year of evaluation.
In the following table summarizes the changes in base compensation during the 2012 Calendar Year.
The Compensation/Benefits Committee increased base compensation during the 2012 Calendar Year to reward the executives for, among other things, improving operating results, successfully acquiring substantially all of the assets of a failed bank from the FDIC, and exiting the Treasury’s CPP program.
Annual Incentive Awards
In addition to base salary, we may provide Named Executive Officers the opportunity to earn annual incentives for the achievement of short-term performance objectives during the year. Annual incentive awards are determined at the end of the fiscal year based on audited financial results as well as each individual’s contribution to that performance.
In September 1996, the Board approved the Management Performance Incentive Compensation Plan (the “MPICP”). The purpose of the MPICP is to share the rewards of excellent performance with those executives who provide knowledge and direction to First Financial and First Federal and work to accomplish results that are above expectations. Company-wide and individual standards of measurement are developed annually and approved by the Board.
First Financial’s Named Executive Officers did not receive annual incentive awards for the 2012 Calendar Year or the Transition Period. Payments awarded under the MPICP were suspended for the 2012 Calendar Year as a result of its efforts to conserve capital in the current economic environment and, therefore, no specific performance targets were approved in the 2012 Calendar Year. Further, First Financial’s participation in the CPP program prohibited the accrual or payment of annual incentives, retention awards or other incentive compensation to its five most highly compensated executive officers during the period in which the Treasury held shares of First Financial’s Series A Preferred Stock. Therefore, the Named Executive Officers were not eligible for annual incentive awards until March 29, 2012 when the Treasury completed the sale of its 65,000 shares of the Series A Preferred Stock investment in First Financial.
Corporate goals usually include return on equity, other profitability goals such as return on average assets, net interest margin, revenue growth, efficiency ratio, problem asset ratio, client satisfaction scores and volume goals, such as loan production volumes, new accounts and household growth. Typically, the executive officers have a high percentage of their goals related to corporate goals while other senior officers may have a mix such as 50% corporate and 50% individual. The CEO’s annual incentive award is the average (individual percentages earned totaled and divided by the number of team members who earned their incentives) of all goals achieved by all members of the management team.
In order for any incentives to be earned under this plan, First Financial and First Federal must meet the goals as identified in their strategic business plans. If the minimum return on equity is not achieved, no performance incentive is awarded to senior vice presidents, executive vice presidents or the CEO under the plan. If the minimum return on equity is achieved, there is a maximum payout of 65% of base pay. A matrix is utilized to determine whether the award will be 25%, 50%, 75% or 100% of the maximum payout of 65% of base pay.
Long-term Equity Incentive Compensation
The equity-based component of First Financial’s executive compensation program aligns the executives’ interests with those of First Financial’s stockholders while providing an opportunity for the executives to increase their ownership in First Financial. In 2008, First Financial adopted its 2007 Equity Incentive Plan, which provides the Compensation/Benefits Committee with the ability to issue stock options and shares of restricted stock. First Financial’s CPP participation prohibited First Financial from paying or accruing stock options during the period in which the Treasury held shares of the Series A Preferred Stock, but permitted the issuance of restricted stock. Nonetheless, the Compensation/Benefits Committee determined not to make any grants of long-term equity awards in the 2012 Calendar Year.
401(k) Savings Plan
First Financial offers a tax-qualified retirement savings plan in which all employees who have completed 30 days of service are eligible to participate. There are two types of salary deferrals - regular 401(k) deferrals and Roth 401(k) deferrals. Those who participate in the regular 401(k) can contribute up to 100% of their annual salary on a pre-tax basis, subject to limits prescribed by the Internal Revenue Code. Those who participate in the Roth 401(k) must pay current income tax on the deferral contribution.
All employee contributions and matching contributions are fully vested upon contribution. Plan participants are able to direct the investment of all contributions made by First Financial, as well as their own contributions, from among the investment funds made available under the plan. The investment funds available are a number of mutual funds, including targeted retirement date funds and First Financial common stock.
