Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the Quarterly Period Ended September 30, 2010

OR

 

¨

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Transition Period from                      to                     

Commission file number 0-26850

First Defiance Financial Corp.

(Exact name of registrant as specified in its charter)

 

Ohio   34-1803915

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

 

601 Clinton Street, Defiance, Ohio   43512
(Address or principal executive office)   (Zip Code)

Registrant’s telephone number, including area code: (419) 782-5015

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No   ¨

Indicate by check mark whether the registrant submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   ¨     No   ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

   

Large accelerated filer     ¨

 

Accelerated filer     x

   
 

Non-accelerated filer     ¨

 

Smaller reporting company     ¨

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

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date. Common Stock, $.01 Par Value – 8,117,770 shares outstanding at October 29, 2010.


Table of Contents

 

FIRST DEFIANCE FINA NCIAL CORP.

INDEX

 

          Page Number  

PART I.-FINANCIAL INFORMATION

  

Item 1.

  

Consolidated Condensed Financial Statements (Unaudited): Consolidated Condensed Statements of Financial Condition – September 30, 2010 and December 31, 2009

     2   
  

Consolidated Condensed Statements of Income - Three and nine months ended September 30, 2010 and 2009

     4   
  

Consolidated Condensed Statements of Changes in Stockholders’ Equity – Nine months ended September 30, 2010 and 2009

     5   
  

Consolidated Condensed Statements of Cash Flows - Nine months ended September 30, 2010 and 2009

     6   
  

Notes to Consolidated Condensed Financial Statements

     7   

Item 2.

  

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

     33   

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

     60   

Item 4.

  

Controls and Procedures

     60   

PART II-OTHER INFORMATION:

  

Item 1.

  

Legal Proceedings

     61   

Item 1A.

  

Risk Factors

     61   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     61   

Item 3.

  

Defaults upon Senior Securities

     61   

Item 4.

  

(Removed and Reserved)

     61   

Item 5.

  

Other Information

     61   

Item 6.

  

Exhibits

     62   
  

Signatures

     63   

 

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PART 1-FINANCIAL INFOR MATION

Item 1. Financial State ments

FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Financial Condition

(UNAUDITED)

(Amounts in Thousands, except share and per share data)

 

 

 

     September 30,
2010
     December 31,
2009
 

Assets

     

Cash and cash equivalents:

     

Cash and amounts due from depository institutions

   $ 31,662       $ 29,613   

Interest-bearing deposits

     117,000         91,503   
                 
     148,662         121,116   

Securities:

     

Available-for-sale, carried at fair value

     156,355         137,458   

Held-to-maturity, carried at amortized cost (fair value $947 and $1,958 at September 30, 2010 and December 31, 2009, respectively)

     918         1,920   
                 
     157,273         139,378   

Loans held for sale

     21,613         10,346   

Loans receivable, net of allowance of $41,343 at September 30, 2010 and $36,547 at December 31, 2009, respectively

     1,508,334         1,580,575   

Accrued interest receivable

     7,248         6,851   

Federal Home Loan Bank stock

     21,376         21,376   

Bank owned life insurance

     32,751         30,804   

Premises and equipment

     42,276         43,597   

Real estate and other assets held for sale

     11,127         13,527   

Goodwill

     57,556         56,585   

Core deposit and other intangibles

     6,485         6,888   

Mortgage servicing rights

     8,289         8,958   

Deferred taxes

     4,865         3,289   

Other assets

     14,384         14,233   
                 

Total assets

   $ 2,042,239       $ 2,057,523   
                 

(continued)

 

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FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Financial Condition

(UNAUDITED)

(Amounts in Thousands, except share and per share data)

 

 

 

     September 30,
2010
    December 31,
2009
 

Liabilities and stockholders’ equity

    

Liabilities:

    

Deposits

   $ 1,590,648      $ 1,580,226   

Advances from the Federal Home Loan Bank

     116,896        146,927   

Securities sold under repurchase agreements

     41,923        48,398   

Subordinated debentures

     36,083        36,083   

Advance payments by borrowers

     501        665   

Other liabilities

     15,159        11,138   
                

Total liabilities

     1,801,210        1,823,437   

Stockholders’ equity:

    

Preferred stock, $.01 par value per share: 37,000 shares authorized and issued with a liquidation preference of $37,236, net of discount

     36,418        36,293   

Preferred stock, $.01 par value per share: 4,963,000 shares authorized; no shares issued

     —          —     

Common stock, $.01 par value per share: 25,000,000 shares authorized; 12,739,496 and 12,739,496 shares issued and 8,117,770 and 8,117,520 shares outstanding, respectively

     127        127   

Common stock warrant

     878        878   

Additional paid-in capital

     140,808        140,677   

Accumulated other comprehensive income (loss), net of tax of $1,184 and $(85), respectively

     2,198        (158

Retained earnings

     133,228        128,900   

Treasury stock, at cost, 4,621,726 and 4,621,976 shares respectively

     (72,628     (72,631
                

Total stockholders’ equity

     241,029        234,086   
                

Total liabilities and stockholders’ equity

   $ 2,042,239      $ 2,057,523   
                

See accompanying notes

 

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FIRST DEFIAN CE FINANCIAL CORP.

Consolidated Condensed Statements of Income

(UNAUDITED)

(Amounts in Thousands, except per share data)

 

 

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  

Interest Income

        

Loans

   $ 22,230      $ 23,766      $ 67,104      $ 70,229   

Investment securities:

        

Taxable

     1,022        949        3,091        3,028   

Non-taxable

     512        473        1,465        1,360   

Interest-bearing deposits

     68        41        198        89   

FHLB stock dividends

     225        258        678        726   
                                

Total interest income

     24,057        25,487        72,536        75,432   

Interest Expense

        

Deposits

     4,667        6,163        15,192        20,206   

FHLB advances and other

     1,187        1,267        3,625        3,865   

Subordinated debentures

     332        344        982        1,139   

Notes payable

     109        140        329        433   
                                

Total interest expense

     6,295        7,914        20,128        25,643   
                                

Net interest income

     17,762        17,573        52,408        49,789   

Provision for loan losses

     5,196        8,051        17,525        14,762   
                                

Net interest income after provision for loan losses

     12,566        9,522        34,883        35,027   

Non-interest Income

        

Service fees and other charges

     3,301        3,577        9,856        9,989   

Insurance commission income

     1,421        1,129        3,838        3,945   

Mortgage banking income

     2,322        980        5,114        7,677   

Gain on sale of non-mortgage loans

     10        151        97        251   

Gain on sale or call of securities

     —          154        6        279   

Other-than-temporary impairment (OTTI) losses on investment securities

        

Total impairment losses on investment securities

     (190     (1,052     (331     (2,780

Losses recognized in other comprehensive income

     —          58        —          239   
                                

Net impairment loss recognized in earnings

     (190     (994     (331     (2,541

Trust income

     118        101        372        306   

Income from Bank Owned Life Insurance

     226        201        917        338   

Other non-interest income

     271        257        167        475   
                                

Total non-interest income

     7,479        5,556        20,036        20,719   

Non-interest Expense

        

Compensation and benefits

     7,114        6,551        20,161        21,501   

Occupancy

     1,734        1,860        5,264        5,901   

FDIC insurance premium

     907        649        2,881        2,713   

State franchise tax

     542        571        1,621        1,668   

Data processing

     1,186        1,100        3,556        3,330   

Acquisition related charges

     16        —          53        —     

Amortization of intangibles

     356        355        1,139        1,101   

Other non-interest expense

     5,247        3,700        12,303        9,701   
                                

Total non-interest expense

     17,102        14,786        46,978        45,915   
                                

Income before income taxes

     2,943        292        7,941        9,831   

Federal income taxes

     668        (37     2,100        3,193   
                                

Net Income

   $ 2,275      $ 329      $ 5,841      $ 6,638   
                                

Dividends accrued on preferred shares

   $ (463   $ (473   $ (1,388   $ (1,403

Accretion on preferred shares

   $ (43   $ (40   $ (125   $ (118
                                

Net income (loss) applicable to common shares

   $ 1,769      $ (184   $ 4,328      $ 5,117   
                                

Earnings (loss) per common share (Note 7)

        

Basic

   $ 0.22      $ (0.02   $ 0.53      $ 0.63   

Diluted

   $ 0.22      $ (0.02   $ 0.53      $ 0.63   

Dividends declared per share (Note 6)

   $ —        $ 0.04      $ —        $ 0.295   

Average shares outstanding (Note 7)

        

Basic

     8,118        8,117        8,118        8,117   

Diluted

     8,118        8,117        8,143        8,172   

See accompanying notes

 

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FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Changes in Stock holders’ Equity

(UNAUDITED)

(Amounts in Thousands)

 

 

 

     Preferred
Stock
     Common
Stock
     Common
Stock
Warrant
     Treasury
Stock
    Additional
Paid-In
Capital
     Accumulated
Other
Comprehensive
Income (Loss)
    Retained
Earnings
    Total
Stockholders’
Equity
 

Balance at January 1, 2010

   $ 36,293       $ 127       $ 878       $ (72,631   $ 140,677       $ (158   $ 128,900      $ 234,086   

Comprehensive income:

                    

Net income

     —           —           —           —          —           —          5,841        5,841   

Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of $1,270

     —           —           —           —          —           2,356        —          2,356   
                          

Total comprehensive income

                       8,197   

Stock option expense

     —           —           —           —          131         —          —          131   

Stock options exercised

     —           —           —           3        —           —          —          3   

Preferred Stock Dividends

     —           —           —           —          —           —          (1,388     (1,388

Accretion on preferred shares

     125         —           —           —          —           —          (125     —     
                                                                    

Balance at September 30, 2010

   $ 36,418       $ 127       $ 878       $ (72,628   $ 140,808       $ 2,198      $ 133,228      $ 241,029   
                                                                    

Balance at January 1, 2009

   $ 36,134       $ 127       $ 878       $ (72,638   $ 140,447       $ (1,904   $ 126,115      $ 229,159   

Comprehensive income:

                    

Net income

     —           —           —           —          —           —          6,638        6,638   

Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of $1,265

     —           —           —           —          —           2,350        —          2,350   
                          

Total comprehensive income

                       8,988   

Stock option expense

     —           —           —           —          175         —          —          175   

Stock options exercised

     —           —           —           7        —           —          (2     5   

Preferred stock dividends

     —           —           —           —          —           —          (1,403     (1,403

Accretion on preferred shares

     118         —           —           —          —           —          (118     —     

Common stock dividends declared

     —           —           —           —          —           —          (2,395     (2,395
                                                                    

Balance at September 30, 2009

   $ 36,252       $ 127       $ 878       $ (72,631   $ 140,622       $ 446      $ 128,835      $ 234,529   
                                                                    

See Accompanying Notes

 

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FIRST DEFIANCE FINANCIAL CORP.

