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Commission File No. 333-59338

                                     

 

FIRST SECURITY GROUP, INC.

(Exact Name of Registrant as Specified in its Charter)

 

Tennessee	58-2461486
(State of Incorporation)	(I.R.S. Employer Identification No.)
817 Broad Street, Chattanooga, TN	37402
(Address of principal executive offices)	(Zip Code)

PART I

Item 1.

Business

Unless otherwise indicated, all references to “First Security,” “we,” “us,” and “our” in this Annual Report on Form 10-K refer to First Security Group, Inc. and its wholly-owned subsidiary, FSGBank, National Association (“FSGBank”).

BUSINESS

First Security Group, Inc.

First Security was incorporated in 1999 as a Tennessee corporation to serve as a bank holding company, and is regulated and supervised by the Board of Governors of the Federal Reserve System. First Security conducts all of its business activities through its wholly-owned subsidiary, FSGBank, National Association, a national banking association regulated and supervised by the Office of the Comptroller of the Currency. As of December 31, 2004, First Security had total assets of approximately $766.7 million, total deposits of approximately $640.5 million, and shareholders’ equity of approximately $86.4 million.

FSGBank, National Association

FSGBank is the successor to three banks owned by First Security: Dalton Whitfield Bank (organized in 1999), Frontier Bank (acquired in 2000) and First State Bank (acquired in 2002). Dalton Whitfield Bank was a state bank organized under the laws of Georgia engaged in a general commercial banking business. Dalton Whitfield Bank opened for business in September 1999, and simultaneously acquired selected assets and substantially all of the deposits of Colonial Bank’s three branches located in Dalton, Georgia. In 2003, Premier National Bank of Dalton merged with and into Dalton Whitfield Bank for an aggregate purchase price of $11.7 million in cash and stock.

Frontier Bank was a state savings bank organized under the laws of Tennessee in 2000 as First Central Bank of Monroe County. First Security acquired First Central Bank of Monroe County in 2000 for an aggregate purchase price of $2.3 million in cash. Upon its acquisition by First Security, First Central Bank of Monroe County was renamed Frontier Bank and re-chartered as a state bank under the laws of Tennessee to engage in a general commercial banking business. Outside of the Chattanooga market, Frontier Bank operated under the name of “First Security Bank.”

First State Bank was a state bank organized under the laws of Tennessee engaged in a general commercial banking business since its organization in 1974. First Security acquired First State Bank in 2002 for an aggregate purchase price of $8.6 million in cash.

During 2003, First Security converted each of its subsidiary banks into national banks, renamed each bank “FSGBank, National Association” and merged the banks under the charter previously held by Frontier Bank. As a result, First Security consolidated its banking operations into one subsidiary, FSGBank, National Association. FSGBank currently conducts its banking operations in Dalton, Georgia under the names “Dalton Whitfield Bank” and “Primer Banco Seguro.” Primer Banco Seguro is our Latino-focused banking initiative. In addition, FSGBank’s banking operations in Ringgold, Georgia are conducted under the name “Catoosa Community Bank.” In all other markets, our banking operations are conducted under the name “FSGBank.”

Since the mergers in 2003, FSGBank has continued the commercial banking business of its predecessors. In addition, in December of 2003, FSGBank acquired certain assets and assumed substantially all of the deposits and other liabilities of National Bank of Commerce’s three branch offices located in Madisonville, Sweetwater and Tellico Plains, Tennessee.

In October 2004, FSGBank acquired 100% of the capital stock of Kenesaw Leasing, Inc. and J&S Leasing, Inc., both Tennessee corporations, from National Bank of Commerce for $13.0 million in cash. Both companies will continue to operate as wholly-owned subsidiaries of FSGBank. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery primarily to companies in the trucking and construction industries.

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FSGBank is a member of the Federal Reserve Bank of Atlanta and a member of the Federal Home Loan Bank of Cincinnati. FSGBank’s deposits are insured by the FDIC. As of December 31, 2004, FSGBank operated twenty-two full-service banking offices in eastern Tennessee and eight offices in northern Georgia. Additionally, FSGBank operated a loan production office in Knoxville, Tennessee and three leasing offices in Tennessee.

Business Strategy

First Security serves the banking and financial needs of the various communities located within 5 miles of the I-75 interstate corridor between Cartersville, Georgia and Knoxville, Tennessee, including Dalton, Georgia and Chattanooga, Tennessee. We believe this interstate corridor offers opportunities for growth and has needs that we can serve effectively. We also intend to extend our vision to include other interstate corridors in eastern Tennessee and northern Georgia. Although the interstate corridors are our primary focus, we may consider acquiring banking operations outside of the corridors if attractive opportunities arise as we continuously evaluate acquisition opportunities.

These interstate communities are primarily served by branches of large regional and national financial institutions headquartered outside of the area. As a result, we believe these markets need, and are best served by, a locally-owned and operated financial institution managed by people in and from the communities served. As First Security grows, we believe it is important to maintain the local flexibility created by local banks with smart bankers while benefiting from the economies of scale created by our size.

We offer personalized and flexible banking services to the communities in our market area and are able to react quickly to changes in those communities, in part by maintaining six local advisory boards. Instead of setting standardized rates across the organization, we continue to give our local markets control over their respective rates. While emphasizing standards to encourage efficiency, control is decentralized to permit rapid adjustments to community changes. We also offer products tailored to the specific needs of our communities.

First Security intends to continue its growth strategy through organic growth and strategic acquisitions. We believe that many opportunities remain in our market area to expand, and we intend to be in the position to acquire additional market share, whether via acquisitions or de novo branches with the right local management. We will continue to identify targets that assist us in achieving strategic and/or financial targets, with the goal of being the bank that other banks call when they have decided to pursue an exit strategy.

Market Area and Competition

We currently conduct business principally through the 30 branches of FSGBank in our market areas of Hamilton, McMinn, Monroe, Loudon, Knox, Union and Jefferson Counties, Tennessee and Whitfield and Catoosa Counties, Georgia. These market areas follow the I-75 corridor between Cartersville, Georgia and Knoxville, Tennessee. The table below shows our deposit market share in our market area counties according to the FDIC as of June 30, 2004.

Market		Number of Branches			Our Market Deposits			Total Market Deposits			Ranking			Market Share Percentage (%)
	(Dollars in Millions)
Tennessee
Hamilton County			7		$	151		$	4,642			6			3.3	%
Jefferson County			2			40			402			6			10.0
Knox County			2			20			5,894			16			0.4
Loudon County			2			22			556			7			4.1
McMinn County			1			21			690			8			3.1
Monroe County			5			76			479			5			15.9
Union County			2			36			110			2			32.8

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Market		Number of Branches			Our Market Deposits			Total Market Deposits			Ranking			Market Share Percentage (%)
		(Dollars in Millions)
Georgia
Catoosa County			1			2			778			10			0.2
Whitfield County			5			190			1,420			3			13.4
Consolidated			27		$	558		$	14,971			6			3.7	%

Subsequent to June 30, 2004, we opened an additional branch in Knox county and two “Primer Banco Seguro” branches in Whitfield County.

The retail, commercial and mortgage divisions of FSGBank operate in highly competitive markets. We compete directly in retail and commercial banking markets with other commercial banks, savings and loan associations, credit unions, mortgage brokers and mortgage companies, mutual funds, securities brokers, consumer finance companies, other lenders and insurance companies, locally, regionally and nationally, and certain of which compete with offerings by mail, telephone, computer and/or the Internet. Interest rates, both on loans and deposits, and prices of services are significant competitive factors among financial institutions generally. Office locations, types and quality of services and products, office hours, customer service, a local presence, community reputation and continuity of personnel are also important competitive factors that we emphasize.

In addition, our leasing operations via Kenesaw Leasing and J&S Leasing primarily serve lease customers located within 150 miles of Knoxville, Memphis and Nashville, TN.

Many other commercial or savings institutions currently have offices in our primary market areas. These institutions include many of the largest banks operating in Tennessee and Georgia, including some of the largest banks in the country. Many of our competitors serve the same counties we do. Within our market area, there are 49 different commercial or savings institutions.

Virtually every type of competitor for business of the type served by our bank has offices in Atlanta, Georgia, approximately 75 miles from Dalton and 100 miles from Chattanooga. In our market area, our five largest competitors include First Tennessee Bank, NA, SunTrust Bank, AmSouth Bank, Home Federal Bank of Tennessee, and Branch Banking & Trust Company. These institutions, as well as other competitors of ours, have greater resources, have broader geographic markets, have higher lending limits, offer various services that we do not offer, and can better afford and make broader use of media advertising, support services and electronic technology than we do. To offset these competitive disadvantages, we depend on our reputation as being an independent and locally-owned community bank and as having greater personal service, community involvement and ability to make credit and other business decisions quickly and locally.

Lending Activities

We originate loans primarily secured by single and multi-family real estate, residential construction, and owner-occupied commercial buildings. In addition, we make loans to small and medium-sized commercial businesses, as well as to customers for a variety of purposes.

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Our loan portfolio at December 31, 2004 was comprised as follows:

Type		Dollar Amount			Percentage of Portfolio
		(In Thousands)
Commercial - Leases		$	60,228			10.2	%
Commercial - Loans			116,490			19.7	%
Consumer			70,891			11.9	%
Real Estate - Construction			77,804			13.1	%
Real Estate - Mortgage			264,606			44.7	%
Other			2,338			0.4	%
Total		$	592,357			100.0	%

In addition, we have entered into contractual obligations, via lines of credit and standby letters of credit, to extend approximately $184.7 million in credit as of December 31, 2004. We use the same credit policies in making these commitments as we do for our other loans. At December 31, 2004, our contractual obligations to extend credit were comprised as follow:

Type		Dollar Amount			Percentage of Contractual Obligations
		(In Thousands)
Commercial - Leases		$	0			0.0	%
Commercial - Loans			61,821			33.5	%
Consumer			20,879			11.3	%
Real Estate - Construction			59,058			32.0	%
Real Estate - Mortgage			42,324			22.9	%
Other			643			0.3	%
Total		$	184,725			100.0	%

Commercial - Leases . Our commercial lease portfolio includes leases made by our leasing companies, Kenesaw Leasing and J&S Leasing. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery to owner-managed businesses primarily in the trucking and construction industries. The leased property usually serves as collateral for the lease.   Our lease customers are primarily based within 150 miles of Knoxville, Memphis and Nashville, Tennessee. Our commercial leases are underwritten on the basis of the value of the underlying leased property as well as the basis of the commercial lessee’s ability to service the lease. Commercial leases generally entail greater risks than commercial loans or loans secured by real estate, but less risk than unsecured consumer loans. The increased risk in commercial leases is generally due to the rolling stock nature of the items leased, as well as the illiquid nature of the secondary market for used equipment. The increased risk also derives from the low barriers to entry in the trucking and construction industries.

Commercial - Loans. Our commercial loan portfolio includes loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, as well as letters of credit that are generally secured by collateral other than real estate. Commercial borrowers typically secure their loans with assets of the business, personal guaranties of their principals, and often mortgages on the principals’ personal residences. Our commercial loans are primarily made within our market areas and are underwritten on the basis of the commercial borrower’s ability to service the debt from income. In general, commercial loans involve more credit risk than residential and commercial mortgage loans, but less risk than consumer loans. The increased risk in commercial loans is generally due to the type of assets collateralizing these loans. The increased risk also derives from the expectation that commercial loans generally will be serviced from the operations of the business, and those operations may not be successful.

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Consumer. We make a variety of loans to individuals for personal, family and household purposes, including secured and unsecured installment and term loans. Consumer loans entail greater risk than other loans, particularly in the case of consumer loans that are unsecured or secured by depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by job loss, divorce, illness or personal hardships.

Real Estate—Construction. We also make construction and development loans to residential and, to a lesser extent, commercial contractors and developers located within our market areas. Construction loans generally are secured by first liens on real estate and have floating interest rates. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the value of the project is dependent on its successful completion. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, upon the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, there is no assurance that we will be able to recover all of the unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While we have underwriting procedures designed to identify what we believe to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above.

Real Estate—Mortgage. We make commercial mortgage loans to finance the purchase of real property as well as loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, including letters of credit, that are also secured by real estate. Commercial mortgage lending typically involves higher loan principal amounts, and the repayment of loans is dependent, in large part, on sufficient income from the properties collateralizing the loans to cover operating expenses and debt service. As a general practice, we require our commercial mortgage loans to be collateralized by well-managed income producing property with adequate margins and to be guaranteed by responsible parties. In addition, a substantial percentage of our commercial mortgage loan portfolio is secured by owner-occupied commercial buildings. We look for opportunities where cash flow from the collateral provides adequate debt service coverage and the guarantor’s net worth is centered on assets other than the project we are financing. Our commercial mortgage loans are generally collateralized by first liens on real estate, have fixed or floating interest rates and amortize over a 10 to 20-year period with balloon payments due at the end of one to five years. Payments on loans collateralized by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market.

In underwriting commercial mortgage loans, we seek to minimize our risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition. Our underwriting analysis also includes credit checks, reviews of appraisals and environmental hazards or EPA reports and a review of the financial condition of the borrower. We attempt to limit our risk by analyzing our borrowers’ cash flow and collateral value on an ongoing basis.

Our residential mortgage loan program primarily originates loans for the purchase of residential property to individuals for other third-party lenders. Residential loans to individuals retained in our loan portfolio primarily consist of first liens on 1-4 family residential mortgages, home equity loans and lines of credit. These loans are generally made on the basis of the borrower’s ability to repay the loan from his or her employment and other income and are secured by residential real estate, the value of which is reasonably ascertainable. We expect that these loan-to-value ratios will be sufficient to compensate for fluctuations in real estate market value and to minimize losses that could result from a downturn in the residential real estate market. We generally do not retain long term, fixed rate residential real estate loans in our portfolio due to interest rate and collateral risks and low levels of profitability.

Credit Risks. The principal economic risk associated with each category of the loans that we make is the creditworthiness of the borrower and the ability of the borrower to repay the loan. General economic conditions and the strength of the services and retail market segments affect borrower creditworthiness. General factors affecting a commercial borrower’s ability to repay include interest rates, inflation and the demand for the commercial borrower’s products and services, as well as other factors affecting a borrower’s customers, suppliers and employees.

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Risks associated with real estate loans also include fluctuations in the value of real estate, new job creation trends, tenant vacancy rates and, in the case of commercial borrowers, the quality of the borrower’s management. Consumer loan repayments depend upon the borrower’s financial stability and are more likely to be adversely affected by divorce, job loss, illness and personal hardships.