Until January 2009, First Financial made a matching contribution equal to the sum of 100% of the amount of salary reductions, including any catch-up contributions and/or any Roth elective deferrals that are not in excess of 3% of compensation, plus 50% of the amount of salary reductions that exceed 3% of compensation but not in excess of 5% of compensation. First Financial announced in January 2009 that its 401(k) savings plan contributions would be discontinued for the foreseeable future in order to conserve capital.
Profit Sharing Contributions
The discretionary profit sharing contribution under First Financial’s Profit Sharing Plan is “allocated” or divided among participants eligible to share in the contribution for the plan year. An individual’s share of the contribution will depend upon how much compensation is received during the year and the compensation received by other eligible participants. The allocation of the discretionary profit sharing contribution is determined by the following formula:
Employer’s Discretionary Contribution X Individual’s Compensation
Total Compensation of All
Participants Eligible to Share
The percentage contributed to the profit sharing plan is at the discretion of the Board. In January 2009, First Financial announced that profit sharing contributions would be discontinued for the foreseeable future in order to conserve capital.
Perquisites and Executive Benefits
First Financial’s Named Executive Officers receive health and welfare benefits, such as group medical, group dental, group life and long-term disability coverage, under plans generally available to all other full-time employees of First Financial and First Federal. They also receive personal time off and discounted loan rates under programs generally available to full-time employees. Perquisites and other benefits represent a small part of our overall compensation package and are offered only after consideration of business need. The Named Executive Officers are provided with the use of a First Financial automobile, largely for business purposes. The Named Executive Officers are also provided with relocation expenses when relocating as a result of employment with First Financial. Total costs of this perquisite and other executive benefits for the Named Executive Officers for the 2012 Calendar Year are included in the “All Other Compensation” column in the Summary Compensation Table.
Effect of 2012 Stockholder Advisory Vote to Approve Compensation of Named Executive Officers
The SEC rules adopted under the Dodd-Frank Act require First Financial to give shareholders the opportunity to vote to approve, on a non-binding, advisory basis, the compensation of the Named Executive Officers as disclosed in this report in accordance with the compensation disclosure rules of the SEC. At the 2012 Annual Meeting of Shareholders, First Financial held an advisory vote on executive officer compensation and over 95% of votes cast were for approval of executive officer compensation. First Financial has considered and appreciate this strong supporting vote by the shareholders.
Summary Compensation Table
The following table summarizes for the 2012 Calendar Year, the Transition Period, and the fiscal years ended September 30, 2011 and September 30, 2010, the current and long-term compensation for the CEO, the CFO and First Financial’s three most
highly compensated executive officers other than the CEO and CFO at the end of the 2012 Calendar Year. Each component of compensation is discussed in further detail in the footnotes following the table.
(1)Ms. Bettendorf was employed on January 25, 2010.
(2)Mr. Arthur was employed on January 19, 2010.
(3)Consists of a $20,000 discretionary cash bonus paid to the executive on January 24, 2013 based on performance from March 30, 2012 through December 31, 2012.
(4)Consists of $58,000 paid to offset a bonus forfeited from his former employer, and $40,571 to aid in the sale of his Charlotte, NC home.
(5)Consists of $10,138 auto provision, $25,434 in relocation expenses, $10,117 in tax gross up on relocation expenses, and $1,476 in life insurance.
(6)Consists of $11,324 auto provision, $24,865 in relocation expenses, $5,465 in miscellaneous expenses, and $1,637 in life insurance.
(7)Details on the amounts reported for “All Other Compensation” in 2011 are set forth in the following supplementary table:
Details on All Other Compensation Reported in the Summary Compensation Table for the Transition Period October 1, 2011 thru December 31, 2011, and for the 2012 Calendar Year
(a)The auto provision amounts represent: (i) the annual and the transition periods depreciated amount of the automobile plus maintenance during the respective periods, and does not represent the taxable income to each Named Executive Officer.
(b)The life insurance amounts represent premiums paid on behalf of the Named Executive Officers and does not represent the taxable income to each named executive officer.