Consolidated Condensed Statements of Cash Flows

(UNAUDITED)

(Amounts in Thousands)

 

 

 

     Nine Months Ended
September 30,
 
     2010     2009  

Operating Activities

    

Net income

   $ 5,841      $ 6,638   

Items not requiring (providing) cash

    

Provision for loan losses

     17,525        14,762   

Depreciation

     2,543        2,876   

Amortization of mortgage servicing rights, net of impairment (recoveries)

     2,411        1,708   

Amortization of core deposit and other intangible assets

     1,139        1,102   

Net amortization of premiums and discounts on loans and deposits

     819        582   

Amortization of premiums and discounts on securities

     348        (400

Change in deferred taxes

     (2,845     (2,235

Proceeds from the sale of loans held for sale

     229,192        427,095   

Originations of loans held for sale

     (236,939     (436,646

Gain from sale of loans

     (5,359     (7,527

OTTI losses on investment securities

     331        2,262   

Gain from sale or call of securities

     (6  

Loss on sale or write-down of real estate and other assets held for sale

     2,653        1,226   

Loss on sale of premises and equipment

     1        6   

Stock option expense

     131        175   

Income from bank owned life insurance

     (649     (338

Gain on life insurance

     (268     —     

Changes in:

    

Accrued interest receivable

     (397     (817

Other assets

     (151     (1,468

Other liabilities

     887        (944
                

Net cash provided by (used in) operating activities

     17,207        8,057   

Investing Activities

    

Proceeds from maturities of held-to-maturity securities

     1,002        89   

Proceeds from maturities, calls and pay-downs of available-for-sale securities

     31,528        18,036   

Proceeds from sale of real estate and other assets held for sale

     8,311        3,330   

Proceeds from the sale of available-for-sale securities

     28        6,383   

Proceeds from sale of non-mortgage loans

     6,653        6,103   

Purchases of available-for-sale securities

     (47,501     (32,075

Purchases of bank owned life insurance

     (1,758     (1,500

Proceeds from bank owned life insurance

     728        —     

Purchases of premises and equipment, net

     (1,223     (1,498

Net cash paid for group benefits line of business

     (1,500     —     

Net decrease (increase) in loans receivable

     38,717        (28,030
                

Net cash provided by (used in) investing activities

     34,985        (30,062

Financing Activities

    

Net increase in deposits and advance payments by borrowers

     10,317        73,203   

Repayment of Federal Home Loan Bank long-term advances

     (30,031     (30

Net increase (decrease) in Federal Home Loan Bank short-term advances

     —          (9,100

Increase (decrease) in securities sold under repurchase agreements

     (6,475     (6,174

Net change in secured borrowings

     2,928        —     

Proceeds from the exercise of stock options

     3        5   

Cash dividends paid on common stock

     —          (3,450

Cash dividends paid on preferred stock

     (1,388     (1,285
                

Net cash provided by (used in) financing activities

     (24,646     53,169   
                

Increase (decrease) in cash and cash equivalents

     27,546        31,164   

Cash and cash equivalents at beginning of period

     121,116        46,152   
                

Cash and cash equivalents at end of period

   $ 148,662      $ 77,316   
                

Supplemental cash flow information:

    

Interest paid

   $ 20,425      $ 26,322   
                

Income taxes paid

   $ 4,650      $ 6,600   
                

Transfers from loans to other real estate owned and other assets held for sale

   $ 10,086      $ 6,908   
                

See accompanying notes.

 

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FIRST DEFIANCE FINANCIAL CORP.

Notes to Consolidated Condensed Financial Statements

(Unaudited at September 30, 2010 and 2009)

 

 

1. Basis of Presentation

First Defiance Financial Corp. (“First Defiance” or the “Company”) is a unitary thrift holding company that conducts business through its two wholly owned subsidiaries, First Federal Bank of the Midwest (“First Federal”) and First Insurance and Investments, Inc. (“First Insurance”). All significant intercompany transactions and balances are eliminated in consolidation.

First Federal is primarily engaged in attracting deposits from the general public through its offices and using those and other available sources of funds to originate loans primarily in the counties in which its offices are located. First Federal’s traditional banking activities include originating and servicing residential, commercial and consumer loans and providing a broad range of depository, trust and wealth management services. First Insurance is an insurance agency that does business in the Defiance, Archbold, Bryan, and Bowling Green, Ohio areas offering property and casualty, and group health and life insurance products. In May 2010, First Insurance acquired a group medical benefits business line from Andres O’Neil & Lowe Insurance Agency.

The consolidated condensed statement of financial condition at December 31, 2009 has been derived from the audited financial statements at that date, which were included in First Defiance’s Annual Report on Form 10-K.

The accompanying consolidated condensed financial statements as of September 30, 2010 and for the three and nine month periods ended September 30, 2010 and 2009 have been prepared by First Defiance without audit and do not include information or footnotes necessary for the complete presentation of financial condition, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States. These consolidated condensed financial statements should be read in conjunction with the financial statements and notes thereto included in First Defiance’s 2009 Annual Report on Form 10-K for the year ended December 31, 2009. However, in the opinion of management, all adjustments, consisting of only normal recurring items, necessary for the fair presentation of the financial statements have been made. The results for the three and nine month periods ended September 30, 2010 are not necessarily indicative of the results that may be expected for the entire year.

2 . Significant Accounting Policies

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Significant areas where First Defiance uses estimates are the valuation of certain investment securities, the determination of the allowance for loan losses, the valuation of mortgage servicing rights and goodwill, the determination of unrecognized income tax benefits, and the determination of post-retirement benefits.

 

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Earnings Per Common Share

Basic earnings per common share is net income applicable to common shares divided by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share include the dilutive effect of additional potential common shares issuable under stock options, warrants and stock grants.

Reclassifications

Some items in the prior financial statements were reclassified to conform to the current presentation.

Adoption of New Accounting Standards

In July 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses , which requires significant new disclosures about the allowance for credit losses and the credit quality of financing receivables. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled debt restructurings will also be required. The disclosures are to be presented at the level of disaggregation that management uses when assessing and monitoring the portfolio’s risk and performance. This ASU is effective for interim and annual reporting periods after December 15, 2010. The Company will include these disclosures in the notes to the December 31, 2010 financial statements.

 

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3. Comprehensive Income

Comprehensive income consists of net income and other comprehensive income (loss) (“OCI”). Other comprehensive income (loss) includes unrealized gains and losses on securities available-for-sale and the net unrecognized actuarial losses and unrecognized prior services costs associated with the Company’s Defined Benefit Postretirement Medical Plan. All items reported in other comprehensive income (loss) are reported net of tax. Following is a summary of other comprehensive income (loss) for the three and nine months ended September 30, 2010 and 2009:

 

     Three Months  Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  
     (In thousands)  

Net income

   $ 2,275      $ 329      $ 5,841      $ 6,638   

Change in securities available-for-sale (AFS):

        

Unrealized gains (losses) on securities AFS for which other-than-temporary impairment losses have been recognized in income

     (151     (350     (232     (1,864

Other-than-temporary impairment losses on AFS realized in income

     190        994        331        2,541   
                                

Net unrealized gains (losses)

     39        664        99        677   

Unrealized holding gains (losses) on securities AFS arising during the period

     1,097        2,983        3,533        3,217   

Reclassification adjustment for (gains) losses realized in income

     —          (154     (6     (279
                                

Net unrealized gains (losses)

     1,097        2,829        3,527        2,938   

Income tax effect

     (397     (1,214     (1,270     (1,265
                                

Other comprehensive income (loss)

     738        2,259        2,356        2,350   
                                

Comprehensive income

   $ 3,013      $ 2,588      $ 8,197      $ 8,988   
                                

The following table summarizes the changes within each classification of accumulated other comprehensive income for the nine months ended September 30, 2010 and 2009:

 

     Unrealized gains
(losses) on available
for sale securities
     Postretirement
Benefit
    Accumulated
other
comprehensive
income (loss), net
 
     (In thousands)  

Balance at December 31, 2009

   $ 468       $ (626   $ (158

Other comprehensive income (loss), net

     2,356         —          2,356   
                         

Balance at September 30, 2010

   $ 2,824       $ (626   $ 2,198   
                         

 

     Unrealized gains
(losses) on available
for sale securities
    Postretirement
Benefit
    Accumulated
other
comprehensive
income (loss), net
 
     (In thousands)  

Balance at December 31, 2008

   $ (1,100   $ (804   $ (1,904

Other comprehensive income (loss), net

     2,350        —          2,350   
                        

Balance at September 30, 2009

   $ 1,250      $ (804   $ 446   
                        

 

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4. Fair Value

FASB ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

FASB ASC Topic 820 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on the best information available. In that regard, FASB ASC Topic 820 established a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

   

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

 

   

Level 2 : Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by a correlation or other means.