Lending Policies. Our board of directors has established and periodically reviews our bank’s lending policies and procedures. We have established common documentation and standards based on the type of loans between our regions. There are regulatory restrictions on the dollar amount of loans available for each lending relationship. National banking regulations provide that no loan relationship may exceed 15% of banks’ Tier 1 capital. At December 31, 2004, FSGBank’s legal lending limit was approximately $9.5 million. In addition, we have established a “house” limit of $4 million for each lending relationship. Any loan request exceeding the house limit must be approved by a committee of the board of directors. We occasionally sell participation interests in loans to other lenders, primarily when a loan exceeds FSGBank’s house lending limits.

Concentrations. The retail nature of the commercial banking operations for FSGBank allows for diversification of depositors and borrowers, and management believes that FSGBank does not depend upon a single or a few customers. As of December 31, 2004, First Security identified one credit risk concentration of carpet-industry related commercial banking loans of approximately $8.6 million or 13.6 % of FSGBank’s Tier 1 Capital . These carpet-industry related loans include loans to carpet and rug manufacturers, finishing plants, winding mills, textile machinery companies and carpet sample companies. Otherwise, we do not believe our credits are concentrated within a single industry or group of related industries.

Deposits

Our principal source of funds for loans and investing in securities is core deposits. We offer a wide range of deposit services, including checking, savings, money market accounts, and certificates of deposit. We obtain most of our deposits from individuals and businesses in our market areas. We believe that the rates we offer for core deposits are competitive with those offered by other financial institutions in our market areas. Secondary sources of funding include brokered deposits, advances from the Federal Home Loan Bank of Cincinnati, subordinated debt and other borrowings. These secondary sources enable us to borrow funds at rates and terms, which at times, are more beneficial to us.

Other Banking Services

Given client demand for increased convenience and account access, we offer a range of products and services, including 24-hour internet banking, direct deposit, traveler’s checks, safe deposit boxes, United States savings bonds and automatic account transfers. We earn fees for most of these services. We also receive ATM transaction fees from transactions performed by our customers participating in a shared network of automated teller machines and a debit card system that our customers can use throughout Tennessee and Georgia, as well as in other states.

Securities

After establishing necessary cash reserves and funding loans, we invest our remaining liquid assets in securities allowed under banking laws and regulations. We invest primarily in obligations of the United States or obligations guaranteed as to principal and interest by the United States, other taxable securities and in certain obligations of states and municipalities. We also invest excess funds in federal funds with our correspondent banks. The sale of federal funds represents a short-term loan from us to another bank. Risks associated with securities include, but are not limited to, interest rate fluctuation, maturity, and concentration.

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Seasonality and Cycles

Although we do not consider our commercial banking business to be seasonal, our mortgage banking business is somewhat seasonal, with the volume of home financings, in particular, being lower during the winter months. The Dalton, Georgia economy also is seasonal and cyclical as a result of its dependence upon the carpet industry and changes in construction of residential and commercial establishments. While the Dalton, Georgia economy is dominated by the carpet and carpet-related industries, FSGBank does not have any one customer from whom more than 10% of its revenues are derived. However, FSGBank has multiple customers, commercial and retail, that are directly or indirectly affected by, or are engaged in businesses related to the carpet industry that, in the aggregate, have historically provided greater than 10% of FSGBank’s revenues.

Employees

On December 31, 2004, we had 295 full-time employees and 20 part-time employees. Our staff will increase as a result of our increased branching activities anticipated in 2005. We consider our employee relations to be good, and we have no collective bargaining agreements with any employees.

Website Address

Our corporate website address is www.fsgbank.com. From this website, select the “Corporate Info” tab followed by selecting “SEC Filings.” This is a direct link to First Security’s filings with the Securities and Exchange Commission (“SEC”), including but not limited to our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports. These reports are accessible soon after we file them with the SEC.

SUPERVISION AND REGULATION

Both First Security and FSGBank are subject to extensive state and federal banking regulations that impose restrictions on and provide for general regulatory oversight of their operations. These laws generally are intended to protect depositors and not shareholders. The following discussion describes the material elements of the regulatory framework that applies to us.

First Security

Since First Security owns all of the capital stock of FSGBank, it is a bank holding company under the federal Bank Holding Company Act of 1956. As a result, First Security is primarily subject to the supervision, examination, and reporting requirements of the Bank Holding Company Act and the regulations of the Federal Reserve.

Acquisitions of Banks .   The Bank Holding Company Act requires every bank holding company to obtain the Federal Reserve’s prior approval before:

·	acquiring direct or indirect ownership or control of any voting shares of any bank if, after the acquisition, the bank holding company will directly or indirectly own or control more than 5% of the bank’s voting shares;

 

·	acquiring all or substantially all of the assets of any bank; or

 

·	merging or consolidating with any other bank holding company.

Additionally, the Bank Holding Company Act provides that the Federal Reserve may not approve any of these transactions if it would result in or tend to create a monopoly or, substantially lessen competition or otherwise function as a restraint of trade, unless the anti-competitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks concerned and the convenience and needs of the community to be served. The Federal Reserve’s consideration of financial resources generally focuses on capital adequacy, which is discussed below.

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Under the Bank Holding Company Act, if adequately capitalized and adequately managed, First Security, as well as additional banks located within Tennessee or Georgia, may purchase a bank located outside of Tennessee or Georgia. Conversely, an adequately capitalized and adequately managed bank holding company located outside of Tennessee or Georgia may purchase a bank located inside Tennessee or Georgia. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in specified concentrations of deposits. For example, Georgia law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been incorporated for three years, and Tennessee Law prohibits a bank holding company from acquiring control of a financial institution until the target financial institution has been incorporated for five years.

Change in Bank Control . Subject to various exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with related regulations, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person or company acquires 10% or more, but less than 25%, of any class of voting securities and either:

·	the bank holding company has registered securities under Section 12 of the Securities Act of 1934; or

 

·	no other person owns a greater percentage of that class of voting securities immediately after the transaction.

Our common stock is registered under Section 12 of the Securities Exchange Act of 1934. The regulations provide a procedure for challenging any rebuttable presumption of control.

Permitted Activities .   A bank holding company is generally permitted under the Bank Holding Company Act, to engage in or acquire direct or indirect control of more than 5% of the voting shares of any company engaged in the following activities:

·	Banking or managing or controlling banks; and

 

·	Any activity that the Federal Reserve determines to be so closely related to banking as to be a proper incident to the business of banking.

Activities that the Federal Reserve has found to be so closely related to banking as to be a proper incident to the business of banking include:

·	Factoring accounts receivable;

 

·	Making, acquiring, brokering or servicing loans and usual related activities;

 

·	Leasing personal or real property;

 

·	Operating a non-bank depository institution, such as a savings association;

 

·	Trust company functions;

 

·	Financial and investment advisory activities;

 

·	Conducting discount securities brokerage activities;

 

·	Underwriting and dealing in government obligations and money market instruments;

 

·	Providing specified management consulting and counseling activities;

 

·	Performing selected data processing services and support services;

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·	Acting as agent or broker in selling credit life insurance and other types of insurance in connection with credit transactions; and

 

·	Performing selected insurance underwriting activities.

Despite prior approval, the Federal Reserve may order a bank holding company or its subsidiaries to terminate any of these activities or to terminate its ownership or control of any subsidiary when it has reasonable cause to believe that the bank holding company’s continued ownership, activity or control constitutes a serious risk to the financial safety, soundness, or stability of it or any of its bank subsidiaries.

In addition to the permissible bank holding company activities listed above, a bank holding company may qualify and elect to become a financial holding company, permitting the bank holding company to engage in additional activities that are financial in nature or incidental or complementary to financial activity. The Bank Holding Company Act expressly lists the following activities as financial in nature:

·	Lending, trust and other banking activities;

 

·	Insuring, guaranteeing, or indemnifying against loss or harm, or providing and issuing annuities, and acting as principal, agent, or broker for these purposes, in any state;

 

·	Providing financial, investment, or advisory services;

 

·	Issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly;

 

·	Underwriting, dealing in or making a market in securities;

 

·	Other activities that the Federal Reserve may determine to be so closely related to banking or managing or controlling banks as to be a proper incident to managing or controlling banks;

 

·	Foreign activities permitted outside of the United States if the Federal Reserve has determined them to be usual in connection with banking operations abroad;

 

·	Merchant banking through securities or insurance affiliates; and

 

·	Insurance company portfolio investments.

To qualify to become a financial holding company, FSGBank and any other depository institution subsidiary of First Security must be well capitalized and well managed and must have a Community Reinvestment Act rating of at least “satisfactory.” Additionally, First Security must file an election with the Federal Reserve to become a financial holding company and must provide the Federal Reserve with 30 days’ written notice prior to engaging in a permitted financial activity. While First Security meets the qualification standards applicable to financial holding companies, First Security has not elected to become a financial holding company at this time.

Support of Subsidiary Institution. Under Federal Reserve policy, First Security is expected to act as a source of financial strength for FSGBank and to commit resources to support FSGBank. This support may be required at times when, without this Federal Reserve policy, First Security might not be inclined to provide it. In addition, any capital loans made by First Security to FSGBank will be repaid only after its deposits and various other obligations are repaid in full. In the unlikely event of First Security’s bankruptcy, any commitment by it to a federal bank regulatory agency to maintain the capital of FSGBank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

FSGBank

Since FSGBank is chartered as a national bank, it is primarily subject to the supervision, examination and reporting requirements of the National Bank Act and the regulations of the Office of the Comptroller of the Currency. The Office of the Comptroller of the Currency regularly examines FSGBank’s operations and has the authority to approve or disapprove mergers, the establishment of branches and similar corporate actions. The Office of the Comptroller of the Currency also has the power to prevent the continuance or development of unsafe or unsound banking practices or other violations of law. Additionally, FSGBank’s deposits are insured by the FDIC to the maximum extent provided by law. FSGBank is also subject to numerous state and federal statutes and regulations that affect its business, activities and operations.

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Branching . National banks are required by the National Bank Act to adhere to branching laws applicable to state banks in the states in which they are located. Under both Tennessee and Georgia law, FSGBank may open branch offices throughout Tennessee or Georgia with the prior approval of the Office of the Comptroller of the Currency. In addition, with prior regulatory approval, FSGBank may acquire branches of existing banks located in Tennessee or Georgia. FSGBank and any other national or state-chartered bank generally may branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. Tennessee and Georgia law, with limited exceptions, currently permit branching across state lines through interstate mergers.

Under the Federal Deposit Insurance Act, states may “opt-in” and allow out-of-state banks to branch into their state by establishing a new start-up branch in the state. Tennessee has opted in and therefore, any out-of-state bank can establish a start-up branch in Tennessee as long as that state’s banking law would also allow Tennessee banks to establish start-up branches in that state. Therefore, FSGBank may establish start-up branches in any state that would allow a Tennessee bank to do the same.

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, the federal banking regulators have established five capital categories (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) in which all institutions are placed. Federal banking regulators are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. The federal banking agencies have specified by regulation the relevant capital level for each category.

An institution that is categorized as undercapitalized, significantly undercapitalized, or critically undercapitalized is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. A bank holding company must guarantee that a subsidiary depository institution meets its capital restoration plan, subject to various limitations. The controlling holding company’s obligation to fund a capital restoration plan is limited to the lesser of 5% of an undercapitalized subsidiary’s assets at the time it became undercapitalized or the amount required to meet regulatory capital requirements. An undercapitalized institution is also generally prohibited from increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval. The regulations also establish procedures for downgrading an institution to a lower capital category based on supervisory factors other than capital.

FDIC Insurance Assessments. The FDIC has adopted a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. The system assigns an institution to one of three capital categories: (1) well capitalized; (2) adequately capitalized; and (3) undercapitalized. These three categories are substantially similar to the prompt corrective action categories described above, with the “undercapitalized” category including institutions that are undercapitalized, significantly undercapitalized, and critically undercapitalized for prompt corrective action purposes. The FDIC also assigns an institution to one of three supervisory subgroups based on a supervisory evaluation that the institution’s primary federal regulator provides to the FDIC and information that the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds. Assessments range from 0 to 27 cents per $100 of deposits, depending on the institution’s capital group and supervisory subgroup. In addition, the FDIC imposes assessments to help pay off the $780 million in annual interest payments on the $8 billion Financing Corporation bonds issued in the late 1980s as part of the government rescue of the thrift industry. This assessment rate is adjusted quarterly and is set at 1.44 cents per $100 of deposits for the first quarter of 2005.

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The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, or condition imposed by the FDIC.

Community Reinvestment Act. The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their respective jurisdictions, the Federal Reserve, the FDIC, or the Office of the Comptroller of the Currency, shall evaluate the record of each financial institution in meeting the credit needs of its local community, including low and moderate-income neighborhoods. These facts are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on the Bank   Additionally, we must publicly disclose the terms of various Community Reinvestment Act-related agreements.

Other Regulations. Interest and other charges collected or contracted for by FSGBank are subject to state usury laws and federal laws concerning interest rates. For example, under the Servicemembers Civil Relief Act, which amended the Soldiers’ and Sailors’ Civil Relief Act of 1940, a lender is generally prohibited from charging an annual interest rate in excess of 6% on any obligation for which the borrower is a person on active duty with the United States military.

FSGBank’s loan operations are also subject to federal laws applicable to credit transactions, such as the:

·	Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 

·	Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 

·	Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;

 

·	Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies;

 

·	Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

·	Servicemembers Civil Relief Act, which amended the Soldiers’ and Sailors’ Civil Relief Act of 1940, governing the repayment terms of, and property rights underlying, secured obligations of persons in military service; and

 

·	the rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

In addition to the federal laws noted above, the Georgia Fair Lending Act (“GAFLA”) imposes restrictions and procedural requirements on most mortgage loans made in Georgia, including home equity loans and lines of credit. On August 5, 2003, the Office of the Comptroller of the Currency issued a formal opinion stating that the entirety of GAFLA is preempted by federal law for national banks and their operating subsidiaries. As a result, FSGBank is exempt from the requirements of GAFLA.

The deposit operations of FSGBank are subject to:

·	The Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and

·

The Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve to implement that act, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.

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Capital Adequacy

First Security and FSGBank are required to comply with the capital adequacy standards established by the Federal Reserve, in the case of First Security, and the Office of the Comptroller of the Currency, in the case of FSGBank. The Federal Reserve has established a risk-based and a leverage measure of capital adequacy for bank holding companies. FSGBank is also subject to risk-based and leverage capital requirements adopted by the Office of the Comptroller of the Currency, which are substantially similar to those adopted by the Federal Reserve for bank holding companies.

The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance-sheet exposure, and to minimize disincentives for holding liquid assets. Assets and off-balance-sheet items, such as letters of credit and unfunded loan commitments, are assigned to broad risk categories, each with appropriate risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance-sheet items.