Outstanding Equity Awards at Fiscal Year-End
The Outstanding Equity Awards at Fiscal Year-End Table below reflects each Named Executive Officer’s equity award holdings at December 31, 2012 on an individual award basis.
Option Exercises and Stock Vested
No stock options were exercised by the Named Executive Officers during the 2012 Calendar Year.
Pension Benefits
First Financial does not provide pension benefits to the Named Executive Officers.
Nonqualified Deferred Compensation
First Financial does not provide nonqualified deferred compensation to its Named Executive Officers.
Terms of the Change in Control Severance Agreements
Mr. R. Wayne Hall, Ms. Bettendorf, Mr. J. Dale Hall, Mr. Arthur and Mr. Amy have entered into change in control severance agreements with First Financial which provide that if any of these executives is terminated without cause or resigns for good reason within two years following a change in control (or prior to such change in control if such termination was at the request of a third party who had indicated an intention or taken steps reasonably calculated to effect a change in control and who effectuates a change in control) (as each of those terms are provided below), the executive will be entitled to the following benefits:
·A lump-sum payment equal to a pro-rata target annual bonus for the year in which the termination occurs;
·A cash amount equal to 2.99 times the sum of the executive’s annual base salary and the average of the annual bonuses paid or payable to the executive for the fiscal years ending before the date of termination, payable in approximately equal installments in accordance with First Financial’s regular payroll practices (but not a part of the employee payroll) over the 12-month period commencing on the date of termination for Messrs. R. Wayne Hall and J. Dale Hall and in a lump sum for Ms. Bettendorf, Mr. Arthur and Mr. Amy; and
·For a period of three years, continued welfare benefits on a basis that is at least favorable as was available immediately prior to the date of termination; provided, if such continued benefits cannot be provided because of tax law or other legal requirements, First Financial will pay the executive an amount equal to the executive’s cost of procuring such welfare benefits on an after-tax basis.
Under the change in control severance agreements, First Financial has the right to reduce any such payments as necessary under the Internal Revenue Code to avoid the imposition of excise taxes on the executive unless the executive would receive a larger net after-tax benefit if no reduction occurred, in which case the executive will receive the full amount of payments and benefits and be responsible for any resulting excise tax.
Under the terms of the change in control severance agreements, each executive has the right to terminate his or her employment for “good reason” if he or she determines that, within two years after a “change in control,” there has been either a material diminution in (i) his or her base compensation; (ii) his or her authority, duties or responsibilities; (iii) his or her reporting responsibilities, titles or offices; or (iv) his or her material employee benefit plans; or (i) a material change in geographic location at which he or she must be based or (ii) a material breach of the agreement by First Financial.
A “change in control” generally means (i) any person becoming a beneficial owner of at least 25% or more of First Financial’s voting stock, subject to certain exceptions; (ii) the then-current composition of the Board changing such that a majority of the Board would be made up of new directors, subject to certain exceptions; (iii) consummation of a merger or other similar transaction, subject to certain further provisions and rules; (iv) stockholders approving a plan of complete liquidation or dissolution; or (v) consummation of a sale (or a series of sales) of all or substantially all of the assets of First Financial to an unaffiliated party.
“Cause” is defined to include intentional failure to perform stated duties; conviction of a felony or any crime involving fraud, dishonesty or moral turpitude; intentional act of theft, fraud, misappropriation or malfeasance; or disqualification or bar by any regulatory authority from carrying out the duties and responsibilities of the office.
Potential Payments Upon Termination Following a Change in Control
First Financial’s change in control severance agreements are double trigger agreements such that if Messrs. R. Wayne Hall, J. Dale Hall, Arthur, Amy and Ms. Bettendorf were terminated without cause absent a change in control, then none of the executives would be entitled to any severance payments under the change in control severance agreements. The following table discloses severance payments and other benefits payable in the event of a termination without cause following a change in control as defined in each executive’s change in control severance agreement as of December 31, 2012.
1These estimated benefits shall be reduced, to the extent necessary, to cause the aggregate present value of all payments in the nature of compensation to the executive not to exceed 2.99 times the “base amount,” as defined in section 280G of the Internal Revenue Code.