 

   

Level 3 : Unobservable inputs for determining fair value of assets and liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

 

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Available for sale securities - Securities classified as available for sale are generally reported at fair value utilizing Level 2 inputs where the Company obtains fair value measurements from an independent pricing service which uses matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows and the bonds’ terms and conditions, among other things. Securities in Level 1 include federal agency preferred stock securities. Securities in Level 2 include U.S. Government agencies, mortgage-backed securities and municipal securities. The Company classifies its pooled trust preferred collateralized debt obligations as Level 3. The portfolio consists of collateralized debt obligations backed by pools of trust preferred securities issued by financial institutions and insurance companies. Based on the lack of observable market data, the Company estimated fair values based on the observable data available and reasonable unobservable market data. The Company estimated fair value based on a discounted cash flow model which used appropriately adjusted discount rates reflecting credit and liquidity risks. The Company’s valuations were supported by analysis prepared by an independent third party that is described further in Note 8.

Impaired loans - The fair value of impaired loans with specific allocations of the allowance for loan loss is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in impaired loans being valued using Level 3 inputs.

Mortgage servicing rights - Mortgage servicing rights are reported at fair value utilizing Level 2 inputs. MSRs are valued by a third party consultant using a proprietary cash flow valuation model.

Mortgage banking derivative - The fair value of mortgage banking derivatives are based on derivative valuation models using market data inputs as of the valuation date (Level 2).

Real estate held for sale - Real estate held for sale is determined using Level 3 inputs which include current and prior appraisals and estimated costs to sell.

 

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The following table summarizes the financial assets measured at fair value on a recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

Assets and Liabilities Measured on a Recurring Basis

 

September 30, 2010    Level 1 Inputs      Level 2 Inputs      Level 3 Inputs      Total Fair
Value
 
     (In Thousands)  

Available for sale securities:

Obligations of U.S. Government corporations and agencies

   $ —         $ 11,109       $ —         $ 11,109   

Mortgage-backed – residential

     —           36,519         —           36,519   

REMICs

     —           3,598         —           3,598   

Collateralized mortgage obligations

     —           51,566         —           51,566   

Trust preferred stock

     —           —           1,432         1,432   

Preferred stock

     35         —           —           35   

Obligations of state and political subdivisions

     —           52,096         —           52,096   

Mortgage banking derivative – asset

     —           1,376         —           1,376   

Mortgage banking derivative – liability

     —           132         —           132   

 

December 31, 2009      Level 1 Inputs         Level 2 Inputs         Level 3 Inputs        

 

Total Fair

Value

  

  

     (In Thousands)   

Available for sale securities:

Obligations of U.S. Government corporations and agencies

   $ —         $ 14,251       $ —         $ 14,251   

Mortgage-backed – residential

     —           31,504         —           31,504   

REMICs

     —           3,923         —           3,923   

Collateralized mortgage obligations

     —           41,371         —           41,371   

Trust preferred stock

     —           —           1,589         1,589   

Preferred stock

     87         —           —           87   

Obligations of state and political subdivisions

     —           44,733         —           44,733   

Mortgage banking derivative – asset

     —           380         —           380   

Mortgage banking derivative – liability

     —           —           —           —     

The table below presents a reconciliation and income classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30, 2010 and September 30, 2009:

 

     Fair Value  Measurements
Using Significant Unobservable
Inputs (Level 3)
(In Thousands)
 

Beginning balance, January 1, 2010

   $ 1,589   

Total gains or losses (realized/unrealized)

  

Included in earnings

     (214

Included in other comprehensive income

(presented gross of taxes)

     66   

Purchases, issuances, and settlements

     16   

Sales

     (25

Transfers in and/or out of Level 3

     —     
        

Ending balance, September 30, 2010

   $ 1,432   
        

 

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     Fair Value Measurements
Using Significant Unobservable
Inputs (Level 3)

(In Thousands)
 

Beginning balance, July 1, 2010

   $ 1,516   

Total gains or losses (realized/unrealized)

  

Included in earnings

     (73

Included in other comprehensive income (presented gross of taxes)

     (21

Purchases, issuances, and settlements

     10   

Sales

     —     

Transfers in and/or out of Level 3

     —     
        

Ending balance, September 30, 2010

   $ 1,432   
        
     Fair Value Measurements
Using Significant Unobservable
Inputs (Level 3)

(In Thousands)
 

Beginning balance, January 1, 2009

   $ 3,873   

Total gains or losses (realized/unrealized)

  

Included in earnings

     (2,541

Included in other comprehensive income (presented gross of taxes)

     547   

Purchases, issuances, and settlements

     (2

Transfers in and/or out of Level 3

     —     
        

Ending balance, September 30, 2009

   $ 1,877   
        
     Fair Value Measurements
Using Significant Unobservable
Inputs (Level 3)

(In Thousands)
 

Beginning balance, July 1, 2009

   $ 2,161   

Total gains or losses (realized/unrealized)

  

Included in earnings

     (994

Included in other comprehensive income (presented gross of taxes)

     709   

Purchases, issuances, and settlements

     1   

Transfers in and/or out of Level 3

     —     
        

Ending balance, September 30, 2009

   $ 1,877   
        

 

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The following table summarizes the financial assets measured at fair value on a non-recurring basis segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

Assets and Liabilities Measured on a Non-Recurring Basis

 

September 30, 2010    Level 1 Inputs      Level 2 Inputs      Level 3 Inputs      Total Fair
Value
 
     (In Thousands)  

Impaired loans

   $ —         $ —         $ 30,133       $ 30,133   

Mortgage servicing rights

     —           8,289         —           8,289   

Real estate held for sale

     —           —           3,680         3,680   

 

December 31, 2009    Level 1 Inputs      Level 2 Inputs      Level 3 Inputs      Total Fair
Value
 
     (In Thousands)  

Impaired loans

   $ —         $ —         $ 28,336       $ 28,336   

Mortgage servicing rights

     —           8,958         —           8,958   

Real estate held for sale

     —           —           935         935   

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a fair value of $30,133,000, with a valuation allowance of $16,613,000 at September 30, 2010. A provision expense of $3,947,000 and $13,414,000 for the three and nine months ended September 30, 2010 was included in earnings.

Mortgage servicing rights which are carried at lower of cost or fair value had a fair value of $8,289,000 at September 30, 2010, resulting in a valuation allowance of $2,255,000. A charge of $527,000 and $777,000 for the three and nine months ended September 30, 2010 was included in earnings.

Real estate held for sale is determined using Level 3 inputs which include appraisals and estimated costs to sell. The change in fair value of real estate held for sale was $1,614,000 and $2,643,000 for the three and nine months ended September 30, 2010 which was recorded directly as an adjustment to current earnings through non-interest expense.

In accordance with FASB ASC Topic 825, the table below is a comparative condensed consolidated statement of financial condition based on carrying amount and estimated fair values of financial instruments as of September 30, 2010 and December 31, 2009. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of First Defiance.

Much of the information used to arrive at “fair value” is highly subjective and judgmental in nature and therefore the results may not be precise. Subjective factors include, among other things, estimated cash flows, risk characteristics and interest rates, all of which are subject to change. With the exception of investment securities, the Company’s financial instruments are not readily marketable and market prices do not exist. Since negotiated prices for the instruments, which are not readily marketable depend greatly on the motivation of the buyer and seller, the amounts that will actually be realized or paid per settlement or maturity of these instruments could be significantly different.

 

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The carrying amount of cash and cash equivalents, term notes payable and advance payments by borrowers for taxes and insurance, as a result of their short-term nature, is considered to be equal to fair value.

Fair value for available for sale securities is as previously described. For investment securities held to maturity, fair has been based on current market quotations. If market prices are not available, fair value has been estimated based upon the quoted price of similar instruments.

It was not practicable to determine the fair value of the Federal Home Loan Bank (“FHLB”) stock due to restrictions placed on its transferability.

The fair value of loans which reprice within 90 days is equal to their carrying amount. For other loans, the estimated fair value is calculated based on discounted cash flow analysis, using interest rates currently being offered for loans with similar terms. The allowance for loan losses is considered to be a reasonable adjustment for credit risk.

FASB ASC Topic 825 requires that the fair value of demand, savings, NOW and certain money market accounts be equal to their carrying amount. The Company believes that the fair value of these deposits may be greater or less than that prescribed by FASB ASC Topic 825.

The carrying value of subordinated debentures and deposits with fixed maturities is estimated based on interest rates currently being offered on instruments with similar characteristics and maturities. FHLB advances with maturities greater than 90 days are valued based on discounted cash flow analysis, using interest rates currently being quoted for similar characteristics and maturities. The cost or value of any call or put options is based on the estimated cost to settle the option at September 30, 2010.