The minimum guideline for the ratio of total capital to risk-weighted assets is 8%. Total capital consists of two components, Tier 1 Capital and Tier 2 Capital. Tier 1 Capital generally consists of common stock, minority interests in the equity accounts of consolidated subsidiaries, noncumulative perpetual preferred stock, and a limited amount of qualifying cumulative perpetual preferred stock, less goodwill and other specified intangible assets. Tier 1 Capital must equal at least 4% of risk-weighted assets. Tier 2 Capital generally consists of subordinated debt, other preferred stock, and a limited amount of loan loss reserves. The total amount of Tier 2 Capital is limited to 100% of Tier 1 Capital. At December 31, 2004 our ratio of total capital to risk-weighted assets was 12.4% and our ratio of Tier 1 Capital to risk-weighted assets was 11.2%.

In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to average assets, less goodwill and other specified intangible assets, of 3% for bank holding companies that meet specified criteria, including having the highest regulatory rating and implementing the Federal Reserve’s risk-based capital measure for market risk. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%.   At December 31, 2004, our leverage ratio was 9.9%. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without reliance on intangible assets. The Federal Reserve considers the leverage ratio and other indicators of capital strength in evaluating proposals for expansion or new activities.

Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and certain other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements. See “ Item 1.—Business— SUPERVISION AND REGULATION — FSGBank—Prompt Corrective Action.”

See Note 15 in the “Notes to Consolidated Financial Statements” for the capital ratios of First Security and FSGBank.

Payment of Dividends

First Security is a legal entity separate and distinct from FSGBank. The principal sources of First Security’s cash flow, including cash flow to pay dividends to its shareholders, are dividends that FSGBank pays to its sole shareholder, First Security. Statutory and regulatory limitations apply to FSGBank’s payment of dividends to First Security as well as to First Security’s payment of dividends to its shareholders.

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FSGBank is required by federal law to obtain prior approval of the Office of the Comptroller of the Currency for payments of dividends if the total of all dividends declared by FSGBank’s board of directors in any year will exceed (1) the total of FSGBank’s net profits for that year, plus (2) FSGBank’s retained net profits of the preceding two years, less any required transfers to surplus.

The payment of dividends by First Security and FSGBank may also be affected by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. If, in the opinion of the Office of the Comptroller of the Currency, FSGBank were engaged in or about to engage in an unsafe or unsound practice, the Office of the Comptroller of the Currency could require, after notice and a hearing, that the Bank stop or refrain engaging in the practice. The federal banking agencies have indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act of 1991, a depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings. To date, neither First Security nor FSGBank have paid any cash dividends. See “ Item 1.—Business— SUPERVISION AND REGULATION — FSGBank—Prompt Corrective Action.”

Restrictions on Transactions with Affiliates

First Security and FSGBank are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:

·	a bank’s loans or extensions of credit to affiliates;

 

·	a bank’s investment in affiliates;

 

·	assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve;

 

·	loans or extensions of credit to third parties collateralized by the securities or obligations of affiliates; and

 

·	a bank’s guarantee, acceptance or letter of credit issued on behalf of an affiliate.

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. FSGBank must also comply with other provisions designed to avoid the taking of low-quality assets.

First Security and FSGBank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibit an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

FSGBank is also subject to restrictions on extensions of credit to their executive officers, directors, principal shareholders and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

Privacy

Financial institutions are required to disclose their policies for collecting and protecting confidential information. Customers generally may prevent financial institutions from sharing nonpublic personal financial information with nonaffiliated third parties except under narrow circumstances, such as the processing of transactions requested by the consumer or when the financial institution is jointly sponsoring a product or service with a nonaffiliated third party. Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing to consumers.

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Consumer Credit Reporting

On December 4, 2003, President Bush signed the Fair and Accurate Credit Transactions Act amending the federal Fair Credit Reporting Act. These amendments to the Fair Credit Reporting Act (the “FCRA Amendments”) became effective in 2004.

 

The FCRA Amendments include, among other things:

·	requirements for financial institutions to develop policies and procedures to identify potential identity theft and, upon the request of a consumer, place a fraud alert in the consumer’s credit file stating that the consumer may be the victim of identity theft or other fraud;

 

·	consumer notice requirements for lenders that use consumer report information in connection with risk-based credit pricing programs;

 

·

for entities that furnish information to consumer reporting agencies (which would include FSGBank) , requirements to implement procedures and policies regarding the accuracy and integrity of the furnished information, and regarding the correction of previously furnished information that is later determined to be inaccurate; and

 

·	a requirement for mortgage lenders to disclose credit scores to consumers.

The FCRA Amendments also prohibit a business that receives consumer information from an affiliate from using that information for marketing purposes unless the consumer is first provided a notice and an opportunity to direct the business not to use the information for such marketing purposes (the “opt-out”), subject to certain exceptions. We do not share consumer information among our affiliated companies for marketing purposes, except as allowed under exceptions to the notice and opt-out requirements. Because no affiliate of First Security is currently sharing consumer information with any other affiliate of First Security for marketing purposes, the limitations on sharing of information for marketing purposes do not have a significant impact on First Security.

Anti-Terrorism and Money Laundering Legislation

FSGBank is subject to the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism of 2001 (the “USA PATRIOT Act”), the Bank Secrecy Act, and rules and regulations of the Office of Foreign Assets Control (the “OFAC”). These statutes and related rules and regulations impose requirements and limitations on specific financial transactions and account relationships, intended to guard against money laundering and terrorism financing. FSGBank has established a customer identification program pursuant to Section 326 of the USA PATRIOT Act and the Bank Secrecy Act, and otherwise has implemented policies and procedures to comply with the foregoing rules.

Proposed Legislation and Regulatory Action

New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of financial institutions operating and doing business in the United States. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.

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Effect of Governmental Monetary Polices

Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Bank’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve affect the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. We cannot predict the nature or impact of future changes in monetary and fiscal policies.

 

Item 2.

Properties

During 2004, we conducted our business primarily through our office located at 817 Broad Street, Chattanooga, Hamilton County, Tennessee. This facility is four stories with a basement. First Security and FSGBank lease and occupy the first three floors and half of the basement, which consists of approximately 15,256 square feet of finished space. The rest of the building is unfinished. The original term of the lease expired on February 28, 2003; however, the lease provided three successive one-year renewal options. In 2004 we exercised our third and final renewal option extending the lease until February 28, 2006. This location also serves as FSGBank’s main office, opening for business as a bank office on June 26, 2000.

On July 9, 2003, First Security acquired a building located at 531 Broad Street, Chattanooga, Hamilton County, Tennessee. The building is masonry construction with one story and a full basement. Combining the main level and the basement, the building contains approximately 39,700 square feet. The current use of the main level of the building is monthly-pay covered parking and is a source of income to First Security. The basement is currently not being used. First Security purchased this building in anticipation of renovating it and relocating our primary business offices and the main office of FSGBank to that location. We intend to renovate this location this year to enable First Security and FSGBank to relocate their main offices to this location prior to the expiration of our lease at 817 Broad Street in February 2006.

Our banking offices are in good condition, are suitable to our needs, and, for the most part, are relatively new. The following table summarizes pertinent details of our branch, loan production and leasing offices.

Office Address	Date Opened	Owned/Leased	Lease Expiration Date	Square Footage	Use of Office
401 South Thornton Avenue Dalton, Whitfield County, Georgia	September 17, 1999 1	Owned	-	16,438 2	Branch 3
1237 Cleveland Road Dalton, Whitfield County, Georgia	September 17, 1999 1	Owned	-	3,300	Branch 3
761 New Highway 68 Sweetwater , Monroe County , Tennessee	June 26, 2000 4	Owned	-	3,000	Branch
1740 Gunbarrel Road Chattanooga, Hamilton County, Tennessee	July 3, 2000	Leased	May 24, 2010 5	3,400	Branch
4227 Ringgold Road East Ridge, Hamilton County, Tennessee	July 28, 2000	Leased	July 20, 2010 5	3,400	Branch
835 South Congress Parkway Athens, McMinn County, Tennessee	November 6, 2000	Owned	-	1,400	Branch 6
4535 Highway 58 Chattanooga, Hamilton County, Tennessee	May 7, 2001	Owned	-	3,400	Branch
820 Ridgeway Avenue Signal Mountain, Hamilton County, Tennessee	May 29, 2001	Owned	-	2,500	Branch
2709 Chattanooga Road, Suite 5 Rocky Face, Whitfield County, Georgia	June 4, 2001	Leased	September 30, 2005 7	2,400	Branch 3
1409 Cowart Street Chattanooga, Hamilton County, Tennessee	October 22, 2001	Building Owned Land Leased	December 31, 2010 8	1,000	Branch
9217 Lee Highway Ooltewah, Hamilton County, Tennessee	July 8, 2002	Owned	-	3,400	Branch

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Office Address	Date Opened	Owned/Leased	Lease Expiration Date	Square Footage	Use of Office
2905 Maynardville Highway Maynardville, Union County, Tennessee	July 20, 2002 9	Owned 10	-	12,197 2	Branch
216 Maynardville Highway Maynardville, Union County, Tennessee	July 20, 2002 9	Leased	March 16, 1993 11	2,000	Branch
109 Northshore Drive, Suite 300 Knoxville, Knox County, Tennessee	March 14, 2003	Leased	March 1, 2008 12	4,282	Loan Production 13
2918 East Walnut Avenue Dalton, Whitfield County, Georgia	March 31, 2003 14	Owned	-	10,337 2	Branch 3
715 South Thornton Avenue Dalton, Whitfield County, Georgia	March 31, 2003 14	Building Owned Land Leased	March 31, 2031 8	4,181	Branch 3
109 Northshore Drive, Suite 100 Knoxville, Knox County, Tennessee	May 20, 2003	Leased	July 1, 2006 12	550	Branch
2270 Highway 72 N Loudon, Loudon County, Tennessee	June 30, 2003	Owned	-	1,860	Branch 15
35 Poplar Springs Road Ringgold, Catoosa County, Georgia	July 14, 2003	Owned	-	3,400	Branch 16
167 West Broadway Boulevard Jefferson City, Jefferson County, Tennessee	October 14, 2003	Owned	-	3,743	Branch
705 East Broadway Lenoir City, Loudon County, Tennessee	October 27, 2003	Owned	-	3,610	Branch
301 North Main Street Sweetwater, Monroe County, Tennessee	December 4, 2003 17	Owned	-	4,650	Branch
215 Warren Street Madisonville, Monroe County, Tennessee	December 4, 2003 17	Owned	-	8,456 2	Branch
405 Highway 165 Tellico Plains, Monroe County, Tennessee	December 4, 2003 17	Owned	-	3,565	Branch
155 North Campbell Station Road Knoxville, Knox County, Tennessee	March 2, 2004	Building Owned Land Leased	April 1, 2024 18	3,743	Branch
4215 Highway 411 Madisonville, Monroe County, Tennessee	March 15, 2004	Owned	-	472	Branch
1013 South Highway 92 Dandridge, Jefferson County, Tennessee	April 5, 2004 19	Owned	-	3,500	Branch
307 Lovell Road Knoxville, Knox County, Tennessee	August 16, 2004	Building Owned Land Leased	December 31, 2013 20	3,500	Branch
1111 Northshore Drive, Suite S600 Knoxville, Knox County, Tennessee	October 1, 2004 21	Leased	March 31, 2012	9,867	Loan & Leasing 22
1810 Ailor Avenue, Center City Offices’ Building One Knoxville, Knox County, Tennessee	October 1, 2004 21	Leased	October 1, 2005 23	1,780	Leasing 24
665 Oak Leaf Office Lane, Suite E Memphis, Shelby County, Tennessee	October 1, 2004 21	Leased	June 30, 2006 8	930	Leasing 25
1249 Murray Avenue Dalton, Whitfield County, Georgia	November 18, 2004	Leased	August 31, 2005 26	2,400	Branch 27
430 Fields Avenue, Suite Number B-1 Dalton, Whitfield County, Georgia	December 16, 2004	Leased	August 31, 2005 26	712	Branch 27

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1

Date we acquired this branch from Colonial Bank.

 

2

Previously served as the headquarters of an independent community bank.

 

3

This branch operates under the trade name Dalton Whitfield Bank.

 

4

Date we acquired this branch through our acquisition of First Central Bank of Monroe County.

 

5

This lease has two successive five-year renewal options, as well as options to purchase the facility in the fifth and tenth years of the original lease.

 

6

This branch is a modular facility. In 2005, we plan to replace this modular facility with a brick and mortar facility of approximately 3,400 square feet.

 

7

This lease has a five-year renewal option.

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8

This lease has two successive five-year renewal options.

 

9

Date we acquired, or assumed the lease on, this facility through our acquisition of First State Bank.

 

10

To purchase the land, on January 5, 1995, the predecessor institution entered, and we assumed, a 240-month mortgage, which matures on January 5, 2015.

 

11

This lease had one fifteen-year renewal option, which was exercised by the predecessor institution. In 1999, the State of Tennessee advised First State Bank that this branch was in the path of the future project to widen Highway 33. As a result, First State Bank purchased a vacant lot in close proximity so that it may relocate this branch. To date, the highway widening project has not commenced and neither has construction on a replacement branch.

 

12

This lease has four successive three-year renewal options.

 

1 3

On January 18, 2005, we relocated our offices to 1111 Northshore Drive, Suite S600, Knoxville, Knox County, Tennessee, which had previously been occupied by National Bank of Commerce and is adjacent to Kenesaw Leasing, Inc., which we acquired effective October 1, 2004. We are actively seeking a tenant to sublease this office.

 

14

Date we acquired this branch through our acquisition of Premier National Bank of Dalton.

 

15

This branch is a modular facility.

 

16

This branch operates under the trade name Catoosa Community Bank.

 

17

Date we acquired this branch from National Bank of Commerce.

 

18

This lease has four successive five-year renewal options.

 

19

Date we opened a 1,860 square foot modular facility. On November 16, 2004, we opened the permanent brick and mortar facility on the same property site. The modular facility is vacant and we anticipate moving it to Varnell, Whitfield County, Georgia.

 

20

This lease has six successive five-year renewal options.

 

21

Date we assumed this lease through our acquisitions of Kenesaw Leasing, Inc. & J&S Leasing, Inc.

 

22

This is an office of Kenesaw Leasing, Inc. and a corporate and loan production office of FSGBank. On January 18, 2005, we moved FSGBank’s corporate and loan production offices located at 109 Northshore Drive, Suite 300, Knoxville, Knox County, Tennessee to this location.

 

23

This lease has one twelve-month renewal option.

 

24

This is an office of J&S Leasing, Inc.

 

25

This is an office of Kenesaw Leasing, Inc.

 

26

This lease has two successive one-year renewal options.

 

27

This branch operates under the trade name Primer Banco Seguro.