Compensation Committee Interlocks and Insider Participation
The Board of First Financial has a Compensation/Benefits Committee composed of Dr. Sharples, Mrs. Bethea, Mr. Johnson, Dr. Shelley and Mr. Willcox. No member of the Compensation/Benefits Committee was an officer or employee of First Financial or any of its subsidiaries during the 2012 Calendar Year, was formerly an officer or employee of First Financial or any of its subsidiaries, or had any relationship otherwise requiring disclosure.
Director Compensation
On December 20, 2011, First Financial’s Board approved an amendment to Article VIII of First Financial’s Bylaws to change its fiscal year-end from September 30th to December 31st of each year. The change was effective December 31, 2011 and, the current fiscal year began on January 1, 2012 and ended on December 31, 2012. As a result of its change in fiscal year end, there was a three-month transition period which began on October 1, 2011 and ended on December 31, 2011. In this report, the period from January 1, 2012 to December 31, 2012 is referred to as the “2012 Calendar Year” and the three-month period from October 1, 2011 to December 31, 2011 as the “Transition Period.” As a result of the change in First Financial’s fiscal year end, the following tables set forth information regarding the compensation earned by or awarded to each director who served on the Board during the 2012 Calendar Year and during the Transition Period, with the exception of R. Wayne Hall. The compensation of Mr. Hall is reflected below under “Executive Compensation.”
2012 Calendar Year
Transition Period
Please see the description of directors’ fees below.
Consists of payments to travel to Board of Director meetings.
Non-employee members of First Financial’s Board who also serve on First Federal’s Board receive monthly fees of $1,900, except the Chairman and Vice Chairman of the Board, who receive monthly fees of $2,400 and $2,150, respectively. Non-employee members who serve on the Board of either First Financial or First Federal receive monthly fees of $1,667. First Financial’s Audit Committee members each receive an additional annual fee of $2,000 and the Audit Committee Chairman receives an additional annual fee of $6,000. Directors also receive $1,250 per day for attending all day joint meetings (with First Financial’s management) for strategic planning purposes. These meetings are generally scheduled to occur twice each year. The Chairman of First Financial’s Compensation/Benefits Committee receives an annual fee of $3,000 and members of this Committee receive an annual fee of $1,000. Non-employee directors who serve on First Financial’s non-banking subsidiary boards were paid $200 to $500 on a quarterly basis. Each director is also entitled to reimbursement for his or her reasonable out-of-pocket expenses incurred in connection with travel to and from, and attendance at, meetings of the Board or its committees and related activities, including director education courses and materials.
In fiscal 2008, First Financial adopted the 2007 Equity Incentive Plan. No equity incentive awards or options were granted to directors during the 2012 Calendar Year or the Transition Period. Directors were eligible to defer their cash payments in the 2012 Calendar Year and the Transition Period; however, no First Financial Director elected to do so.
The 2005 Performance Equity Plan for Non-Employee Directors was approved by shareholders at the 2005 annual shareholder meeting. Under this plan, the Boards of First Financial and First Federal specified performance targets for First Financial and First Federal, as appropriate, and the percentage of total Board fees eligible for conversion to shares of First Financial common stock upon the attainment of the performance targets. Performance targets (return on equity) for fiscal years 2010 and 2011 were not achieved and thus no shares were distributed to directors in the Transition Period or the 2012 Calendar Year under this plan.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Equity Compensation Plan Information
The following table summarizes share and exercise price information as of December 31, 2012, with respect to compensation plans under which shares of First Financial’s common stock may be issued.
Security Ownership of Certain Beneficial Owners and Management
The following table shows the persons known to First Financial to be the beneficial owners of more than 5% of First Financial’s outstanding common stock as of February 25, 2013.
Name and Address Number of
Shares Owned Percent of
Common Stock
Outstanding
Wellington Management Co. LLP
280 Congress Street
Boston, Massachusetts 02210 (1) 1,509,182 (2) 9.13
Dimensional Fund Advisors (1) 848,373 (2) 5.13
(1)Based on information contained in a Form 13F filed with the SEC for December 31, 2012.