 

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Table of Contents

 

     September 30, 2010      December 31, 2009  
     Carrying
Value
     Estimated
Fair Values
     Carrying
Value
     Estimated
Fair Values
 
     (In Thousands)   

Assets:

           

Cash and cash equivalents

   $ 148,662       $ 148,662       $ 121,116       $ 121,116   

Investment securities

     157,273         157,302         139,378         139,416   

Federal Home Loan Bank Stock

     21,376         N/A         21,376         N/A   

Loans, net, including loans held for sale

     1,529,947         1,546,527         1,590,921         1,586,101   

Mortgage banking derivative asset

     1,376         1,376         380         380   

Accrued interest receivable

     7,248         7,248         6,851         6,851   
                                   
     1,865,882       $ 1,861,115         1,880,022       $ 1,853,864   
                       

Other assets

     176,357            177,501      
                       

Total assets

   $ 2,042,239          $ 2,057,523      
                       

Liabilities and stockholders’ equity:

           

Deposits

   $ 1,590,648       $ 1,599,882       $ 1,580,226       $ 1,586,466   

Advances from Federal Home Loan Bank

     116,896         122,697         146,927         152,643   

Securities sold under repurchase agreements

     41,923         41,923         48,398         48,398   

Subordinated debentures

     36,083         34,399         36,083         32,057   

Mortgage banking derivative liability

     132         132         —           —     

Accrued interest payable

     937         937         1,234         1,234   

Advance payments by borrowers for taxes and insurance

     501         501         665         665   
                                   
     1,787,120       $ 1,800,471         1,813,533       $ 1,821,463   
                       

Other liabilities

     14,090            9,904      
                       

Total liabilities

     1,801,210            1,823,437      

Stockholders’ equity

     241,029            234,086      
                       

Total liabilities and stockholders’ equity

   $ 2,042,239          $ 2,057,523      
                       

 

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5. Stock Compensation Plans

First Defiance has established incentive stock option plans for its directors and employees. On March 15, 2010, the Board adopted, and the shareholders approved at the 2010 Annual Shareholders Meeting, the First Defiance Financial Corp. 2010 Equity Incentive Plan (the “2010 Equity Plan”). The 2010 Equity Plan replaces all existing plans. All awards currently outstanding under the prior plans will remain in effect in accordance with their respective terms. Any new awards will be made under the 2010 Equity Plan. As of September 30, 2010, 423,750 options (401,750 for employees and 22,000 for directors) had been granted under prior option plans and remain outstanding at option prices based on the market value of the underlying shares on the date the options were granted. 5,000 options have been granted under the 2010 Equity Plan. Options granted under all plans vest 20% per year except for the options granted in 2009 to the Company’s then five most-highly compensated employees, which options vest 40% in 2011 and then 20% annually, subject to certain other limitations. As of September 30, 2010, 300,370 of the outstanding options were currently exercisable. All options expire ten years from date of grant. Vested options of retirees expire on the earlier of the scheduled expiration date or three months after the retirement date.

The fair value of each option award is estimated on the date of grant using the Black-Scholes model. Expected volatilities are based on historical volatilities of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

 

     Nine Months Ended September 30,  
     2010     2009  

Expected average risk-free rate

     1.57     3.38

Expected average life

     7.20  years      6.41  years 

Expected volatility

     44.62     26.10

Expected dividend yield

     0.00     3.62

The weighted-average fair value of options granted for the nine months ended September 30, 2010 and 2009 were $4.05 and $1.87, respectively.

 

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Following is activity under the prior option plans:

 

     Options
Outstanding
    Weighted
Average
Exercise Price
     Weighted
Average
Remaining
Contractual
Term (in years)
     Aggregate
Intrinsic
Value
 

Options outstanding, beginning of period

     467,500      $ 19.41         

Forfeited or cancelled

     (43,500     20.71         

Exercised

     (250     9.22         

Granted

     5,000        9.96         
                                  

Options outstanding, end of period

     428,750      $ 19.18         5.0       $ 45   
                                  

Vested or expected to vest at period end

     428,750      $ 19.18         5.0       $ 45   
                                  

Exercisable at period end

     300,370      $ 20.54         3.8       $ 9   
                                  

Proceeds, related tax benefits realized from options exercised and intrinsic value of options exercised were as follows:

 

     Nine Months Ended
September 30,
 
     2010      2009  

Cash received from option exercises

   $ 3,000       $ 5,000   

Tax benefit realized from option exercises

     —           —     

Intrinsic value of options exercised

     1,000         1,000   

As of September 30, 2010, there was $286,000 of total unrecognized compensation costs related to unvested stock options granted under the Company’s stock option plans. The cost is expected to be recognized over a weighted-average period of 2.56 years.

6. Dividends on Common Stock

No common stock dividends were declared by First Defiance in the first nine months of 2010. A quarterly cash dividend of $0.17, $0.085 and $0.04 per common share was declared for the first, second and third quarters of 2009, respectively.

As a result of its participation in the U.S. Treasury’s Capital Purchase Program (“CPP”), First Defiance is prohibited without prior approval of the U.S. Treasury, from paying a quarterly cash dividend of more than $0.26 per share until the earlier of December 5, 2011 or the date the preferred stock issued to the U.S. Treasury by First Defiance is redeemed or transferred to an unaffiliated third party. Further, First Defiance has agreed with its primary regulator to obtain approval of cash dividends prior to declaration.

 

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7. Earnings Per Common Share

The following table sets forth the computation of basic and diluted earnings per common share (in thousands except per share data):

 

     Three months ended
September 30,
    Nine months  ended
September 30,
 
     2010      2009     2010      2009  

Numerator for basic and diluted earnings per common share – Net income applicable to common shares

   $ 1,769       $ (184   $ 4,328       $ 5,117   

Denominator:

          

Denominator for basic earnings per common share – weighted average common shares

     8,118         8,117        8,118         8,117   

Effect of warrants

     —           —          25         54   

Effect of employee stock options

     —           —          —           1   
                                  

Denominator for diluted earnings per common share

     8,118         8,117        8,143         8,172   
                                  

Basic earnings per common share

   $ 0.22       $ (0.02   $ 0.53       $ 0.63   
                                  

Diluted earnings per common share

   $ 0.22       $ (0.02   $ 0.53       $ 0.63   
                                  

There were 428,750 shares under option granted to employees excluded from the diluted earnings per common share calculation as they were anti-dilutive for the three and nine months ended September 30, 2010. There were 475,900 and 412,800 shares under option granted to employees excluded from the diluted earnings per common share calculation as they were anti-dilutive for the three and nine months ended September 30, 2009. Shares under option of 550,595 issuable related to warrants were excluded from the diluted earnings per common share calculations as they were anti-dilutive for the three months ended September 30, 2010 and 2009.

 

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8. Investment Securities

The following is a summary of available-for-sale and held-to-maturity securities (in thousands):

 

     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair Value  

At September 30, 2010

          

Available-for-Sale Securities:

          

Obligations of U.S. government corporations and agencies

   $ 10,982       $ 127       $ —        $ 11,109   

Mortgage-backed securities – residential

     34,955         1,564         —          36,519   

REMICs

     3,462         136         —          3,598   

Collateralized mortgage obligations

     49,553         2,032         (19     51,566   

Trust preferred securities and preferred stock

     3,783         —           (2,316     1,467   

Obligations of state and political subdivisions

     49,274         2,913         (91     52,096   
                                  

Totals

   $ 152,009       $ 6,772       $ (2,426   $ 156,355   
                                  

Held-to-Maturity Securities*:

          

FHLMC certificates

   $ 98       $ 7       $ —        $ 105   

FNMA certificates

     271         7         —          278   

GNMA certificates

     90         3         —          93   

Obligations of state and political subdivisions

     459         12         —          471   
                                  

Totals

   $ 918       $ 29       $ —        $ 947   
                                  

At December 31, 2009

          

Available-for-Sale Securities:

          

Obligations of U.S. government corporations and agencies

   $ 14,038       $ 252       $ (39   $ 14,251   

Mortgage-backed securities – residential

     30,341         1,194         (31     31,504   

REMICs

     3,718         205         —          3,923   

Collateralized mortgage obligations

     40,878         824         (331     41,371   

Trust preferred securities and preferred stock

     4,122         —           (2,446     1,676   

Obligations of state and political subdivisions

     43,640         1,251         (158     44,733   
                                  

Totals

   $ 136,737       $ 3,726       $ (3,005   $ 137,458   
                                  

Held-to-Maturity Securities*:

          

FHLMC certificates

   $ 119       $ 7       $ —        $ 126   

FNMA certificates

     304         9         —          313   

GNMA certificates

     107         3         —          110   

Obligations of state and political subdivisions

     1,390         19         —          1,409   
                                  

Totals

   $ 1,920       $ 38       $ —        $ 1,958   
                                  

 

*

FHLMC, FNMA, and GNMA certificates are residential mortgage-backed securities.

 

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The amortized cost and fair value of securities at September 30, 2010 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. For purposes of the maturity table, mortgage-backed securities (“MBS”), collateralized mortgage obligations (“CMO”) and real estate mortgage investment conduits (“REMICs”), which are not due at a single maturity date, have not been allocated over the maturity groupings. The MBS, CMO and REMIC securities may mature earlier than their weighted-average contractual maturities because of principal prepayments.

 

     Available-for-Sale      Held-to-Maturity  
     Amortized      Fair      Amortized      Fair  
     Cost      Value      Cost      Value  
     (In Thousands)   

Due in one year or less

   $ 3,068       $ 3,045       $ 60       $ 60   

Due after one year through five years

     4,255         4,436         120         132   

Due after five years through ten years

     10,383         10,938         279         279   

Due after ten years

     46,333         46,253         —           —     

MBS/CMO/REMIC

     87,970         91,683         459         476   
                                   
   $ 152,009       $ 156,355       $ 918       $ 947   
                                   

Investment securities with a carrying amount of $119.2 million at September 30, 2010 were pledged as collateral on public deposits, securities sold under repurchase agreements and FHLB advances.

As of September 30, 2010, the Company’s investment portfolio consisted of 307 securities, 16 of which were in an unrealized loss position.