As of December 31, 2003, First Security and its subsidiary owned five plots of land that were either vacant or were held as future branch sites. The vacant lots are located at 925 Highway 68, Sweetwater, Monroe County, Tennessee (2.4 acres); Lot #6 of Kirkland Heights Property on Maynardville Highway, Maynardville, Union County, Tennessee (1.0 acre); 4300 Maynardville Highway, Maynardville, Union County, Tennessee (0.25 acre); 1020 South Highway 92, Dandridge, Jefferson County, Tennessee (1.0 acres) ; and, Southwestern Corner of Highway 71 & GA 2, Cohutta (Varnell), Whitfield County, Georgia (1.1 acres). Our intent is to establish a banking facility on the Varnell property. The other four lots are currently available for sale. We originally purchased, or a predecessor institution purchased, each site for bank purposes.

Item 3.

Legal Proceedings

While First Security and FSGBank are from time to time parties to various legal proceedings arising in the ordinary course of their business, management believes, after consultation with legal counsel, that there are no proceedings threatened or pending against First Security or FSGBank that will, individually or in the aggregate, have a material adverse affect on the business or consolidated financial condition of First Security.

Item 4.

Submission of Matters to a Vote of Security Holders

No matter was submitted during the fourth quarter of the fiscal year ended December 31, 2004 to a vote of shareholders of First Security, through the solicitation of proxies or otherwise.

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PART II

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

No active trading market exists for our common stock, and we can give no assurance that an active trading market will develop in the future. We are currently considering listing our common stock on the Nasdaq National Market during 2005. As of March 1, 2005, there were approximately 1,522 holders of record of First Security’s common stock, and approximately 12,726,140 shares of common stock were issued and outstanding. We file periodic financial and other reports with the SEC.

Our shares are infrequently traded in private transactions, and such trades are not necessarily indicative of the value of such shares. Management is aware of sporadic trades in 2004, each occurring at a split-adjusted price of $8.33.

We have never paid any cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain future earnings, if any, to support the development and growth of our business. Payment of future dividends, if any, will be at the discretion of our board of directors and will depend upon our earnings, our financial condition, the capital adequacy of First Security and FSGBank, opportunities for growth and expansion, our subsidiary’s need for funds, and other relevant factors, including applicable restrictions and governmental policies and regulations.

Our sources of income, other than investments held by us, and fees paid to us by our subsidiary, are limited to dividends we may receive from FSGBank. FSGBank’s ability to pay dividends is subject to statutory and regulatory restrictions on the payment of cash dividends applicable to FSGBank, and our need to maintain adequate capital in FSGBank and in our holding company. See “Item 1.—Business— SUPERVISION AND REGULATION —FSGBank—Payment of Dividends.”

Item 6.

Selected Financial Data

The data presented below is derived from the consolidated financial statements.

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Selected Consolidated Financial Data

		First Security
		Fiscal Year Ended December 31,
		2004			2003			2002			2001			2000
Income Statement Data: 1		(in thousands, except per share data)
Gross interest income		$	37,771		$	31,554		$	25,621		$	20,793		$	11,824
Gross interest expense			8,759			8,897			8,417			9,783			5,510
Net interest income			29,012			22,657			17,204			11,010			6,314
Provision for loan losses			3,399			2,122			1,948			2,496			811
Net interest income after provision for loan losses			25,613			20,535			15,256			8,514			5,503
Noninterest income			6,351			5,318			3,819			2,743			1,088
Noninterest expense 3, 4			27,117			22,278			14,915			11,004			7,504
Income before income taxes 3, 4			4,847			3,575			4,160			253			(913	)
Income tax provision (benefit)			1,365			1,119			1,558			235			(347	)
Income before extraordinary item 3, 4			3,482			2,456			2,602			18			(566	)
Extraordinary gain on business combination,   net of tax 2			785			-			-			-			-
Net income (loss) 3, 4		$	4,267		$	2,456		$	2,602		$	18		$	(566	)
Per Common Share: 1
Net income before extraordinary items - basic		$	0.28		$	0.20		$	0.28		$	0.00		$	(0.11	)
Net income - basic			0.34			0.20			0.28			0.00			(0.11	)
Net income before extraordinary items - diluted			0.27			0.20			0.27			0.00			(0.11	)
Net income - diluted			0.33			0.20			0.27			0.00			(0.11	)
Cash dividends declared			0.00			0.00			0.00			0.00			0.00
Tangible book value (shareholders’ equity)			5.60			5.25			5.44			4.59			4.05
Book value (shareholders’ equity)			6.80			6.49			6.23			6.54			6.21
At Period End: 1
Loans		$	592,357		$	478,013		$	348,582		$	291,043		$	152,913
Earning assets			702,985			575,996			436,774			328,330			177,461
Total assets			766,691			644,765			472,924			361,866			199,552
Deposits			640,526			540,304			384,483			293,877			162,514
Shareholders’ equity			86,445			82,438			67,933			39,265			30,594
Shares outstanding - basic 5			12,705			12,702			10,914			7,205			5,912
Shares outstanding - diluted 5			12,915			12,809			11,029			7,322			5,912
Average Balances: 1
Loans		$	514,479		$	422,332		$	311,774		$	221,624		$	107,483
Earning assets			610,585			530,777			384,483			254,739			132,377
Total assets			676,381			578,258			415,810			279,377			150,308
Deposits			588,547			496,654			337,198			233,007			114,239
Shareholders’ equity			83,630			78,284			56,039			33,292			30,754
Shares outstanding - basic 5			12,705			12,190			9,415			6,270			5,912
Shares outstanding - diluted 5			12,912			12,328			9,533			6,378			5,912
Key Ratios: 1
Return on average assets			0.63	%		0.42	%		0.63	%		0.01	%		(0.38	%)
Return on average shareholders’ equity			5.10	%		3.14	%		4.64	%		0.05	%		(1.84	%)
Net interest margin, taxable equivalent			4.83	%		4.34	%		4.53	%		4.32	%		4.77	%
Efficiency ratio 6			76.68	%		79.64	%		70.95	%		76.50	%		101.40	%
Dividend payout ratio			0.00	%		0.00	%		0.00	%		0.00	%		0.00	%
Average equity to average assets			12.36	%		13.54	%		13.48	%		11.92	%		15.30	%
Nonperforming assets to total assets			0.59	%		0.45	%		0.16	%		0.17	%		0.06	%
Nonperforming assets to loan loss reserve			54.78	%		54.33	%		14.10	%		15.77	%		5.66	%

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1

Data includes the consolidated financial statements of First Security Group, Inc., including the following from their date of acquisition: First State Bank in July 2002; Premier National Bank in March 2003; National Bank of Commerce’s branch offices located in Madisonville, Sweetwater and Tellico Plains, Tennessee in December 2003; and Kennesaw Leasing, Inc. and J&S Leasing, Inc. in October 2004.

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2	The extraordinary gain was recognized in conjunction with the Company’s acquisition of Kennesaw Leasing, Inc. and J&S Leasing, Inc. effective October 1, 2004. See “Note 2—Business Combinations” in the accompanying notes to the consolidated financial statements for further discussion.

3

Includes goodwill amortization of $481 thousand and $443 thousand in 2001 and 2000, respectively. Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”), No. 142, “Goodwill and other Intangible Assets,” which requires that goodwill no longer be amortized and instead be tested for impairment at least annually.

4	Includes amortization expense of $797 thousand, $550 thousand, and $102 thousand for core deposit intangibles in 2004, 2003, and 2002, respectively. Core deposit intangibles represent premiums paid for acquisitions of core deposits and are amortized on an accelerated basis over 10 years.

5	All share data has been retroactively adjusted for the 12 for 10 stock split to shareholders of record on December 10, 2004. See “Note 10—Common Stock Data” in the accompanying notes to the consolidated financial statements for further discussion.

6	Noninterest Expense divided by the sum of Net Interest Income and Noninterest Income.

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operation

The following discussion and analysis should be read in conjunction with “Selected Financial Data” and our financial statements and notes included in this Annual Report on Form 10-K. The discussion in the Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report. Our actual results could differ materially from those discussed in this Annual Report on Form 10-K.

All per share data has been retroactively adjusted for the 12 for 10 stock split effected on December 22, 2004. As a result of the split, the par value has been adjusted from $.0083 to $0.0069 per share; however, we have rounded the par value to $0.01 per share for presentation purposes. Retroactive adjustments were also made to all per share data for the previous two stock splits: (1) 12 for 10 split effected June 16, 2003, which resulted in the par value decreasing to $0.0083 from $0.01 and (2) 13 for 10 stock split in the form of a stock dividend effected on April 15, 2001.

Year Ended December 31, 2004

The following discussion and analysis sets forth the major factors that affected First Security’s financial condition as of December 31, 2004 and 2003, and results of operations for the three years ended December 31, 2004 as reflected in the audited financial statements.

Overview

As of December 31, 2004, First Security had total consolidated assets of $766.7 million, total loans of $592.4 million, total deposits of $640.5 million, and shareholders’ equity of $86.4 million. In 2004, our net income, after recognizing an extraordinary gain of $785 thousand (net of tax), was $4.3 million, resulting in basic and diluted net income of $0.34 and $0.33 per share, respectively.

We believe that our net income will continue to improve in 2005 as a result of our above-average net interest margin, our growth in 2004, and our anticipated growth through branching and marketing efforts in 2005.

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Critical Accounting Policies

The accounting and reporting policies of First Security and its subsidiaries are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. First Security’s significant accounting policies are discussed in detail in Note 1 in the “Notes to Consolidated Financial Statements.” Critical accounting policies include the initial adoption of an accounting policy that has a material impact of its financial presentation and accounting estimates reflected in its financial statements that require First Security to make assumptions about matters that were highly uncertain at the time of estimation. Disclosure about critical estimates is required if different estimates that First Security reasonably could have used in the current period, would have a material impact on the presentation of First Security’s financial condition, changes in financial condition or results of operations. Accounting policies related to the allowance for loan losses represent a critical accounting estimate.

 

The allowance for loan losses is established and maintained at levels management deems adequate to cover probable losses inherent in the portfolio as of the balance sheet date. The level is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, underlying estimated values of collateral securing loans, current economic conditions and other factors. Should any of these factors change, the estimate of credit losses in the loan portfolio and the related allowance would also change. For further discussion regarding our methodology for the allowance for loan and lease losses, see “Item 7.—Managements’ Discussion and Analysis of Financial Condition and Results of Operation—Provision for Loan Losses.”

Results of Operations

First Security reported net income for 2004 of $4.3 million versus net income for 2003 of $2.5 million. The net income for 2002 was $2.6 million. In 2004, basic net income was $0.34 per share on 12,705 thousand shares and $0.33 on 12,912 thousand weighted average diluted shares outstanding, respectively. In 2003, basic and diluted net income per share was $0.20 on 12,190 thousand and 12,328 thousand weighted average basic and diluted shares outstanding, respectively. For 2002, basic and diluted net income per share was $0.28 and $0.27 on 9,415 thousand and 9,533 thousand weighted average basic and diluted shares outstanding, respectively.

Net income in 2004 was above the 2003 level as a result of our enhanced net interest spread, our improved non-interest income and our recognition of a $785 thousand (net of tax) extraordinary gain on business combination. The gain on business combination resulted from our acquisition of Kenesaw Leasing, Inc. and J&S Leasing, Inc. (Knoxville, Tennessee) from National Bank of Commerce. Our overhead also increased in 2004 because we opened six new full service bank branches (two of which are designed to serve the Latino community in and around Dalton, Georgia) and acquired Kenesaw Leasing and J&S Leasing. As of December 31, 2004, we had 30 banking offices, including the headquarters, one loan production office, three leasing offices and 308 full time equivalent employees. Although, we anticipate that our branch network and our employees will enable growth in 2005, we are mindful of the fact that growth and increasing the number of branches adds expenses (such as administrative costs and occupancy, salaries and benefits expenses) before earnings.

The following table summarizes the components of income and expense and the changes in those components for the past three years.

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		Condensed Consolidated Statements of Income
		For the Years Ended December 31,
					Change									Change									Change
					From Prior									From Prior									From Prior
		2004			Year			%			2003			Year			%			2002			Year			%
		(Dollar amounts in thousands)
Interest income		$	37,771		$	6,217			19.7	%	$	31,554		$	5,933			23.2	%	$	25,621		$	4,828			23.2	%
Interest expense			8,759			(138	)		-1.6	%		8,897			480			5.7	%		8,417			(1,366	)		-14.0	%
Net interest income			29,012			6,355			28.1	%		22,657			5,453			31.7	%		17,204			6,194			56.3	%
Provision for loan losses			3,399			1,277			60.2	%		2,122			174			8.9	%		1,948			(548	)		-22.0	%
Net interest income after provision for loan losses			25,613			5,078			24.7	%		20,535			5,279			34.6	%		15,256			6,742			79.2	%
Noninterest income			6,351			1,033			19.4	%		5,318			1,499			39.3	%		3,819			1,076			39.2	%
Noninterest expense			27,117			4,839			21.7	%		22,278			7,363			49.4	%		14,915			3,911			35.5	%
Income before income taxes			4,847			1,272			35.6	%		3,575			(585	)		-14.1	%		4,160			3,907			1544.3	%
Income tax provision			1,365			246			22.0	%		1,119			(439	)		-28.2	%		1,558			1,323			563.0	%
Income before extraordinary item			3,482			1,026			41.8	%		2,456			(146	)		-5.6	%		2,602			2,584			14355.6	%
Extraordinary gain on business combination, net of income tax			785			785			100.0	%		-			-			-			-			-			-
Net income		$	4,267		$	1,811			73.7	%	$	2,456		$	(146	)		-5.6	%	$	2,602		$	2,584			14355.6	%

Further explanation, with year-to-year comparisons of the income and expense, is provided below.

Net Interest Income

Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. In 2004, net interest income was $29.0 million or 28% more than the 2003 level of $22.7 million, which in turn was 32% more than the 2002 level of $17.2 million.

First Security monitors and evaluates the effects of certain risks on its earnings and seeks balance between the risks assumed and the returns sought. Some of these risks include interest rate risk, credit risk and liquidity risk.

The level of net interest income is determined primarily by the average balances (volume) of interest-earning assets and the various rate spreads between our interest-earning assets and our funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest-earning assets and interest-bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest-earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest-bearing deposits.