(2)The percentage of total beneficial ownership are based on shares of common stock outstanding on February 25, 2013.
The following table shows how much common stock of First Financial is owned by the directors and the Named Executive Officers, and all directors and executive officers as a group, as of February 25, 2013. The mailing address for each beneficial owner is care of First Financial Holdings, Inc., 2440 Mall Drive, Charleston South Carolina, 29406.
(1)Includes shares for which the named person has sole voting and investment power, has shared voting and investment power, or holds in an IRA or other retirement plan program, unless otherwise indicated in these footnotes.
(2)Includes shares that may be acquired within the next days as of February 25, by exercising vested stock options but does not include any unvested stock options.
(3)For each individual, this percentage is determined by assuming the named person exercises all options which he or she has the right to acquire within days, but that no other persons exercise any options or warrants. For the directors and executive officers as a group, this percentage is determined by assuming that each director and executive officer exercises all options which he or she has the right to acquire within days, but that no other persons exercise any options. The percentages of total beneficial ownership are based on 16,526,752 shares of common stock outstanding on February 25, 2013.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Related Persons Transactions
In granting loans to officers and directors, First Federal has followed a policy that fully complies with all applicable federal regulations. Loans and extensions of credit to directors, executive officers and related persons are made in the ordinary course of business and on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with persons not related to the lender, in accordance with our underwriting guidelines, and do not involve more than the normal risk of collectability or present other unfavorable features. All loan approvals and review procedures are governed by written policies.
Business loans to directors, executive officers and their related persons are not made with preferential rates or terms. Personal loans, including residential mortgage loans, to those individuals may be made with favorable rates under applicable federal law, so long as those rates are the same as those available to all non-officer employees of First Financial. In accordance with the policy, these favorable rates return to market rates and terms in effect at the time of origination when the director or executive officer ceases to be affiliated with First Financial.
As required by the rules of the NASDAQ Stock Market, First Financial conducts an appropriate review of all related party transactions for potential conflict of interest situations on an ongoing basis and all such transactions must be approved by First Financial’s Corporate Governance/Nominating Committee. First Financial annually requires each of its directors and executive officers to complete a directors’ and officers’ questionnaire that elicits information about related person transactions and uses this information to make a formal determination regarding each director’s independence under the NASDAQ Stock Market listing standards and applicable SEC rules. The Corporate Governance/Nominating Committee annually reviews all transactions and relationships disclosed in the director and officer questionnaires.
The following table reflects loans to directors and executive officers who, during the 2012 Calendar Year, had aggregate indebtedness to First Federal that exceeded $120,000 at below market rates.
Origination and underwriting fees are waived on all first mortgage loans made under the employee loan program.
First Mortgages: Preferential rates are 1% over the one year constant treasury compared with customers’ rates which are generally 2.75% over the same index. Preferential rates for Consumer Real Estate loans (first or second mortgage) are 1.50% over the one year constant treasury compared with the customers’ rates which are generally 3% over the same index.
Refinanced 2/7/12 to market rate 1st mortgage loan and market rate Equity Access Line. First Mortgage interest rate prior to refinance was 1.375% and Consumer Real Estate Second Mortgage interest rate was 1.625%.
First mortgage loan secured by former primary residence paid off 6/15/12. The interest rate at the time the loan paid off was 2.00%.
First Federal purchases automobiles through the Ford Motor Company Fleet Program. This program allows automobiles to be purchased at current fleet prices or prevailing market prices, whichever is lower. Mr. Johnson, one of First Federal’s directors, owns several car dealerships and some automobiles are purchased from his dealerships. During the 2012 Calendar Year, the total payments made to Mr. Johnson’s dealerships were $114,562. Several times during the year, First Federal compares market pricing among Ford dealerships to ensure it is receiving the best possible prices.