The following table summarizes First Defiance’s securities that were in an unrealized loss position at September 30, 2010:

 

     Duration of Unrealized Loss Position        
     Less than 12 Months     12 Month or Longer     Total  
     Fair
Value
     Gross
Unrealized
Loss
    Fair
Value
     Gross
Unrealized
Loss
    Fair
Value
     Unrealized
Losses
 
     (In Thousands)  

At September 30, 2010

               

Available-for-sale securities:

               

Collateralized mortgage obligations and REMICs

   $ —         $ —        $ 466       $ (19   $ 466       $ (19

Trust preferred stock and preferred stock

     —           —          1,432         (2,316     1,432         (2,316

Obligations of state and political subdivisions

     875         (44     1,207         (47     2,082         (91
                                                   

Total temporarily impaired securities

   $ 875       $ (44   $ 3,105       $ (2,382   $ 3,980       $ (2,426
                                                   

With the exception of Trust Preferred Securities, the above securities all have fixed interest rates, and all securities have defined maturities. Their fair value is sensitive to movements in market interest rates. First Defiance has the ability and intent to hold these investments for a time necessary to recover the amortized cost without impacting its liquidity position and it is not more than likely that the Company will be required to sell the investments before anticipated recovery.

 

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Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. The investment portfolio is evaluated for OTTI by segregating the portfolio into two general segments. Investment securities classified as available-for-sale or held-to-maturity are generally evaluated for OTTI under FASB ASC Topic 320. Certain collateralized debt obligations are evaluated for OTTI under FASB ASC Topic 325, Investment – Other .

When OTTI occurs under either model, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected compared to the book value of the security and is recognized in earnings. The amount of OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

Management’s analysis for the third quarter of 2010 deemed that OTTI write-downs were necessary on two CDOs resulting in OTTI write-downs of $73,000 compared to $994,000 for the same period in 2009. Also in the third quarter of 2010, $117,000 of OTTI was recognized relating to the write-down of the preferred stock issued by Fannie Mae and Freddie Mac. These investments were written down to fair value of $17,500 (Fannie Mae) and $17,200 (Freddie Mac). For the first nine months of 2010, the Company has recorded OTTI write-downs of $331,000 compared to $2.5 million for the same period in 2009.

The Company held nine collateralized debt obligations (“CDOs”) at September 30, 2010. Four of those CDOs were written down in full prior to January 1, 2010. The remaining five CDOs have a total amortized cost of $3.7 million at September 30, 2010. Of these, three, with a total amortized cost of $1.8 million, were identified as OTTI in prior periods. The final two CDOs, with a total amortized cost of $2.0 million, continue to pay principal and interest payments in accordance with the contractual terms of the securities and no credit loss impairment has been identified in management’s analysis. Therefore, these two CDO investments have not been deemed by management to be OTTI. The Company held three additional CDOs at December 31, 2009 with a total amortized cost of $25,000. These CDOs were classified as held for sale at December 31, 2009 and were sold during the first quarter of 2010.

As required under FASB ASC Topic 320, beginning January 1, 2009, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.

 

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Given the conditions in the debt markets and the absence of observable transactions in the secondary and new issue markets, the Company’s CDOs are classified within Level 3 of the fair value hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

The Company’s CDO valuations were supported by analysis prepared by an independent third party and supported by management’s analyses. Their approach to determining fair value involved several steps: 1) Detailed credit and structural evaluation of each piece of collateral in the CDO; 2) Collateral performance projections for each piece of collateral in the CDO (default, recovery and prepayment/amortization probabilities) and 3) Discounted cash flow modeling.

Trust Preferred CDOs Discount Rate Methodology

First Defiance uses market-based yield indicators as a baseline for determining appropriate discount rates, and then adjusts the resulting discount rates on the basis of its credit and structural analysis of specific CDO instruments. The primary focus is on the returns a fixed income investor would require in order to allocate capital on a risk adjusted basis. There is currently no active market for trust preferred CDOs, however, First Defiance looks principally to market yields for stand-alone trust preferred securities issued by banks, thrifts and insurance companies for which there is an active and liquid market. The next step is to make a series of adjustments to reflect the differences that nevertheless exist between these products (both credit and structural) and, most importantly, to reflect idiosyncratic credit performance differences (both actual and projected) between these products and the underlying collateral in the specific CDOs. Importantly, as part of the analysis described above, First Defiance considers the fact that structured instruments frequently exhibit leverage not present in stand-alone instruments, and make adjustments as necessary to reflect this additional risk.

Fundamental to this evaluation is an assessment of the likelihood of CDO coverage test failures that would have the effect of diverting cash flow away from the relevant CDO bond for some period of time. Generally speaking, the Company adjusts indicative credit spreads upwards in the case of CDOs that have relatively weaker collateral and/or less cushion with respect to overcollateralization and interest coverage test ratios and downwards if the reverse is true. This aspect of the Company’s discount rate methodology is important because there is frequently a great difference in the risks present in CDO instruments that are otherwise very similar (i.e. CDOs with the same basic type of collateral, the same manager, the same vintage, etc., may exhibit vastly different performance characteristics). With respect to this last point, First Defiance notes that given today’s credit environment, characterized by high default and deferral rates, it is typically the case that deal-specific credit performance (determined on the basis of the credit characteristics of remaining collateral) is the best indicator of what a willing market participant would pay for an instrument.

The Company uses the same methodology for all of its CDOs and believes its valuation methodology is appropriate for all of its CDOs in accordance with FASB ASC Topic 320 as well as other related guidance.

 

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The default and recovery probabilities for each piece of collateral were formed based on the evaluation of the collateral credit and a review of historical industry default data and current/near-term operating conditions. For collateral that has already deferred, the Company assumed a recovery of 10% of par for banks, thrifts or other depository institutions and 15% for insurance companies. Although there is a possibility that the deferring collateral will become current at some point in the future, First Defiance has conservatively assumed that it will continue to defer and gradually will default.

The following table details the seven securities with other-than-temporary impairment, their lowest credit rating at September 30, 2010 and the related credit losses recognized in earnings for the three month periods ended March 31, 2010, June 30, 2010 and September 30, 2010 (In Thousands):

 

    

Preferred

Term VI

    

TPREF

Funding II

    

Alesco

VIII

    

Preferred

Term

Security

XXVII

    

Trapeza

CDO I

    

Alesco

Preferred

Funding

VIII

    

Alesco

Preferred

Funding

IX

        
     Rated Caa1      Rated Caa3      Rated Ca      Rated Ca      Rated Ca      Not Rated      Not Rated      Total  

Cumulative OTTI related to credit loss at January 1, 2010

   $ 17       $ 243       $ 1,000       $ —         $ 857       $ 453       $ 465       $ 3,035   

Addition – Qtr 1

     48         —           —           22         —           —           —           70   
                                                                       

Cumulative OTTI related to credit loss at March 31, 2010

   $ 65       $ 243       $ 1,000       $ 22       $ 857       $ 453       $ 465       $ 3,105   
                                                                       

Addition – Qtr 2

     —           17         —           54         —           —           —           71   
                                                                       

Cumulative OTTI related to credit loss at June 30, 2010

   $ 65       $ 260       $ 1,000       $ 76       $ 857       $ 453       $ 465       $ 3,176   
                                                                       

Addition – Qtr 3

     15         58         —           —           —           —           —           73   
                                                                       

Cumulative OTTI related to credit loss at September 30, 2010

   $ 80       $ 318       $ 1,000       $ 76       $ 857       $ 453       $ 465       $ 3,249   
                                                                       

In addition to the table above and below, $117,000 of OTTI was recognized relating to the write-down of the preferred stock issued by Fannie Mae and Freddie Mac in the third quarter of 2010.

 

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The following table provides additional information related to the five CDO investments for which a balance remains as of September 30, 2010 (dollars in thousands):

CDO

   Class      Amortized
Cost
     Fair
Value
     Unrealized
Loss
    OTTI
Losses
2010
    Lowest
Rating
     Current
Number of
Banks and
Insurance
Companies
     Actual
Deferrals
and
Defaults
as a % of
Current
Collateral
    Expected
Deferrals
and
Defaults
as a % of
Remaining
Performing
Collateral
    Excess
Sub-ordination
as a % of
Current
Performing
Collateral
 

Preferred Term VI

     Mezz       $ 183       $ 84       $ (99   $ (63     Caa1         5         71.33     —       —  

TPREF Funding II

     B         677         262         (415     (75     Caa3         18         37.37     26.28     —     

I-Preferred Term Sec I

     B-1         1,000         482         (518     —          CCC         16         9.04     19.13     13.92

Dekania II CDO

     C-1         989         453         (536     —          CCC         36         —          15.01     28.80

Preferred Term Sec XXVII

     C-1         899         151         (748     (76     Ca         33         29.37     26.18     0.52
                                                 

Total

      $ 3,748       $ 1,432       $ (2,316   $ (214            
                                                 

The increase in OTTI in the third quarter of 2010 was the result of deterioration in the performance of the underlying collateral. Specifically, depreciation was driven by both realized credit events (i.e. defaults and deferrals) and weakening credit fundamentals in some of the performing collateral, which led to an increased probability of default going forward. Excluding Preferred Term VI, the Company’s assumed average lifetime default rate on the securities in the above table, declined from 29.9% at the end of the second quarter 2010 to a rate of 29.8% at the end of the third quarter 2010.