Interest income in 2004 was $37.8 million, a 20% increase over the 2003 level of $31.6 million, which was 23% more than the $25.6 million earned in 2002. Year-to-year increases since 2002 are due to the annual increases in the volume of earning assets. Average earning assets in 2004 were $610.6 million, an increase of $79.8 million or 15% from 2003 average earning assets. The increase from 2002 to 2003 was $146.3 million or 38%. In 2004, our earning assets increased due to the deposit gathering activities (including the issuance of brokered CDs) of FSGBank. Deposits raised were used to fund or acquire earning assets, including our acquisition of Kenesaw Leasing and J&S Leasing. In 2003, our earning assets increased due to (1) the deposit gathering activities of FSGBank - deposits raised were used to fund or acquire earning assets, (2) the acquisition of Premier National Bank of Dalton - which had approximately $76.2 million in earning assets on the acquisition date, March 31, 2003, and (3) the acquisition of the National Bank of Commerce branches - which had approximately $12.9 million in earning assets on the acquisition date, December 4, 2003. These additional earning assets have enabled First Security to earn more interest income. Supplementing the additional earnings from increased volumes was the increase in yield on earnings assets. The tax equivalent yield on earning assets increased 25 basis points in 2004 to 6.26% from 6.01% in 2003; conversely, the yield on earning assets decreased in 2003 by 71 basis points from the 2002 level of 6.72%. The changes in the yield relate to (1) our changing the mix of earning assets from lower yielding assets such as federal funds sold to higher yielding loans and investment securities and (2) the Federal Reserve increasing the federal funds rate and the discount rate in 2004, which caused increases in the prime-lending rate.

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Total interest expense was $8.8 million in 2004 compared to $8.9 million in 2003, or 1.6% lower. Interest expense decreased in 2004 from 2003 because the savings generated through lower average rates paid on interest bearing liabilities exceeded the increase in interest expense resulting from the additional volume of interest bearing liabilities. Average interest-bearing liabilities increased $66.6 million or 16% from 2003 to 2004. The increase from 2002 to 2003 was $115.2 million or 39%. The increase in interest bearing liabilities in 2004 was due to FSGBank’s market penetration, and the issuance of brokered CD’s. The increase in 2003 was due to FSGBank’s market penetration, our acquisition of Premier National Bank of Dalton, and our acquisition of the National Bank of Commerce branches. The average rate paid on average interest-bearing liabilities decreased 33 basis points from 2.15% in 2003 to 1.82% in 2004, and from 2.81% in 2002 to 2.15% in 2003, a decrease of 66 basis points. The rate decreases in 2004, 2003 and 2002 resulted from Federal Reserve policy changes and the associated repricing characteristics of the interest bearing liabilities. Absent any competitive pricing pressures, we feel that our average rate paid on interest bearing liabilities will increase as our time deposits mature and reprice at current market levels, which have risen as a result of the Federal Reserves rate increase initiative.

The banking industry uses two key ratios to measure relative profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities. The net interest rate spread does not consider the impact of noninterest-bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest-bearing deposits in earning assets.

First Security’s net interest rate spread (on a tax equivalent basis) was 4.44% in 2004, 3.86% in 2003, and 3.91% in 2002, while the net interest margin (on a tax equivalent basis) was 4.83% in 2004, 4.34% in 2003, and 4.53% in 2002. The increased net interest margin from 2003 to 2004 was due to (1) our earning assets repricing faster than our interest bearing liabilities in an increasing interest rate environment and (2) changes in the mix of our earning assets (we invested federal funds sold into higher yielding assets such as loans and investment securities). Average interest bearing liabilities as a percentage of average earning assets was 79% in 2004, and 78% in 2003 and 2002.

At the beginning of 2002, the federal funds rate and the prime lending rate were 1.75% and 4.75%, respectively. In 2002, the Federal Reserve dropped interest rates 50 basis points, which effectively decreased the federal funds rate and the prime-lending rate to 1.25% and 4.25%, respectively. In 2003, the Federal Reserve dropped interest rates 25 basis points, which effectively decreased the federal funds rate and the prime-leading rate to 1.00% and 4.00%, respectively. During 2004, the Federal Reserve raised the federal funds rate five times by a total of 125 basis points, from 1.00% to 2.25%. So far in 2005, the Federal Reserve has raised the federal funds rate one time by 25 basis points to 2.50%. In 2005, we believe our net interest margin will remain relatively stable due to anticipated Federal Reserve rate increases and competitive deposit pricing.

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AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS

FULLY TAX-EQUIVALENT BASIS

		For the Years Ended December 31,
		2004									2003									2002
		Average			Income/			Yield/			Average			Income/			Yield/			Average			Income/			Yield/
		Balance			Expense			Rate			Balance			Expense			Rate			Balance			Expense			Rate
		(Dollar amounts in thousands)
		(Fully tax equivalent basis)
ASSETS
Earning assets:
Loans, net of unearned income		$	514,479		$	34,327			6.67	%	$	422,332		$	28,689			6.79	%	$	311,774		$	23,144			7.42	%
Investment securities			86,220			3,590			4.16	%		71,790			2,707			3.77	%		46,848			2,214			4.73	%
Other earning assets			9,886			332			3.36	%		36,655			520			1.42	%		25,861			470			1.82	%
Total earning assets			610,585			38,249			6.26	%		530,777			31,916			6.01	%		384,483			25,828			6.72	%
Allowance for loan losses			(6,044	)								(6,170	)								(4,198	)
Intangible assets			15,296									11,507									7,202
Cash & due from banks			21,259									17,263									13,253
Premises & equipment			25,514									18,997									10,949
Other assets			9,771									5,884									4,121
Total assets		$	676,381								$	578,258								$	415,810
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest bearing liabilities:
NOW accounts		$	52,104			183			0.35	%	$	36,362			121			0.33	%	$	24,431			249			1.02	%
Money market accounts			100,952			1,030			1.02	%		92,685			1,154			1.25	%		68,855			1,412			2.05	%
Savings deposits			32,789			114			0.35	%		23,120			151			0.65	%		13,228			171			1.29	%
Time deposits < $100			162,221			3,988			2.46	%		145,903			4,136			2.83	%		106,661			3,665			3.44	%
Time deposits > $100			96,433			2,522			2.62	%		92,635			2,749			2.97	%		66,218			2,450			3.70	%
Brokered CD’s			7,466			263			3.52	%		1,956			114			5.83	%		-			-			-
Federal funds purchased			4,686			88			1.88	%		356			4			1.12	%		1,277			24			1.88	%
Repurchase agreements			13,672			88			0.64	%		12,796			115			0.90	%		12,193			179			1.47	%
Other borrowings			10,494			483			4.60	%		8,399			351			4.18	%		6,165			267			4.33	%
Total interest bearing liabilities			480,817			8,759			1.82	%		414,212			8,895			2.15	%		299,028			8,417			2.81	%
Net interest spread					$	29,490			4.44	%				$	23,021			3.86	%				$	17,411			3.91	%
Noninterest bearing demand deposits			107,730									82,442									57,805
Accrued expenses and other liabilities			4,204									3,320									2,938
Shareholders’ equity			83,849									77,782									55,657
Accumulated other comp income			(219	)								502									382
Total liabilities and shareholders’ equity		$	676,381								$	578,258								$	415,810
Impact of  noninterest bearing sources  and other changes in balance sheet  composition									0.39	%								0.48	%								0.62	%
Net interest margin									4.83	%								4.34	%								4.53	%

 

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The following table shows the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest-bearing liabilities and the rates earned and paid by FSGBank on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amounts of the change in each category.

CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS

		2004 compared to 2003									2003 compared to 2002
		increase (decrease) in									increase (decrease) in
		interest income and expense									interest income and expense
		due to changes in:									due to changes in:
		Volume			Rate			Total			Volume			Rate			Total
		(Dollar amounts in thousands)
Earning assets:
Loans, net of unearned income		$	6,255		$	(617	)	$	5,638		$	7,510		$	(1,965	)	$	5,545
Investment securities			543			340			883			940			(447	)		493
Other earning assets			(380	)		192			(188	)		153			(103	)		50
Total earning assets			6,418			(85	)		6,333			8,603			(2,515	)		6,088
Interest bearing liabilities:
NOW accounts			52			10			62			40			(168	)		(128	)
Money market accounts			108			(232	)		(124	)		297			(555	)		(258	)
Savings deposits			62			(99	)		(37	)		65			(85	)		(20	)
Time deposits < $100			463			(611	)		(148	)		1,147			(619	)		528
Time deposits > $100			113			(340	)		(227	)		822			(466	)		356
Brokered CD’s			321			(172	)		149			-			-			-
Federal funds purchased			49			35			84			-			(20	)		(20	)
Repurchase agreements			8			(35	)		(27	)		5			(69	)		(64	)
Other borrowings			88			44			132			93			(9	)		84
Total interest bearing liabilities			1,264			(1,400	)		(136	)		2,469			(1,991	)		478
Increase (decrease) in net interest income		$	5,154		$	1,315		$	6,469		$	6,134		$	(524	)	$	5,610

Provision for Loan Losses

The provision for loan losses charged to operations during 2004 was $3.4 million compared to $2.1 million in 2003, and $1.9 million in 2002. In 2004, net charge-offs totaled $2.9 million, which is an increase of $200 thousand over 2003 charge-offs of $2.7 million. Charge-offs in 2002 were $788 thousand. Net charge-offs as a percentage of average loans were 0.57% in 2004, 0.63% for 2003, and 0.25% in 2002 and our Bank’s peer group averages (as reported in the December 31, 2004 Uniform Bank Performance Report) were 0.17%, 0.25%, and 0.22%, in 2004, 2003, and 2002, respectively. (See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset Quality.”)

In 2004 the provision for loan losses was more than in 2003 as a result of our analysis of inherent risks in the loan portfolio in relation to the portfolio’s growth, the level of past due, charged-off, classified, and nonperforming loans, as well as general economic weakness. The loan portfolio increased by $114.3 million from year-end 2003 to year-end 2004, compared to an increase of $129.4 million from year-end 2002 to year-end 2003. In 2004 we acquired approximately $60.6 million in leases in the acquisition of Kenesaw Leasing and J&S Leasing. With regard to our loan growth in 2003, we acquired approximately $57.7 million in loans in the acquisition of Premier National Bank of Dalton, and we acquired approximately $12.9 million in loans in the acquisition of the Monroe County branches from National Bank of Commerce. Excluding maturities, prepayments, and payoffs of the purchased loans, our organic loan growth for 2004 was approximately $53.7 million as a result the marketing efforts of our loan officers.

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We anticipate that during 2005 our provision expense for loan losses will increase due to continued loan growth. We believe that our organic loan growth in 2005 will outpace the 2004 level of $56.6 million as a result of our branching and marketing activities.

The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. We periodically analyze our loan portfolio in an effort to establish an allowance for loan losses that we believe will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, we review the size, quality and risk of loans in the portfolio. We also, on at least a quarterly basis, consider such factors as:

Ÿ      FSGBank’s loan loss experience;

Ÿ      the amount of past due and nonperforming loans;

Ÿ      specific known risks;

Ÿ      the status and amount of past due and nonperforming assets;

Ÿ      underlying estimated values of collateral securing loans;

Ÿ      current economic conditions; and

Ÿ      other factors which we believe affect potential credit losses.

Due to the weak economic climate of 2002 and an increase in our nonperforming assets, management felt it prudent to strengthen our credit underwriting processes, as well as adopt a year-round loan review program. As a result, early in 2003 we hired an experienced senior credit administration officer and an experienced senior loan review officer to oversee these efforts. During 2003, we established a credit administration and loan review process which has strengthened the monitoring, controlling, and measuring of our credit risk. During 2004, we further improved our underwriting by standardizing credit analyses and developing a comprehensive credit policy.

The primary objective of the loan review function is to effectively and efficiently monitor the quality of First Security’s loan portfolio, determine compliance with applicable laws and regulations, assess loan policies and procedures, validate the internal loan risk management system and provide enhancements to strengthen our credit culture. The loan review department reports its findings directly to the audit committee of First Security’s board of directors. In 2004 our loan review department evaluated $177.8 million of our loans or approximately 35% of our loan portfolio’s 2004 average size.

FSGBank’s allowance for loan losses is subject to regulatory examinations and determinations as to adequacy which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses compared to a group of peer banks identified by the regulators. During their routine examinations of banks, regulators may require a bank to make additional provisions to its allowance for loan losses when, in the opinion of the regulators, their credit evaluations and allowance for loan loss methodology differ materially from those of FSGBank.

During 2004 we made further improvements in our methodology and analysis of the loan loss reserve. In addition to analyzing significant classified loans for possible deficiencies in sources of repayment, we also analyzed the loss history in specific pools of loans such as industrial classifications. We then forecasted loss potential on similar pools of loans.

Our primary grouping of loans that are specifically analyzed for loss potential and specific reserves are as follows:

1.

Significant Classified Loans: Significant classified loans generally those loans with a risk rating of substandard and a total exposure exceeding $500,000, as well as all loans with a risk rating of doubtful. For this loan group, management estimates the specific potential losses based upon an individual analysis of the relationship risks, the borrower’s cash flow, the borrower’s management and any underlying secondary sources of repayment. If management believes or an outside third party’s valuation indicates that the value of the secondary sources of repayment is less than the balance of the total corporate exposure, then a specific reserve is established. The definition of both substandard and doubtful risk ratings are outlined in item 2 below.

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2.

Other Classified and Criticized Loans: We reserve for loan pools that are criticized and classified, but are not considered “significant”, as described in item 1 above, using flat percentages depending on the pool’s risk rating and the geographic risk assessment. For this group, we analyze the geographic loan pools as follows:

i.

Loans with Risk Ratings of Special Mention: We reserve for special mention loans using a flat percentage between 3.5% and 5% of the loan balance. The flat percentage is 5% for those loans or local economies that we consider to have moderate to high risk characteristics; and, the flat percentage is 3.5% for those loans or local economies considered to have the same risk factors measured as low to moderate. The special mention risk rating is considered a criticized loan and is not considered as severe as a classified loan risk rating. Special mention loans are loans that must be followed closely because of identified potential weaknesses, which if not checked and corrected, could result in an unacceptable increase in credit risk at some future date. As of December 31, 2004, we had $11.4 million of special mention loans compared to $13.3 million as of December 31, 2003. These loans may be characterized by:

Loans to Businesses:

Ÿ      Downward trend in sales, profit levels and margins

Ÿ      Impaired working capital position compared to industry

Ÿ      Cash flow strained in order to meet debt repayment schedule

Ÿ      Technical defaults due to noncompliance with financial covenants

Ÿ      Recurring trade payable slowness

Ÿ      High leverage compared to industry average with shrinking equity cushion

Ÿ      Questionable abilities of management

Ÿ      Weak industry conditions

Ÿ  Inadequate or outdated financial statements; if audited, adverse opinion may be issued

 

Loans to Businesses or Individuals:

Ÿ      Loan delinquencies and overdrafts may occur

Ÿ      Original source of repayment questionable

Ÿ      Documentation deficiencies may not be easily correctable

Ÿ      Loan may need to be restructured

Ÿ      Collateral or guarantor offers adequate protection

Ÿ      Unsecured debt to tangible net worth is excessive

ii.