Director Independence
First Financial is focused on its corporate governance practices and value independent Board oversight as an essential component of strong corporate performance to enhance stockholder value. First Financial’s commitment to independent oversight is demonstrated by the fact that all of the directors, except R. Wayne Hall, our CEO, and James L. Rowe, who was President of First Southeast Insurance Services, Inc., a former wholly-owned subsidiary of First Financial that was sold in June 2011, are independent under the listing requirements of the NASDAQ Stock Market. In addition, all current members of the Board’ Audit, Compensation/Benefits, and Corporate Governance/Nominating Committees are independent under the listing requirements of the NASDAQ Stock Market. In determining the independence of its directors, the Board considered transactions, relationships and arrangements between First Financial and its directors, including those not otherwise required to be disclosed in this report under the heading “Related Persons Transactions,” and including loans or lines of credit that First Federal has directly or indirectly made to each of its directors.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table presents fees billed during the fiscal year for professional audit services rendered by Grant Thornton LLP for the 2012 Calendar Year and the 2011 fiscal year.
(1)Audit fees including expenses consisting of the following:
Audit of the consolidated financial statements, quarterly reviews, and audit of internal control over financial reporting. 2012 audit fees also include audit fees related to the transition period from October 1, 2011 through December 31, 2011 of $70,304.
(2)Audit related fees include the Audit of Statement of Assets Acquired and Liabilities Assumed - Acquisition of Plantation Federal Bank.
(3)In fiscal 2011, tax services were provided by Porter Keadle Moore LLP and not the principal accountant.
(4)Fees associated with accounting assistance provided for the Form S-3 Registration Statement filed on December 20, 2010 and procedures related to the US Treasury’s Series A Preferred Stock public auction in 2012.
The Audit Committee pre-approves all auditing services and non-auditing services provided to First Financial by its independent registered public accounting firm, including fees and terms. Pre-approval is typically granted by the full Audit Committee. In considering non-audit services, the Audit Committee will consider various factors including, but not limited to, whether it would be beneficial to have the service provided by the independent registered public accounting firm and whether the service could compromise the independence of the independent registered public accounting firm. The Audit Committee pre-approved all of the engagements for the audit of First Financial, audit related engagements, tax engagements and other permitted non-audit services of Grant Thornton LLP paid during fiscal 2012 and fiscal 2011.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
* In accordance with Regulation S-T, the XBRL-related information in Exhibit 101 to this Annual Report on Form 10-K shall be deemed to be “furnished” and not “filed.”
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, First Financial Holdings, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST FINANCIAL HOLDINGS, INC.
Date: March 18, 2013
/s/ R. Wayne Hall
R. Wayne Hall
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of First Financial Holdings, Inc. and in the capabilities and on the dates indicated.
/s/ R. Wayne Hall
/s/ Blaise B. Bettendorf
R. Wayne Hall
Blaise B. Bettendorf
President and Chief Executive Officer
Executive Vice President and Chief Financial Officer
(Principal Executive Officer)
(Principal Financial and Accounting Officer)
March 18, 2013
March 18, 2013
/s/ Paula Harper Bethea
/s/ Paul G. Campbell
Paula Harper Bethea
Paul G. Campbell
Director
Director
March 18, 2013
March 18, 2013
/s/ Ronnie M. Givens
/s/ Thomas J. Johnson
Ronnie M. Givens
Thomas J. Johnson
Director
Director
March 18, 2013
March 18, 2013
/s/ Susan R. Leadem
/s/ James L. Rowe
Susan R. Leadem
James L. RoweJr.
Director
Director
March 18, 2013
March 18, 2013
/s/ D. Kent Sharples
/s/ B. Ed Shelley, Jr.
D. Kent Sharples
B. Ed Shelley, Jr.
Director
Director
March 18, 2013
March 18, 2013
/s/ Richard W. Salmons, Jr.
/s/ Henry M. Swink
Richard W. Salmons, Jr.
Henry M. Swink
Director
Director
March 18, 2013
March 18, 2013
/s/ Hugh L. Wilcox, Jr. .
Hugh L. Wilcox, Jr.
Director
March 18, 2013