The table below presents a roll-forward of the credit losses relating to debt securities recognized in earnings for the nine months ended September 30, 2010 (in thousands):

 

Beginning balance, January 1, 2010

   $ 2,521   

Additions for amounts related to credit loss for which an OTTI was not previously recognized

     76   

Reductions for amounts realized for securities sold during the period

     (2,261

Reductions for amounts related to securities for which the Company intends to sell or that it will be more likely than not that the company will be required to sell prior to recovery of amortized cost basis

     —     

Reductions for increase in cash flows expected to be collected that are recognized over the remaining life of the security

     —     

Increases to the amount related to the credit loss for which other-than-temporary was previously recognized

     138   
        

Ending balance, September 30, 2010

   $ 474   
        

 

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Sales and write-downs of available for sale securities were as follows:

 

     Three Months  Ended
September 30,
     Nine Months  Ended
September 30,
 
     2010      2009      2010      2009  
     (In thousands)      (In thousands)  

Proceeds

   $ —         $ 2,779       $ 28       $ 6,383   

Gross realized gains

     —           154         3         279   

Gross realized losses

     —           —           —           —     

The Company also recognized gross gains of $3,000 and $0 on calls during the first nine months ended September 30, 2010 and 2009, respectively.

9. Loans

Loans receivable consist of the following (in thousands):

 

     September 30,
2010
    December 31,
2009
 

Real Estate:

    

Secured by single family residential

   $ 213,574      $ 227,592   

Secured by multi-family residential

     100,576        103,169   

Secured by non-residential real estate

     676,396        703,721   

Construction

     31,722        48,625   
                
     1,022,268        1,083,107   

Other Loans:

    

Commercial

     372,583        379,408   

Automobile

     17,188        21,661   

Home equity and improvement

     137,747        147,977   

Other

     9,872        12,444   
                
     537,390        561,490   
                

Total loans

     1,559,658        1,644,597   

Deduct:

    

Undisbursed loan funds

     (9,030     (26,494

Net deferred loan origination fees and costs

     (951     (981

Allowance for loan loss

     (41,343     (36,547
                

Totals

   $ 1,508,334      $ 1,580,575   
                

 

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Changes in the allowance for loan losses were as follows (in thousands):

 

     Three Months ended
September 30,
     Nine Months ended
September 30,
 
     2010      2009      2010      2009  

Balance at beginning of period

   $ 38,852       $ 25,840       $ 36,547       $ 24,592   

Provision for loan losses

     5,196         8,051         17,525         14,762   

Charge-offs:

           

Residential

     1,164         744         2,625         1,397   

Commercial real estate

     688         1,152         5,122         3,887   

Commercial

     842         658         4,730         2,310   

Home equity and improvement

     148         196         703         627   

Consumer finance

     28         39         69         245   
                                   

Total charge-offs

     2,870         2,789         13,249         8,466   

Recoveries

     165         146         520         360   
                                   

Net charge-offs

     2,705         2,643         12,729         8,106   
                                   

Ending allowance

   $ 41,343       $ 31,248       $ 41,343       $ 31,248   
                                   

The following table presents the aggregate amounts of non-performing assets, comprised of non-performing loans and real estate owned on the dates indicated:

 

     September 30,
2010
     December 31,
2009
 
     (in thousands)  

Non-accrual loans

   $ 37,377       $ 41,191   

Loans over 90 days past due and still accruing

     —           —     

Troubled debt restructuring, still accruing

     8,784         6,715   
                 

Total non-performing loans

     46,161       $ 47,906   

Real estate and other assets held for sale

     11,127         13,527   
                 

Total non-performing assets

   $ 57,288       $ 61,433   
                 

Impaired loans were as follows as of September 30, 2010 (in thousands):

 

Period-end impaired loans with no allowance for loan losses allocated

   $  20,213   

Period-end impaired loans with allowance for loan losses allocated

     46,745   
        

Total

   $ 66,958   

Amount of the allowance allocated to impaired loans

   $ 16,613   

Impaired loans were as follows as of December 31, 2009 (in thousands):

 

Period-end impaired loans with no allowance for loan losses allocated

   $  18,239   

Period-end impaired loans with allowance for loan losses allocated

     40,585   
        

Total

   $ 58,824   

Amount of the allowance allocated to impaired loans

   $ 12,249   

 

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     Three Months Ended Sept 30,      Nine Months Ended Sept 30,  
     2010      2009      2010      2009  
     (in thousands)  

Average of impaired loans during the period

   $ 63,677       $ 39,945       $ 62,802       $ 33,869   

Interest income recognized during the period

     596         219         1,458         549   

Cash-basis interest income recognized

     578         219         1,288         518   

The Company has no outstanding commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring.

10. Mortgage Banking

Net revenues from the sales and servicing of mortgage loans consisted of the following:

 

     Three Months Ended
Sept 30,
    Nine Months Ended
Sept 30,
 
     2010     2009     2010     2009  
     (in thousands)  

Gain from sale of mortgage loans

   $ 2,886      $ 1,541      $ 5,262      $ 7,276   

Mortgage loans servicing revenue (expense):

        

Mortgage loans servicing revenue

     761        725        2,263        2,109   

Amortization of mortgage servicing rights

     (798     (514     (1,634     (2,625

Mortgage servicing rights valuation adjustments

     (527     (772     (777     917   
                                
     (564     (561     (148     401   
                                

Net revenue from sale and servicing of mortgage loans

   $ 2,322      $ 980      $ 5,114      $ 7,677   
                                

The unpaid principal balance of residential mortgage loans serviced for third parties was $1.2 billion at September 30, 2010 and September 30, 2009.

Activity for capitalized mortgage servicing rights and the related valuation allowance follows for the three and nine months ended September 30, 2010 and 2009:

 

     Three Months Ended
Sept 30,
    Nine Months Ended
Sept 30,
 
     2010     2009     2010     2009  
     (in thousands)  

Mortgage servicing assets:

        

Balance at beginning of period

   $ 10,448      $ 10,022      $ 10,436      $ 9,403   

Loans sold, servicing retained

     894        717        1,742        3,447   

Amortization

     (798     (514     (1,634     (2,625
                                

Carrying value before valuation allowance at end of period

     10,544        10,225        10,544        10,225   

Valuation allowance:

        

Balance at beginning of period

     (1,728     (1,103     (1,478     (2,792

Impairment recovery (charges)

     (527     (772     (777     917   
                                

Balance at end of period

     (2,255     (1,875     (2,255     (1,875
                                

Net carrying value of MSRs at end of period

   $ 8,289      $ 8,350      $ 8,289      $ 8,350   
                                

Fair value of MSRs at end of period

   $ 8,289      $ 8,350      $ 8,289      $ 8,350   
                                

Amortization of mortgage servicing rights is computed based on payments and payoffs of the related mortgage loans serviced.

 

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11. Deposits

A summary of deposit balances is as follows (in thousands):

 

     September 30,
2010
     December 31,
2009
 

Non-interest-bearing checking accounts

   $ 213,414       $ 189,132   

Interest-bearing checking and money market accounts

     543,539         499,575   

Savings accounts

     141,190         130,156   

Retail certificates of deposit less than $100,000

     485,777         550,710   

Retail certificates of deposit greater than $100,000

     161,413         163,300   

Brokered or national certificates of deposit

     45,315         47,353   
                 
   $ 1,590,648       $ 1,580,226   
                 

12. Borrowings

First Defiance’s debt, FHLB advances and junior subordinated debentures owed to unconsolidated subsidiary trusts are comprised of the following:

 

     September 30,
2010
     December 31,
2009
 
     (in thousands)  

FHLB Advances:

     

Overnight borrowings

   $ —         $ —     

Single maturity fixed rate advances

     35,000         35,000   

Single maturity LIBOR based advances

     —           20,000   

Putable advances

     54,000         64,000   

Strike-rate advances

     27,000         27,000   

Amortizable mortgage advances

     896         927   
                 

Total

   $ 116,896       $ 146,927   
                 

Junior subordinated debentures owed to unconsolidated subsidiary trusts

   $ 36,083       $ 36,083   
                 

The putable advances can be put back to the Company at the option of the FHLB on a quarterly basis. As of September 30, 2010, $14.0 million of the putable advances with a weighted average rate of 2.69% are not yet callable by the FHLB, but on October 14, 2010, $5.0 million became callable. The call dates for these advances range from October 14, 2010 to February 11, 2011 and the maturity dates range from February 11, 2013 to March 12, 2018. The FHLB has the option to call the remaining $40.0 million of putable advances with a weighted average rate of 4.80%. The maturity dates of these advances range from February 2, 2011 to January 14, 2015. The strike-rate advances are putable at the option of the FHLB only when the three month LIBOR rates exceed the agreed upon strike-rate in the advance contract which ranges from 7.5% to 8.0%. The three month LIBOR rate at September 30, 2010 was 0.29%. The weighted average rate of the strike-rate advances is 4.18% and the maturity dates range from March 8, 2011 to February 25, 2013.

 

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In March 2007, the Company sponsored an affiliated trust, First Defiance Statutory Trust II (Trust Affiliate II) that issued $15 million of Guaranteed Capital Trust Securities (Trust Preferred Securities). In connection with this transaction, the Company issued $15.5 million of Junior Subordinated Deferrable Interest Debentures (Subordinated Debentures) to Trust Affiliate II. The Company formed Trust Affiliate II for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Subordinated Debentures held by Trust Affiliate II are the sole assets of that trust. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the Trust Preferred Securities issued by Trust Affiliate II are payable quarterly at a fixed rate equal to 6.441% for the first five years and a floating interest rate based on three-month LIBOR plus 1.50% points, repricing quarterly, thereafter.

The Company also sponsored an affiliated trust, First Defiance Statutory Trust I (Trust Affiliate I), that issued $20 million of Trust Preferred Securities in 2005. In connection with this transaction, the Company issued $20.6 million of Subordinated Debentures to Trust Affiliate I. Trust Affiliate I was formed for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds from the sale of these capital securities solely in Subordinated Debentures of the Company. The Junior Debentures held by Trust Affiliate I are the sole assets of the trust. The Company is not considered the primary beneficiary of this Trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability. Distributions on the Trust Preferred Securities issued by Trust Affiliate I are payable quarterly at a variable rate equal to the three-month LIBOR rate plus 1.38%. The Coupon rate payable on the Trust Preferred Securities issued by Trust Affiliate I was 1.67% and 1.63% on September 30, 2010 and December 31, 2009 respectively.