Loans with Risk Ratings of Substandard: We reserve for substandard loans that are generally less than $500,000 using a flat percentage between 11% and 15% of the loan balance. We used a flat percentage of 15% for those loans or economies that we considered to have a moderate to high risk characteristics; and, the flat percentage was 11% for those loans or economies considered to have the same risk factors measured as low to moderate. We generally consider substandard loans to possess three times the risk of special mention loans. Substandard loans are loans that reflect significant deficiencies with specifically identified and well defined weaknesses due to severely adverse trends of a financial, economic, or managerial nature. As of December 31, 2004, First Security had $26.5 million of substandard loans compared to $12.6 million as of December 31, 2003. The significant increase in substandard loans was a result of the acquisition of the Kenesaw Leasing and J&S Leasing portfolios. Substandard leases represented $13.2 million of the $26.5 million in substandard loans at December 31, 2004. We have assigned specific reserves of $725 thousand for those substandard leases. For substandard loans, a protracted work-out is likely due to the following factors, in addition to those listed for special mention loans:

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Loans to Businesses:

 

Ÿ      Sustained losses which have severely eroded equity and cash flows

Ÿ      Concentration in liquid assets

Ÿ      Serious management problems or internal fraud

Ÿ      Chronic trade payable slowness; may be placed on COD or collection by trade creditor

Ÿ      Inability to access other funding sources

Ÿ      Financial statements with adverse opinion or disclaimer; may be received late

Ÿ      Insufficient documented cash flows to meet contractual debt service requirements

 

Loans to Businesses or Individuals:

Ÿ      Chronic or severe delinquency

Ÿ      Original repayment terms liberalized due to inability to meet original terms

Ÿ      Frequent overdrafts

Ÿ      Likelihood of bankruptcy exists

Ÿ      Serious documentation deficiencies

Ÿ      Reliance on secondary sources of repayment which are presently considered adequate

Ÿ      Demand letter may have been sent

Ÿ      Litigation may have been filed against the borrower

Ÿ      Interest non-accrual may be warranted

 

iii.

Loans with Risk Ratings of Doubtful: We analyze doubtful loans individually to determine our best estimate of loss based upon the most recent assessment of all available sources of repayment. The amount of the estimated loss is then specifically reserved in a separate component of the allowance of loan loss reserve. Doubtful loans are loans where the collection or liquidation in full of principal and/or interest is highly questionable or improbable. Doubtful loans must be placed on non-accrual, and the principal balance charged down to estimated collectable value, or a full or partial reserve must be allocated. As of December 31, 2004, First Security had $1.4 million of doubtful loans compared to $1.9 million as of December 31, 2003, and $3 thousand as of December 31, 2002. In addition to the characteristics listed for substandard loans, the following characteristics apply:

 

Loans to Businesses:

Ÿ      Normal operations are severely diminished or have ceased

Ÿ      Seriously impaired cash flow

Ÿ      Numerous exceptions to loan agreement

Ÿ      Outside accountant questions entity’s survivability as a “going concern”

Ÿ      Financial statements may be received late if at all

Ÿ      Material judgments filed

Ÿ      The collection of principal and interest is impaired

Ÿ      Collateral/Guarantor may offer inadequate protection; possibility of partial loss exists

Loans to Businesses or Individuals:

Ÿ      Original repayment terms materially altered

Ÿ      Secondary source of repayment is inadequate

Ÿ      Asset liquidation may be in process with all efforts directed at debt retirement

Ÿ      Documentation deficiencies not correctable

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iv.

Loans with Risk Ratings of Loss: We reserve loss loans at 100% of the loan balance pursuant to our loan policy. Loss loans are loans of such limited value that they do not merit continuance as an acceptable asset, and therefore must be charged off in full in the fiscal quarter this grade is assigned. As of December 31, 2004, December 31, 2003 and December 31, 2002, First Security did not have any loans risk rated as loss.

3.

Unclassified and Uncriticized Loans, excluding Leases: In our analysis of these loan pools, we establish our reserves using our historical net charge-off base rate adjusted for eight risk factors. We calculate the net charge-off base rate as FSGBank’s net charge-off average rate for the prior four years. In other words, for our December 31, 2004 analysis we used the Bank’s 2001 through 2004 average net charge-off rate of 0.43% for the bank’s pool of unclassified and uncriticized loans. Next, we adjusted the net charge-off base rate to reflect the effect of any current conditions for possible loss. To calculate the adjustments, we considered the following eight risk factors, which are also referenced in the Comptroller’s Handbook for National Bank Examiners.

·	Changes in lending policies and procedures, underwriting standards, collection, charge off and recovery practices.

·	Changes in national and local economic and business conditions.

·	Changes in the nature and volume of the portfolio.

·	Changes in the experience, ability, and depth of lending management staff.

·	Changes in the severity of credit quality indicators.

·	Changes in the quality of the bank’s loan review system.

·	The extension and effect of or changes in credit concentrations.

·	The effect of external factors such as competition, legal and regulatory factors.

We assigned a rating of low, medium or high for each of the eight risk factors. A “low” rating decreased the net charge-off base by 10%; a “medium” rating increased the net charge-off base by 10%; and, a “high” rating increased the net charge-off base by 20%. As of December 31, 2004, the adjusted reserve rate for First Security’s unclassified and uncriticized loans was 0.56%.

For purposes of analyzing the allowance for loan losses, the unclassified and uncriticized loan pools do not include binding commitments to lend, standby letters of credit, deposit secured loans or mortgage loans originated with commitments to sell in the secondary market. Loans secured by segregated deposits held by FSGBank are not required to maintain an allowance reserve, nor are originated mortgage loans pending sale in the secondary market.

4.	Unclassified and Uncriticized Leases

For those leases not assigned a classified risk rating we chose to use the historical loss percentage of each leasing company as the factor upon which to establish a reserve for this pool of leases. For the Kenesaw Leasing pool of leases we used a 2.90% factor which equates to their four year average of net lease losses and for the J&S Leasing pool of leases we used their four year annual high of 2.39%.

While it is our practice to charge off in the current period loans for which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise. For further information on First Security’s allowance for loan losses, see “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operation—Asset Quality.”

 

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Noninterest Income

Total noninterest income for 2004 was $6.4 million, compared to $5.3 million in 2003 and $3.8 million in 2002. The following table presents the components of noninterest income for 2004, 2003, and 2002. We believe that our deposit related noninterest income will continue to improve in 2005, but mortgage loan fee income will likely decrease due to declining mortgage originations resulting from increases in the 15- and 30-year mortgage interest rates.

NONINTEREST INCOME

		For the Years ended December 31,
					Percent						Percent
		2004			Change			2003			Change			2002
		(Dollar amounts in thousands)
NSF Fees		$	2,903			75.7	%	$	1,652			27.0	%	$	1,301
Service charges on deposit accounts			970			32.9	%		730			31.1	%		557
Mortgage loan and related fees			1,344			-37.7	%		2,157			63.9	%		1,316
Net gain on sales of available for sale securities			84			250.0	%		24			-72.1	%		86
Other income			1,050			39.1	%		755			35.1	%		559
Total noninterest income		$	6,351			19.4	%	$	5,318			39.3	%	$	3,819

One of the largest sources of noninterest income for First Security is service charges and fees on deposit accounts held by FSGBank. Total service charges, including non-sufficient funds fees, were $3.9 million, or 61% of total noninterest income for 2004, compared with $2.4 million or 45% for 2003 and $1.9 million, or 49% for 2002. During 2004, we implemented a “bounce protection” program for our customers. Bounce protection is an overdraft product that pays our customers’ non-sufficient fund checks (to a predetermined limit) for a fee. This program and our growing deposit base caused our NSF fee income to increase. The year-over-year increase in service charges on deposit accounts is directly related to the increase in the number of deposit accounts at FSGBank. During 2003 we had a net gain of 8,370 transaction and savings accounts, while we had a net gain of 1,851 accounts during 2004. At year-end 2004 we had 31,538 transaction and savings accounts, and anticipate the number of accounts will continue to increase in 2005 .

Mortgage loan and related fees for 2004 were $1.3 million, compared to the 2003 level of $2.2 million, compared to the 2002 level of $1.3 million. Low interest rates and the expansion of our mortgage operations led to the increase in our mortgage related income in 2003. Since then the 15- and 30-year mortgage interest rates increased and our mortgage loan fee income declined. Substantially all of the mortgage loan and related fees recorded during 2004 were received as the result of originating approximately $80.7 million of residential mortgages that were subsequently sold into the secondary market; in 2003, we originated and sold approximately $110.6 million of residential mortgages; and in 2002 we originated $82.7 million of residential mortgages. We sold these loans with the right to service the loans (the servicing asset) being released to the purchaser for a fee.

Other income for 2004 was $1.1 million, compared to the 2003 level of $755 thousand, compared to the 2002 level of $559 thousand. The components of other income primarily consist of point-of-sale fees on debit cards, credit card fee income, ATM fee income, and safe deposit box fee income. The most significant increase relates to point-of-sale fees on debit cards which totaled approximately $391 thousand, $223 thousand, and $160 thousand in 2004, 2003, and 2002, respectively.

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Noninterest Expense

Total noninterest expense for 2004 was $27.1 million, compared to $22.3 million in 2003 and $14.9 million in 2002. Noninterest expense for 2004 included an increase of approximately $2.8 million in salaries and benefits as a result of growth within our core banking markets and the acquisition of Kenesaw Leasing and J&S Leasing. Noninterest expense for 2003 included $248 thousand of charges related to the acquisition of Premier National Bank of Dalton, primarily for legal and professional fees. Noninterest expense for 2002 included $438 thousand of charges related to the acquisition of First State Bank, primarily for employee salaries and professional fees. Unless indicated otherwise in the discussion below, we anticipate increases in noninterest expense for 2005 as a result of our branching activities. The following table represents the components of noninterest expense for the years ended December 31, 2004, 2003 and 2002.

NONINTEREST EXPENSE

		For the Years ended December 31,
					Percent						Percent
		2004			Change			2003			Change			2002
		(Dollar amounts in thousands)
Salaries & Benefits		$	14,776			23.0	%	$	12,014			44.8	%	$	8,299
Occupancy			2,033			33.5	%		1,523			41.0	%		1,080
Furniture and Equipment			2,229			34.6	%		1,656			51.0	%		1,097
Professional Fees			1,129			18.3	%		954			0.9	%		946
Data Processing			1,167			-1.4	%		1,184			56.0	%		759
Printing & Supplies			597			3.7	%		576			52.8	%		377
Communications			531			14.4	%		464			42.8	%		325
Advertising			498			15.6	%		431			39.9	%		308
Intangible Asset Amortization			797			44.9	%		550			439.2	%		102
Other Expense			3,360			14.8	%		2,926			80.4	%		1,622
Total Noninterest Expense		$	27,117			21.7	%	$	22,278			49.4	%	$	14,915

Total salaries and benefits for 2004 increased by 23% over the 2003 level. The increase in salaries and benefits is related to our branch openings and staff additions to accommodate our growth, as well as the acquisition of the leasing companies, which added approximately $348 thousand in salaries and benefits in 2004. As of December 31, 2004, we had 30 full service banking offices, one loan production office and three leasing offices with 308 full time equivalent employees; as of December 31, 2003, we had 24 full service banking offices with 258 full time equivalent employees; and, as of December 31, 2002, we had 16 full service banking offices and three loan production offices with 187 full time equivalent employees. In 2005 we plan to build five new branches in markets not currently served by us . Additionally, we anticipate renovating our new corporate headquarters building located at 531 Broad Street, Chattanooga, Tennessee. We will most likely occupy the new headquarters in the later part of 2005.

Total occupancy expense for 2004 increased by 33.5% compared with 2003, which was 41.0% more than 2002. The increase in 2004 was due to our opening six de novo branches and assuming three facility leases through our acquisition of Kenesaw Leasing and J&S Leasing. Increases in 2003 were the result of acquiring Premier National Bank of Dalton (with its two banking offices), along with the four National Bank of Commerce locations and opening five de novo branches. The increase in 2002 was due to our acquisition of First State Bank, as well as opening two de novo branches and two loan production offices. In 2004 First Security leased 10 facilities and it leased the land for four branches (see “Item 2—Properties”). As a result, current period occupancy expense is higher than if we owned these facilities, including the real estate, but conversely and due to favorable market conditions and lease terms, we have been able to deploy the capital into earning assets rather than capital expenditures for facilities.

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Similar to occupancy expense, furniture and equipment expense and communication expense increased in 2004 due to adding six new branch facilities and the acquisition of Kenesaw Leasing and J&S Leasing. The increase in 2003 was due to the acquisition of Premier National Bank of Dalton, the three full service bank branches from National Bank of Commerce, and our de novo branching additions.

Professional fees increased to $1.1 million or 18% from 2003 to 2004. Professional fees include fees related to outsourcing internal audit, internal control testing, loan review, compliance and information technology audit to Professional Bank Services, as well as human resource/compensation consulting, external audit and tax services, and legal and accounting advice related to, among other things, potential acquisitions, investment securities, trademarks and intangible properties. Most of the increase for 2004 is related to meeting the internal control requirements of Section 404 of the Sarbanes-Oxley Act of 2002. In 2003, we had acquisition/conversion fees related to the Premier National Bank of Dalton and the National Bank of Commerce branch acquisitions.

Data processing expense decreased $17 thousand, or 1.4% as a result of our conversion of the four banking regions into one data processing system. Data processing expense increased $425 thousand from 2002 to 2003 as a result of our growth in loans and deposits, as well as our acquisition of Premier National Bank of Dalton and the National Bank of Commerce branches. Our external data processor is Fidelity Integrated Financial Solutions (formerly Intercept) located in Maryville, Tennessee. The monthly fees associated with data processing are based primarily on transaction volume. Therefore, as First Security grows, we believe that data processing costs will increase correspondingly.

Printing, supplies and advertising increased in 2004 due to our branching efforts. In 2003, the increase was attributable to the acquisition of Premier National Bank of Dalton, the acquisition of the National Bank of Commerce branches and the change of our bank name to FSGBank.

In 2004 intangible asset amortization expense increased by 45% over 2003. Excluding new bank or branch acquisitions and the related intangible assets created, we expect intangible asset amortization expense to decline in 2005 due to our core deposit intangible assets amortizing on an accelerated basis. In 2004 we had a new amortizing intangible asset associated with the purchase of license fee agreements related to operating Primer Banco Seguro branches within our market. These license agreements are amortized on a straight-line basis over a period of 10 years. The gross carrying amount of these license fees is $500 thousand at December 31, 2004. In 2003 we completed two acquisitions which created new intangible assets: (1) the core deposit intangible and goodwill created by the March 31, 2003 acquisition of Premier National Bank of Dalton were $1.3 million and $3.5 million, respectively, and (2) the core deposit intangible and goodwill created by the December 4, 2003 acquisition of the National Bank of Commerce branches were $1.5 million and $760 thousand, respectively. In 2002 a new core deposit intangible asset and goodwill of $1 million and $1.9 million, respectively, were created by the July 20, 2002 acquisition of First State Bank. In each case the estimated useful life of core deposit intangible is 10 years. As a result of the adoption of SFAS 142, goodwill amortization expense has not been incurred since 2001; however, the goodwill will be written down should the carrying value become impaired. In 2004 and 2003 we determined that the carrying value of our goodwill was not impaired and thus no goodwill write-downs were incurred. The following table represents our anticipated intangible asset amortization over the next five years, excluding new additions.

		2005			2006			2007			2008			2009
		(amounts in thousands)
Core Deposit Intangible Amortization Expense		$	596		$	453		$	350		$	273		$	216
License Fee Agreement Amortization Expense			50			50			50			50			50
Total Amortization Expense		$	646		$	503		$	400		$	323		$	266

Income Taxes

First Security booked income tax expense of $1.4 million in 2004, compared with $1.1 million in 2003, and $1.5 million in 2002. First Security’s effective tax rates for 2004, 2003, and 2002 were 28%, 31%, and 37%, respectively. Barring legislative tax changes, we anticipate our effective tax rate to remain stable in 2005. As of December 31, 2004, First Security’s net deferred tax liability was $1 million and as of December 31, 2003, First Security’s net deferred tax liability was $29 thousand.

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Extraordinary Gain on Business Combination

Effective October 1, 2004, the Company acquired 100% of the outstanding common shares of Kenesaw Leasing and J&S Leasing. These companies are located in our immediate market area of Knoxville, Tennessee and were acquired to diversify our loan portfolio and enhance our revenue. As a result of the acquisition, the Company recognized an extraordinary gain, net of income tax, of $785 thousand. See “Note 2—Business Combinations” in the accompanying notes to the consolidated financial statements for discussion of the recognition of the gain in accordance with the provisions of SFAS No. 141.

Statement of Financial Condition

First Security ended 2004 with consolidated assets of $766.7 million, a 19% increase over the year end 2003 level of $644.8 million. Our asset growth is directly related to deposit growth and the funds available to First Security for investment. In 2004 our consolidated assets increased due to (1) the branching and deposit gathering activities of FSGBank and (2) the acquisition of Kenesaw Leasing and J&S Leasing, which we funded by issuing brokered CDs. In 2003 our consolidated assets increased due to (1) the branching and deposit gathering activities of FSGBank, (2) the acquisition of Premier National Bank of Dalton - which had an estimated fair value of approximately $87 million in assets on the acquisition date, and (3) the acquisition of the National Bank of Commerce branches - which had approximately $47.5 million in assets on the acquisition date. In 2004 we opened six de novo bank branches and assumed three leasing offices through our acquisition of Kenesaw Leasing and J&S Leasing. In 2003 we opened five de novo bank branches and acquired five bank branches through our two acquisitions. In 2005 we expect our assets to continue growing because we plan to (1) further leverage our existing bank branches, (2) build five new de novo branches in markets not currently served by us, and (3) actively pursue additional acquisitions of existing banks and bank branches.

First Security continues to seek means to enhance our core deposit market share through acquisitions and further branching to the extent our capital will enable us to do so.

Loans

Our loan demand continues to be fairly strong. Total loans increased 24% from year-end 2003 to year-end 2004, and 37% from year-end 2002 to year-end 2003. The increase in loans in 2004 is attributable to (1) our acquisition of Kenesaw Leasing and J&S Leasing and (2) our branching efforts along with the lending efforts of our senior management lending team. The increase in loans in 2003 is attributable to (1) our acquisition of Premier National Bank of Dalton, (2) our acquisition of the National Bank of Commerce branches, (3) our experienced senior management lending team, (4) our branching efforts and (5) the low interest rate environment (in 2001, the prime-lending rate decreased from 9.5% to 4.75%, decreased to 4.25% in 2002, and decreased to 4.00% in 2003). We believe that general loan growth will remain strong. Funding of future loan growth may be restricted by our ability to raise core deposits, although we will use alternative funding sources if necessary and cost effective. Loan growth may also be restricted by the necessity for us to maintain appropriate capital levels, as well as adequate liquidity. The following table presents a summary of the loan portfolio by category for the last three years.

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LOANS OUTSTANDING

		As of December 31,
		2004			% Change			2003			% Change			2002			% Change
		(Dollars amounts in thousands)
Commercial - leases, net of unearned		$	60,228			100.0	%	$	-			-		$	-			-
Commercial - loans			116,490			1.0	%		115,347			6.1	%		108,761			11.4	%
Real estate - construction			77,804			82.9	%		42,539			48.2	%		28,701			51.7	%
Real estate - mortgage			264,606			9.4	%		241,985			66.7	%		145,203			26.5	%
Installment loans to individuals			70,891			-7.0	%		76,203			17.6	%		64,771			8.7	%
Other			2,338			20.6	%		1,939			69.2	%		1,146			684.9	%
Total loans		$	592,357			23.9	%	$	478,013			37.1	%	$	348,582			19.8	%

Substantially all of First Security’s loans are to customers located in Georgia and Tennessee, in the immediate markets of FSGBank. Other than a carpet industry concentration in Dalton, Georgia (as of December 31, 2004, loans related to the carpet industry were approximately $8.6 million), we believe that First Security is not dependent on any single customer or group of customers whose insolvency would have a material adverse effect on operations. We also believe that the loan portfolio is diversified among loan collateral types, as noted by the following table.

LOANS BY COLLATERAL TYPE

		As of December 31,
					% of						% of						% of
		2004			Loans			2003			Loans			2002			Loans
		(Dollar amounts in thousands)
Secured by Real Estate:
Construction and Land Development		$	77,804			13.1	%	$	42,539			8.9	%	$	28,701			8.2	%
Farmland			14,797			2.5	%		2,659			0.6	%		2,123			0.6	%
Home Equity Lines of Credit			67,761			11.4	%		50,082			10.4	%		31,813			9.1	%
Residential First Liens			68,588			11.6	%		72,045			15.0	%		53,528			15.4	%
Residential Jr. Liens			3,418			0.6	%		4,140			0.9	%		2,582			0.7	%
Multi-family Residential			9,960			1.7	%		11,431			2.4	%		7,550			2.2	%
Non-farm and Non-Residential			100,082			16.9	%		101,628			21.3	%		47,607			13.7	%
Total Real-Estate			342,410			57.8	%		284,524			59.5	%		173,904			49.9	%
Other Loans:
Commercial - leases, net of unearned			60,228			10.2	%		-			-			-			-
Commercial and Industrial			116,490			19.7	%		115,347			24.2	%		108,228			31.0	%
Agricultural Production			1,942			0.3	%		1,728			0.4	%		533			0.2	%
Credit Cards and Other Revolving Credit			1,718			0.3	%		1,071			0.2	%		717			0.2	%
Consumer Installment Loans			69,173			11.7	%		75,132			15.7	%		64,054			18.4	%
Other			396			0.0	%		211			0.0	%		1,146			0.3	%
Total Other Loans			249,947			42.2	%		193,489			40.5	%		174,678			50.1	%
Total Loans		$	592,357			100.0	%	$	478,013			100.0	%	$	348,582			100.0	%

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The following table sets forth the maturity distribution of the loan portfolio as of December 31, 2004. First Security’s loan policy does not permit automatic roll-over of matured loans.

LOANS BY MATURITY

		As of December 31, 2004
					Over three			One year
		Less than			months to			to			Over five
		three months			twelve months			five years			years			Total
		(Dollar amounts in thousands)
Closed end 1-4 Family residential		$	17,738		$	7,333		$	42,172		$	1,345		$	68,588
All other loans			256,601			52,484			182.938			31,746			523,769
Total		$	274,339		$	59,817		$	225,110		$	33,091		$	592,357

Asset Quality

We consider our subsidiary’s asset quality to be of primary importance. At year-end 2004, our loan portfolio was 77% of total assets. At the beginning of 2003, we hired an experienced senior credit administration officer and an experienced senior loan review officer to oversee these respective areas at First Security. We took this action because of the size of our loan portfolio and its historical and future projected growth, as well as the economy not showing signs of recovery and increases in our past due, classified and nonaccrual loans. As a result of these hires, we have gained a better understanding of our asset quality and established better warning and early detection systems regarding our loans. While FSGBank’s trend in nonaccrual loans is higher than prior year, its trend in loans 90 days past due is down. Furthermore, we remain below our peer group on aggregated nonaccrual and 90-day past due loans as a percentage of gross loans. (See “Management’s Discussion and Analysis of Financial Condition and Results of Operations -- Provision for Loan Losses” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Nonperforming Assets.”)

The allowance for loan losses represents management’s estimate of an amount adequate in relation to the risk of losses inherent in the loan portfolio. We analyze the loan portfolio regularly to identify potential problems. We undertake this analysis in conjunction with the establishment of our allowance for loan losses to provide a basis for determining the adequacy of our loan loss reserves to absorb losses that we estimate might be experienced. Furthermore, our credit administration personnel conduct regularly scheduled problem-asset meetings in which past due and classified loans are thoroughly analyzed. In addition to these analyses of existing loans, management considers FSGBank’s historical loan losses, past due and non-performing loans, current economic conditions, underlying loan collateral values and other factors which may affect probable loan losses. First Security’s methodology for determining the adequacy of the allowance for loan losses is explained in further detail in “Management’s Discussion and Analysis of Financial Condition and Results of Operations -- Provision for Loan Losses.”

The following table presents a summary of changes in the allowance for loan losses for the past three years. In 2004 loan charge-offs increased over the level in 2003. Our 2004 and 2003 net charge-offs as a percentage of average loans were 0.61% and 0.63%, respectively, or 44 and 40 basis points more than FSGBank’s peer group average of 0.17% and 0.23%, respectively. In 2004 gross loan charge-offs were $3.8 million of which approximately $2.4 million resulted from bankruptcies. The majority of these bankruptcy related charge-offs were unsecured loans. In 2004 we enhanced our loan policy to strengthen our credit culture. As such, unsecured loan requests now require the borrower to meet more stringent financial requirements. Loans representing approximately one-fourth of these charge-offs had been originated and underwritten by loan officers who are no longer employed by First Security. In 2004 we made aggressive decisions regarding the status of each potential problem loan reviewed to determine whether the loan met all the requirements to remain a bankable asset. We believe that charge-offs, as a percent of average loans, will decrease in 2005 (barring continued increases in bankruptcies) as a result of our efforts to improve our loan underwriting, approval process, servicing, problem identification, and problem resolution.

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ANALYSIS OF CHANGES IN ALLOWANCE FOR LOAN LOSSES

		For the years ended December 31,
		2004			2003			2002
		(Dollar amounts in thousands)
Allowance for loan losses -
Beginning of period		$	5,827		$	5,362		$	3,825
Provision for loan losses			3,399			2,122			1,948
Additions due to business combinations			2,011			1,011			377
Sub-total			11,237			8,495			6,150
Charged off loans:
Commercial - leases			-			-			-
Commercial - loans			1,698			2,188			414
Real estate - construction			45			-			-
Real estate - residential mortgage			328			11			22
Consumer and other			1,356			1,001			432
Total charged off			3,427			3,200			868
Recoveries of charged-off loans:
Commercial - leases			26			-			-
Commercial - loans			385			387			54
Real estate - construction			-			-			-
Real estate - residential mortgage			-			-			-
Consumer			91			145			26
Total recoveries			502			532			80
Net charged-off loans			2,925			2,668			788
Allowance for loan losses - end of period		$	8,312		$	5,827		$	5,362
Total loans - end of period		$	592,357		$	478,013		$	348,582
Average loans		$	514,479		$	422,332		$	311,774
As a percentage of average loans:
Net loans charged-off			0.57	%		0.63	%		0.25	%
Provision for loan losses			0.66	%		0.50	%		0.62	%
Allowance for loan losses as a percentage of:
Year end loans			1.40	%		1.22	%		1.54	%
Non-performing assets			182.56	%		200.03	%		709.26	%

We believe that the allowance for loan losses at December 31, 2004 is sufficient to absorb losses inherent in the loan portfolio based on our assessment of the information available. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance for loan losses cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examinations of FSGBank, may require additional charges to the provision for loan losses in future periods if the results of their reviews warrant. See “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Provision for Loan Losses.”

 

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ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

		December 31,
		2004						2003						2002
					Percent of						Percent of						Percent of
					loans in each						loans in each						loans in each
					category to						category to						category to
		Amount			total loans			Amount			total loans			Amount			total loans
		(Dollar amounts in thousands)
Commercial - leases		$	1,202			10.2	%	$	-			0.0	%	$	-			0.0	%
Commercial - loans			2,244			20.0	%		2,379			24.6	%		2,446			31.2	%
Real estate - construction			700			13.1	%		262			8.9	%		271			8.2	%
Real estate - mortgage			3,432			44.7	%		2,187			50.6	%		1,650			41.7	%
Consumer			728			12.0	%		712			15.9	%		672			18.6	%
Unallocated and charter condition			6			0.0	%		287			0.0	%		323			0.3	%
Total		$	8,312			100.0	%	$	5,827			100.0	%	$	5,362			100.0	%

Nonperforming Assets

Nonperforming assets include nonaccrual loans, accruing loans contractually past due 90 days or more, restructured loans, other real estate, and other real estate under contract for sale. We place loans on non-accrual status when we have concerns relating to our ability to collect the loan principal and interest, and generally when such loans are 90 days or more past due. Nonaccrual loans totaled $985 thousand, $183 thousand and $667 thousand as of December 31, 2004, 2003 and 2002, respectively. We earned interest of $65 thousand, $11 thousand and $27 thousand on these loans during 2004, 2003 and 2002, respectively. If these loans had been performing, we would have earned an additional $16 thousand, $10 thousand and $12 thousand in 2004, 2003 and 2002, respectively. No amount of loans that have been classified by regulatory examiners as loss, substandard, doubtful, or special mention has been excluded from amounts disclosed as nonperforming loans. Nonperforming assets represent potential losses to First Security; however, in compliance with FAS 114, we have measured the impairment of these loans and adjusted them to either the present value of expected future cash flows, the fair value of the collateral, or the observable market price.

Loans 90 days or more past due totaled $1.2 million and consisted of $27 thousand in construction and land development loans, $111 thousand in farmland loans, $93 thousand in residential 1 - 4 family mortgage loans, $165 thousand in non-farm/nonresidential loans, $263 thousand in commercial and industrial loans, $118 thousand in consumer loans and $453 thousand in leases.

The $2,338 thousand in other real estate owned consisted of $520 thousand in vacant land and construction, $1,641 thousand in residential real estate and $177 thousand in non-farm/nonresidential property. All of these properties have been written down to their respective fair values.

There are no commitments to lend additional funds to customers with loans on non-accrual status at December 31, 2004. The table below summarizes First Security’s non-performing assets for the last three years.