The Trust Preferred Securities issued by Trust Affiliates I and II are subject to mandatory redemption, in whole or part, upon repayment of the Subordinated Debentures. The Company has entered into agreements that fully and unconditionally guarantee the Trust Preferred Securities subject to the terms of the guarantees. The Trust Preferred Securities and Subordinated Debentures issued by Trust Affiliate I mature on December 15, 2035 but may be redeemed by the issuer at par after October 28, 2010. The Trust Preferred Securities issued by Trust Affiliate II mature on June 15, 2037, but may be redeemed at the Company’s option at any time on or after June 15, 2012, or at any time upon certain events.

Interest on both issues of Trust Preferred Securities may be deferred for a period of up to five years at the option of the issuer.

13. Commitments, Guarantees and Contingent Liabilities

Loan commitments are made to accommodate the financial needs of First Federal’s customers; however, there are no long-term, fixed-rate loan commitments that result in market risk. Standby letters of credit commit the Company to make payments on behalf of customers when certain specified future events occur. They primarily are issued to facilitate customers’ trade transactions.

 

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Both arrangements have credit risk, essentially the same as that involved in extending loans to customers, and are subject to the Company’s normal credit policies. Collateral (e.g., securities, receivables, inventory and equipment) is obtained based on Management’s credit assessment of the customer.

The Company’s maximum obligation to extend credit for loan commitments (unfunded loans and unused lines of credit) and standby letters of credit outstanding as of the periods stated below were as follows (in thousands):

 

     September 30, 2010      December 31, 2009  
     Fixed Rate      Variable Rate      Fixed Rate      Variable Rate  

Commitments to make loans

   $ 37,618       $ 57,676       $ 29,206       $ 64,243   

Unused lines of credit

     30,816         193,569         36,772         195,692   

Standby letters of credit

     283         31,524         263         21,036   
                                   

Total

   $ 68,717       $ 282,769       $ 66,241       $ 280,971   
                                   

Commitments to make loans are generally made for periods of 60 days or less.

In addition to the above commitments, First Defiance had commitments to sell $92.3 million and $23.8 million of loans to Freddie Mac, Fannie Mae, Federal Home Loan Bank of Cincinnati or BB&T Mortgage at September 30, 2010 and December 31, 2009, respectively.

14. Income Taxes

The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax in the state of Indiana. The Company is no longer subject to examination by taxing authorities for years before 2006. The Company currently operates primarily in the states of Ohio and Michigan, which tax financial institutions based on their equity rather than their income.

15. Derivative Financial Instruments

Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated as hedge relationships. First Federal had approximately $16.7 million and $18.7 million of interest rate lock commitments at September 30, 2010 and December 31, 2009, respectively. There were $75.7 million and $23.8 million of forward commitments for the future delivery of residential mortgage loans at September 30, 2010 and December 31, 2009, respectively.

 

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The fair value of these mortgage banking derivatives are reflected by a derivative asset. The table below provides data about the carrying values of these derivative instruments:

 

     September 30, 2010      December 31, 2009  
     Assets      (Liabilities)            Assets      (Liabilities)         
     Carrying
Value
     Carrying
Value
    Derivative
Net  Carrying
Value
     Carrying
Value
     Carrying
Value
     Derivative
Net  Carrying
Value
 
     (In Thousands)  

Derivatives not designated as hedging instruments

                

Mortgage Banking Derivatives

   $ 1,376       $ (132   $ 1,244       $ 380       $ —         $ 380   
                                                    

The table below provides data about the amount of gains and losses recognized in income on derivative instruments not designated as hedging instruments:

 

     Three Months Ended Sept 30,      Nine Months Ended Sept 30,  
     2010      2009      2010      2009  
     (in thousands)  

Derivatives designated as hedging instruments

           

Mortgage Banking Derivatives – Gain (Loss)

   $ 760       $ 37       $ 864       $ (522
                                   

The above amounts are included in mortgage banking income with gain on sale of mortgage loans.

16. Acquisition

On May 20, 2010, First Defiance acquired a group medical benefits line of business from Andres O’Neil & Lowe Insurance Agency (“AOL”) for a cash purchase price of $1.5 million and future consideration to be paid in cash in 2010, 2011 and 2012. As of September 30, 2010, management has determined goodwill of $971,200 and identifiable intangible assets of $735,800 consisting of customer relationship intangible of $597,800 and a non-compete intangible of $138,000. Disclosure of pro forma results of this acquisition is not material to the Company’s consolidated financial statements.

17. Group Life Plan

On June 30, 2010, First Federal adopted the First Federal Bank of the Midwest Executive Group Life Plan – Post Separation (the “Plan”) in which various employees, including the Company’s named executive offices, may participate.

Under the terms of the Plan, First Federal will purchase and own life insurance policies covering the lives of employees selected by the board of directors of First Federal as participants.

There was no expense required to be recorded as of June 30, 2010. There was $273,278 recorded in the third quarter of 2010 and $273,278 will be recorded and expensed during the fourth quarter.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

General - First Defiance Financial Corp. (“First Defiance” or “the Company”) is a unitary thrift holding company that conducts business through its two wholly owned subsidiaries, First Federal Bank of the Midwest (“First Federal”) and First Insurance and Investments, Inc. (“First Insurance”). First Federal is a federally chartered savings bank that provides financial services through 33 full-service branches in communities based in northwest Ohio, northeast Indiana, and southeastern Michigan. First Federal provides a broad range of financial services including checking accounts, savings accounts, certificates of deposit, real estate mortgage loans, commercial loans, consumer loans, home equity loans and trust services. First Insurance sells a variety of property and casualty, group health and life, and individual health and life insurance products and investment and annuity products. Insurance products are sold through First Insurance’s offices in Defiance, Archbold, Bryan, and Bowling Green, Ohio while investment and annuity products are sold through registered investment representatives located at certain First Federal banking center locations.

Business Strategy - First Defiance’s primary objective is to be a high performing community banking organization, well regarded in its market areas. First Defiance accomplishes this through emphasis on local decision making and empowering its employees with tools and knowledge to serve its customers’ needs. First Defiance believes in a “Customer First” philosophy that is strengthened by its Trusted Advisor initiative. First Defiance also has a tagline of “Bank with the people you know and trust” as an indication of its commitment to local, responsive, personalized service. First Defiance believes this strategy results in greater customer loyalty and profitability through core relationships. First Defiance is focused on diversification of revenue sources and increased market penetration in areas where the growth potential exists for a balance between acquisition and organic growth. The primary segments of First Defiance’s business strategy are commercial banking, consumer banking, including the origination and sale of single family residential loans, enhancement of fee income, wealth management and insurance sales, each united by a strong customer service culture throughout the organization. Management remains concerned about increases in interest rates, inflation, and the unintended consequences of increased government intervention. During 2010, management continues to focus on asset quality, core deposit growth, expense control as well as other opportunities to further service our customers.

Commercial and Commercial Real Estate Lending - Commercial and commercial real estate lending have been an ongoing focus and a major component of First Federal’s success. First Federal provides primarily commercial real estate and commercial business loans with an emphasis on owner occupied commercial real estate and commercial business lending with a focus on the deposit balances that accompany these relationships. First Federal’s client base tends to be small to middle market customers with annual gross revenues generally between $1 million and $50 million. First Federal’s focus is also on securing multiple guarantors in addition to collateral where possible. These customers require First Federal to have a high degree of knowledge and understanding of their business in order to provide them with solutions to their financial needs. First Federal’s Customer First philosophy and culture complements this need of its clients. First Federal believes this personal service model differentiates First Federal from its competitors, particularly the larger regional institutions. First Federal offers a wide variety of products to support commercial clients including remote deposit capture and other cash management services. First Federal also believes that the small business customer is a strong market for First Federal. First Federal participates in many of the Small Business Administration lending programs. Maintaining a diversified portfolio with an emphasis on monitoring industry concentrations and reacting to changes in the credit characteristics of industries is an ongoing focus.

 

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Consumer Banking - First Federal offers customers a full range of deposit and investment products including demand, NOW, money market, certificates of deposits, CDARS and savings accounts. First Federal offers a full range of investment products through the wealth management department and a wide variety of consumer loan products, including residential mortgage loans, home equity loans, installment loans and education loans. First Federal also offers online banking services, which include online bill pay along with debit cards.

Fee Income Development - Generation of fee income and the diversification of revenue sources are accomplished through the mortgage banking operation, insurance subsidiary and the wealth management department as First Defiance seeks to reduce reliance on retail transaction fee income.

Deposit Growth - First Federal’s focus has been to grow core deposits with an emphasis on total relationship banking with both its retail and commercial customers. First Federal has initiated a pricing strategy that considers the whole relationship of the customer. First Federal will continue to focus on increasing its market share in the communities it serves by providing quality products with extraordinary customer service, business development strategies and branch expansion. First Federal will look to grow its footprint in areas believed to further compliment its overall market share and compliment its strategy of being a high performing community bank.