 

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NONPERFORMING ASSETS

 

		As of December 31,
					2004			2003			2002
					( Dollar amounts in thousands)
Nonaccrual loans					$	985		$	183		$	667
Loans past due 90 days and still accruing						1,230			2,194			89
Total nonperforming loans						2,215			2,377			756
Other real estate owned						2,338			536			-
Total nonperforming assets					$	4,553		$	2,913		$	756
Nonperforming loans as a percentage of total loans						0.37	%		0.50	%		0.22	%
Nonperforming assets as a percentage of total assets						0.59	%		0.45	%		0.16	%

While nonperforming assets have increased over prior years, our nonperforming asset ratios generally remain below our peer group, as follows. The ratio of nonaccruals loans and loans 90 days past due to gross loans was 0.37% and 0.53% for FSGBank and our peer group, respectively. The ratio of nonaccruals loans and loans 90 days past due to the allowance for loan losses was 26.65% and 44.00% for FSGBank and our peer group, respectively. The ratio of nonaccruals loans and loans 90 days past due to equity capital was 2.82% and 4.10% for FSGBank and our peer group, respectively. The ratio of nonaccruals loans, loans 90 days past due, and other real estate owned to gross loans and other real estate owned was 0.77% and 0.70% for FSGBank and our peer group, respectively.

Investment Securities and Other Earning Assets

The composition of our securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. Our securities portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for investing available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits and borrowed funds. We use two categories to classify our securities: “held to maturity” or “available for sale.” Currently, none of First Security’s investments are classified as held to maturity. While First Security has no plans to liquidate a significant amount of any securities, the securities classified as available-for-sale may be used for liquidity purposes should management deem it to be in our best interest.

Securities totaled $110.0 million at December 31, 2004, compared to $86.5 million at December 31, 2003. The growth in the securities portfolio occurred as a result of our efforts to invest excess federal funds sold into investments and to maintain a certain level of liquid assets in correlation to our overall asset growth. At December 31, 2004, the securities portfolio had unrealized net gains of approximately $172 thousand. In addition, all investment securities purchased to date have been classified as available-for-sale. Our securities portfolio at December 31, 2004 consisted of United States government agency bonds, federal agency bonds, mortgage backed securities, asset backed securities (SLMA), tax-exempt municipal securities and taxable municipal securities. T he following table provides the amortized cost of our securities by their stated maturities (this maturity schedule excludes security prepayment and call features), as well as the tax equivalent yields for each maturity range.

 

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MATURITY OF INVESTMENT SECURITIES - AMORTIZED COST

		Less than			One year to			Five years to			More than
Investment Security Type		one year			five years			ten years			ten years
		(Dollar amounts in thousands)
Municipal - tax exempt		$	1,026		$	2,585		$	11,640		$	11,597
Municipal - taxable			252			-			-			-
Agency bonds			9,897			20,639			-			-
Agency issued remics			5,829			24,433			-			-
Agency issued pools			136			19,726			-			1,111
Asset backed & CMO			-			980			-			-
Total		$	17,140		$	68,363		$	11,640		$	12,708
Tax equivalent yield			2.96	%		3.97	%		5.30	%		5.73	%

We currently have the ability and intent to hold our available-for-sale investment securities to maturity. However, should conditions change, we may sell unpledged securities. Our management considers the overall quality of the securities portfolio to be high. All securities held are traded in liquid markets, except for one bond. The bond is a $250 thousand investment is a Qualified Zone Academy Bond (within the meaning of Section 1379E of the Internal Revenue Code of 1986, as amended) issued by the Health, Educational and Housing Facility Board of the County of Knox under the authority from the State of Tennessee. As of December 31, 2004, we owned securities from issuers in which the aggregate book value from such issuers exceeded 10% of our stockholders equity. As of year-end 2004, the book value and market value of the securities from each such issuer are as follows:

(Dollar amounts in thousands)		Book Value			Market Value
Fannie Mae		$	25,094		$	25,155
Federal Home Loan Mortgage Corporation		$	24,898		$	24,911
Federal Home Loan Bank (FHLB)		$	10,849		$	10,918

See “Note 3 - Securities” in the Consolidated Financial Statements for the book values of the investments for the dates presented in the consolidated balance sheets.

At December 31, 2004, First Security had no federal funds sold, a decrease of $7 million from our December 31, 2003 balance. The decrease resulted from strong loan demand and our efforts to invest a portion of these federal funds into liquid investment securities and loans to improve our average yield on earning assets.

As of December 31, 2004, First Security held $95 thousand in certificates of deposit at other FDIC insured financial institutions. First State Bank purchased these earning assets prior to its acquisition by First Security. We do not intend to renew the certificates upon maturity, but rather we will invest the funds in liquid investment securities.

Deposits and Other Borrowings

Deposits increased by 18.5% from year-end 2003 to year-end 2004 due to (1) our management team drawing customers away from other financial institutions, (2) our branching efforts which are discussed in “Item 7.-Management’s Discussion and Analysis of Financial Condition and Results of Operations - Statement of Financial Condition” and (3) our issuance of brokered CDs to fund our acquisition of Kenesaw Leasing and J&S Leasing. We believe that by improving our branching network, we will provide more convenient opportunities for customers to bank with us, and thus improve our core deposit funding. For this reason, in 2005 we plan to build five new de novo branches. As a result of these future branches, we anticipate that our deposits will continue to increase in 2005. The table below is a maturity schedule for our certificates of deposit, including brokered CDs, in amounts of $100 thousand or more.

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		Less than			Three months			Six months			Greater than
(Dollar amounts in thousands)		3 months			to six months			to twelve months			twelve months
Certificates of deposit of $100 thousand or more		$	26,792		$	31,671		$	42,367		$	70,193

The following table details the maturities and rates of the term debt borrowed from the Federal Home Loan Bank of Cincinnati (see “Item 7.-Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity”) which was outstanding as of December 31, 2004.

 

Date	Type		Principal	Term	Rate	Maturity
1/8/2002	Fixed Rate Advance		500,000	36 months	4.48%	1/7/05
1/8/2002	Fixed Rate Advance		500,000	48 months	5.04%	1/6/06
1/10/2002	Fixed Rate Advance		500,000	36 months	4.45%	1/10/05
1/10/2002	Fixed Rate Advance		500,000	48 months	5.00%	1/10/06
1/15/2002	Fixed Rate Advance		500,000	36 months	4.22%	1/14/05
1/15/2002	Fixed Rate Advance		500,000	48 months	4.77%	1/13/06
1/17/2002	Fixed Rate Advance		500,000	36 months	4.37%	1/14/05
1/17/2002	Fixed Rate Advance		500,000	48 months	4.90%	1/17/06
			$4,000,000

 

 

Aggregate composite rate			4.65	%
36 month composite rate			4.38	%
48 month composite rate			4.93	%

Interest Rate Sensitivity

Financial institutions are subject to interest rate risk to the degree that their interest-bearing liabilities (consisting principally of customer deposits) mature or reprice more or less frequently, or on a different basis, than their interest-earning assets (generally consisting of intermediate or long-term loans and investment securities). The match between the scheduled repricing and maturities of First Security’s earning assets and liabilities within defined time periods is referred to as “gap” analysis. At December 31, 2004, the cumulative one-year gap for First Security (as consolidated) was a positive (or asset sensitive) $69.9 million, or 9.9% of total earning assets. This means assets reprice slightly faster than liabilities under rate changes.

Intense competition in First Security’s markets continues to pressure quality loan rates downward, while conversely pressuring deposit rates upward. The following table reflects First Security’s rate sensitive assets and liabilities by maturity as of December 31, 2004. Variable rate loans are shown in the category of due “one to three months” because they reprice with changes in the prime lending rate. Fixed rate loans are presented assuming the entire loan matures on the final due date. Actually, payments are made at regular intervals and are not reflected in this schedule. Additionally, demand deposits and savings accounts have no stated maturity; however, it has been First Security’s experience that these accounts are not totally rate sensitive, and accordingly the following analysis assumes 11% of interest bearing demand deposit accounts, 25% of money market deposit accounts, and 20% of savings accounts reprice within one year and the remaining accounts reprice within one to five years.

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Table of Contrents

INTEREST RATE GAP SENSITIVITY

		As of December 31, 2004
														Over Five
														Years and
					One through			Four through			One through			Non-rate
		Immediate			Three Months			Twelve Months			Five Years			Sensitive			Total
		(Dollar amounts in thousands)
Interest Earning Assets:
Interest bearing deposits		$	510		$	-		$	-		$	95		$	-		$	605
Federal Funds Sold			-			-			-			-			-			-
Securities			-			9,806			7,863			50,398			41,956			110,023
Mortgage loans held for sale			-			6,073			-			-			-			6,073
Loans			-			260,902			59,387			201,838			64,157			586,284
Total interest earning assets			510			276,781			67,250			252,331			106,113			702,985
Interest Bearing Liabilities:
Demand deposits			-			2,995			2,995			48,464			-			54,454
MMDA deposits			-			14,331			14,331			85,989			-			114,651
Savings deposits			-			3,269			3,269			26,153			-			32,691
Time deposits			-			63,989			144,236			121,180			-			329,405
Fed Funds Purchased/Repos			23,255			-			-			-			-			23,255
Other borrowings			-			2,000			-			2,000			150			4,150
Total interest bearing liabilities			23,255			86,584			164,831			283,786			150			558,606
Non-interest bearing sources of funds			-			-			-			-			144,379			144,379
Interest sensitivity gap		$	(22,745	)	$	190,197		$	(97,581	)	$	(31,455	)	$	(38,416	)	$	-
Cumulative sensitivity gap		$	(22,745	)	$	167,452		$	69,871		$	38,416		$	-		$	-

Liquidity

The liquidity of First Security (unconsolidated) refers to its ability to adjust its future cash flows to meet the needs of its daily operations. First Security relies primarily on management service fees from FSGBank to fund the liquidity needs of its daily operations. Additionally, we retained a portion of the proceeds of our 2002 private placement stock offering as working capital and a portion of the proceeds for future investment into our subsidiary. This cash, which totaled approximately $6.2 million as of December 31, 2004, is available for funding activities for which FSGBank would not receive direct benefit, such as acquisition due diligence, shareholder relations and holding company reporting and operations. These funds should adequately meet our cash flow needs. If we determine that our cash flow needs will be satisfactorily met, we may deploy a portion of the funds into our subsidiary or use them in an acquisition in order to support continued growth.

The liquidity of FSGBank refers to the ability or financial flexibility to adjust its future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost effective basis. The primary sources of funds for FSGBank are cash generated by repayments of outstanding loans, interest payments on loans, and new deposits. Additional liquidity is available from the maturity and earnings on securities and liquid assets, as well as the ability to liquidate securities available for sale.

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At December 31, 2004, the liquidity ratio (defined as cash, due from banks, federal funds sold, and investment securities less securities pledged to liabilities divided by short-term funding liabilities less liabilities pledged by securities) of First Security (consolidated) was 16.4 % (excluding anticipated loan repayments). T hree, six, nine, and twelve months earlier on September 30 ^th , June 30 ^th , March 31 ^st and December 31 ^st , our liquidity ratios were 16.1%, 17.0%, 18.0% and 24.3%, respectively. FSGBank is a member of the Federal Home Loan Bank of Cincinnati and has attained borrowing capability secured by a blanket lien on its 1-4 family residential mortgage loan portfolio, as well as the commercial real estate loan portfolio. In January 2002, management determined, because interest rates were relatively low, to convert FHLB overnight funding, as well as a portion of federal funds purchased, into FHLB term borrowings. As of December 31, 2004, the outstanding term debt remaining was $4 million. Subsequent to year end, $2 million of this debt matured and was not renewed. See “ Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations— Deposits and Other Borrowings.” FSGBank also used its borrowing capacity at FHLB to purchase a letter of credit that we pledged to the State of Tennessee Bank Collateral Pool. The letter of credit allows us to release investment securities from the Collateral Pool and thus improve our liquidity ratio. Additionally, FSGBank could increase its borrowing capacity at FHLB, subject to more stringent collateral requirements, by pledging loans other than 1-4 family residential mortgage and commercial real estate loans. As of December 31, 2004, our unused borrowing capacity (using 1-4 family residential mortgage and commercial real estate loans) at FHLB was $33.9 million. FHLB maintains standards for loan collateral files. Therefore, our borrowing capacity may be restricted if our collateral file has exceptions, such as expired property insurance.

FSGBank also had unsecured federal funds lines in the aggregate amount of $82.5 million at December 31, 2004 under which it can borrow funds to meet short-term liquidity needs. Another source of funding is loan participations sold to other commercial banks (in which we retain the service rights). As of year-end, we had $9.8 million in loan participations sold. FSGBank may continue to sell loan participations as a source of liquidity. A n additional source of short-term funding would be to pledge investment securities against a line of credit at a commercial bank. As of year-end, we had no borrowings against our investment securities, except for repurchase agreements and public-fund deposits attained in the ordinary course of business. During 2004 First Security entered the brokered deposits market as a source of funding, generating approximately $65 million in new monies in order to fund additional interest earning assets, specifically the acquisition of Kenesaw Leasing and J&S Leasing. As of December 31, 2004, we had $65 million in brokered CDs outstanding with a weighted average remaining life of approximately 18 months, a weighted average coupon rate of 2.95% and a weighted average all-in cost (which includes fees paid to deposit brokers) of 3.14%. Subsequent to year-end, we issued approximately $10 million in brokered CDs to fund loan growth. Our certificates of deposit greater than $100 thousand were generated in FSGBank’s communities and are considered relatively stable. Management believes that FSGBank’s liquidity sources are adequate to meet its operating needs.

First Security also has contractual cash obligations and commitments, which included certificates of deposit, other borrowings, operating leases, and loan commitments. Unfunded loan commitments totaled $184.7 million at year-end (see “Note 17 - Off-Balance-Sheet Activity” in the Consolidated Financial Statements). The following table illustrates our significant contractual obligations at December 31, 2004 by future payment period.

CONTRACTUAL OBLIGATIONS

					Total			Less than One Year			One to Three Years			Three to Five Years			More than Five Years
					(Dollar amounts in thousands)
Certificates of deposit			(1	)	$	329,405		$	208,225		$	105,629		$	15,551		$	-
Federal funds purchased and securities sold under agreements to repurchase			(2	)		23,255			23,255			-			-			-
FHLB borrowings			(3	)		4,000			2,000			2,000			-			-
Operating lease obligations			(4	)		5,928			1,001			1,286			1,071			2,570
Purchase obligations - investment securities			(5	)		235			235			-			-			-
Note payable			(6	)		150			10			23			27			90
Total					$	362,973		$	234,726		$	108,938		$	16,649		$	2,660

 

1

Certificates of deposit give customers rights to early withdrawal. Early withdrawals may be subject to penalties. The penalty amount depends on the remaining time to maturity at the time of early withdrawal. For more information regarding certificates of deposit, see “Note 7—Deposits” in the Consolidated Financial Statements and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation - Deposits and Other Borrowings.”