Asset Quality - Maintaining a strong credit culture is of the utmost importance to First Federal. First Federal has maintained a strong credit approval and review process that has allowed the Company to maintain a credit quality standard that balances the return with the risks of industry concentrations and loan types. First Federal is primarily a collateral lender with an emphasis on cash flow performance, while obtaining additional support from personal guarantees and secondary sources of repayment. First Federal has directed its attention on loan types and markets that it knows well and in which it has historically been successful in. First Federal strives to have loan relationships that are well diversified in both size and industry, and monitor the overall trends in the portfolio to maintain its industry and loan type concentration targets. First Federal maintains a problem loan remediation process that focuses on detection and resolution. First Federal maintains a strong process of internal control that subjects the loan portfolio to periodic internal reviews as well as independent third party loan review.

Expansion Opportunities - First Defiance believes it is well positioned to take advantage of acquisitions or other business opportunities in its market areas, including FDIC-assisted transactions. First Defiance believes it has a track record of successfully accomplishing both acquisitions and de novo branching in its market area. This track record puts the Company in a solid position to enter or expand its business. First Defiance has successfully integrated acquired institutions in the past with the most recent bank acquisition completed in 2008. First Defiance will continue to be disciplined as well as opportunistic in its approach to future acquisitions and de novo branching with a focus on its primary geographic market area, which it knows well and has been competing in for a long period of time. In May 2010, First Insurance acquired a group benefits business line from Andres O’Neil & Lowe Insurance Agency.

 

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Investments - First Defiance invests in U.S. Treasury and federal government agency obligations, obligations of municipal and other political subdivisions, mortgage-backed securities which are issued by federal agencies, corporate bonds, and collateralized mortgage obligations (“CMOs”) and real estate mortgage investment conduits (“REMICs”). Management determines the appropriate classification of all such securities at the time of purchase in accordance with FASB ASC Topic 320.

Securities are classified as held-to-maturity when First Defiance has the positive intent and ability to hold the security to maturity. Held-to-maturity securities are stated at amortized cost and had a recorded value of $918,000 at September 30, 2010. Securities not classified as held-to-maturity are classified as available-for-sale, which are stated at fair value and had a recorded value of $156.4 million at September 30, 2010. The available-for-sale portfolio consists of obligations of U.S. Government corporations and agencies ($11.1 million), certain municipal obligations ($52.1 million), CMOs and REMICs ($55.2 million), mortgage backed securities ($36.5 million) and trust preferred and preferred stock ($1.5 million).

In accordance with ASC Topic 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income.

Lending - In order to properly assess the collateral dependent loans included in its loan portfolio, the Company has established policies regarding the monitoring of the collateral underlying such loans. The Company requires an appraisal that is less than one year old for all new collateral dependent real estate loans, and all renewed collateral dependent real estate loans where new money is extended. The appraisal process is handled by First Federal’s Credit Department, which selects the appraiser and orders the appraisal. First Federal’s loan policy prohibits the account officer from talking or communicating with the appraiser to insure that the appraiser is not influenced by the account officer in any way in making their determination of value.

First Federal generally does not require updated appraisals for performing loans unless new money is requested by the borrower.

When a collateral dependent loan is downgraded to classified status, First Federal reviews the most current appraisal on file and if necessary, based on First Federal’s assessment of the appraisal, such as age, market, etc, First Federal will discount this amount to a more appropriate current value based on inputs from lenders and realtors. This amount may then be discounted further by First Federal’s estimation of the carrying and selling costs. Finally, First Federal assesses whether there is any collateral short fall, considering guarantor support, and determines if a reserve is necessary.

 

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When a collateral dependent loan moves to non-performing status, First Federal generally gets a new third party appraisal and adjusts the reserve as necessary based upon the new appraisal and an estimate of costs to liquidate the collateral. All properties that are moved into the other real estate owned (“OREO”) category are supported by current appraisals, and the OREO is carried at the appraised value less First Federal’s estimate of the liquidation costs.

First Federal does not adjust any appraisals upward without written documentation of this valuation change from the appraiser. When setting reserves on classified loans, appraisal values may be discounted downward based upon First Federal’s experience with liquidating similar properties.

All collateral dependent loans over 90 days past due and or on non-accrual status as well as all troubled debt restructured collateral dependent loans are classified as non-performing loans. Non-performing status automatically occurs in the month in which the 90 day delinquency occurs. For troubled debt restructured collateral dependent loans, the loans are put into non-performing status in the month in which the restructure occurs.

As stated above, once a collateral dependent loan is identified as non-performing, First Federal generally gets an appraisal. Troubled debt restructured collateral dependent loans receive an appraisal as part of the restructure credit decision.

Appraisals are received within approximately 60 days after they are requested. The First Federal Loan Loss Reserve Committee reviews each new appraisal and makes any necessary adjustment to the reserve at its meeting prior to the end of each quarter.

Any partially charged-off collateral dependent loans are considered non-performing and, as such, need to demonstrate an extended period of time of satisfactory payment performance as well as cash flow coverage capability supported by current financial statements before First Federal will consider an upgrade to performing status. If the loan maintains a rate at restructuring that is lower than the market rate for similar credits, the loan will remain classified as a troubled debt restructuring until such time as it is paid off or restructured at prevailing rates and terms. First Federal may consider moving the loan to an accruing status after six months of satisfactory payment performance.

For loans where First Federal determines that an updated appraisal is not necessary, other means are used to verify the value of the real state, such as recent sales of similar properties on which First Federal had loans as well as calls to appraisers, brokers, realtors, and investors. First Federal monitors and tracks its reserves quarterly to determine accuracy. Based on these results, changes may occur in specific reserves assigned. A recent analysis indicates that First Federal is within its target range of the ultimate losses on liquidated loans being on average within 10% of the specific reserves established for these loans.

Loan modifications constitute a troubled debt restructuring if First Federal, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. For loans that are considered troubled debt restructurings, First Federal either computes the present value of expected future cash flows discounted at the original loan’s effective interest rate or, as a practical expedient, it may measure impairment based on the observable market price of the loan or the fair value of the collateral even though troubled debt restructurings are not expected to be deemed collateral dependent. The difference between the carrying value and fair value of the loan is recorded as a valuation allowance.

 

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Earnings - The profitability of First Defiance is primarily dependent on its net interest income and non-interest income. Net interest income is the difference between interest income on interest-earning assets, principally loans and securities, and interest expense on interest-bearing deposits, FHLB advances, and other borrowings. The Company’s non-interest income is mainly derived from service fees and other charges, mortgage banking income, and insurance commissions. First Defiance’s earnings also depend on the provision for loan losses and non-interest expenses, such as employee compensation and benefits, occupancy and equipment expense, deposit insurance premiums, and miscellaneous other expenses, as well as federal income tax expense.

Impact of Recent and Future Legislation

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which significantly changes the regulation of financial institutions and the financial services industry. The Dodd-Frank Act includes provisions affecting large and small financial institutions alike, including several provisions that will profoundly affect how community banks, thrifts, and small bank and thrift holding companies, such as First Defiance, will be regulated in the future. Among other things, these provisions abolish the Office of Thrift Supervision and transfer its functions to other federal banking agencies, relax rules regarding interstate branching, allow financial institutions to pay interest on business checking accounts, change the scope of federal deposit insurance coverage, and impose new capital requirements on bank and thrift holding companies. The Dodd-Frank Act also establishes the Bureau of Consumer Financial Protection as an independent entity within the Federal Reserve, which will be given the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services. Additionally, the Dodd-Frank Act includes a series of provisions covering mortgage loan origination standards, affecting, among other things, originator compensation, minimum repayment standards, and pre-payments. The Dodd-Frank Act contains numerous other provisions affecting financial institutions of all types, many of which may have an impact on the operating environment of First Defiance in substantial and unpredictable ways. Consequently, the Dodd-Frank Act is likely to affect First Defiance’s cost of doing business, it may limit or expand the Company’s permissible activities, and it may affect the competitive balance within the financial services industry and the Company’s market area. The nature and extent of future legislative and regulatory changes affecting financial institutions, including as a result of the Dodd-Frank Act, is very unpredictable at this time. First Defiance’s management team is actively reviewing the provisions of the Dodd-Frank Act, many of which are phased-in over the next several months and years, and assessing its probable impact on the business, financial condition, and results of operations of the Company. However, the ultimate effect of the Dodd-Frank Act on the financial services industry in general, and First Defiance in particular, is uncertain at this time.

 

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Participation in the U.S. Treasury Capital Purchase Program

On October 14, 2008, the Capital Purchase Program (“CPP”) was announced by the U.S. Treasury as part of the Troubled Asset Relief Program (“TARP”). The purpose of the CPP was to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Institution’s participating in the CPP are required to comply with a number of restrictions and provisions, including standards for executive compensation and corporate governance and limitations on share repurchases and the declaration and payment of dividends on common shares. The standard terms of the CPP require that a participating financial institution limit the payment of dividends to the most recent quarterly amount prior to October 14, 2008, which is $0.26 per share in the case of First Defiance. This dividend limitation remains in effect until the preferred shares issued to the U.S. Treasury are no longer outstanding.

First Defiance applied and was approved to participate in the CPP. As a result, on December 5, 2008, First Defiance issued $37.0 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (“Senior Preferred Shares”) to the U.S. Treasury. The Senior Preferred Shares constitute Tier 1 capital and rank senior to First Defiance’s common shares. The Senior Preferred Shares pay cumulative dividends at a rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after five years.

As part of its participation in the CPP, First Defiance also issued a warrant to the U.S. Treasury to purchase 550,595 common shares having an exercise price of $10.08 per share. The initial exercise price for the warrant and the market price for determining the number of common shares subject to the warrant were determined by reference to the market price of the common shares on the date of the investment by the U.S. Treasury in the Senior Preferred Shares (calculated on a 20-day trailing average). The warrant has a term of 10 years.

Forward-Looking Information

Certain statements contained in this quarterly report are not historical facts, including but not limited to statements that can be identified by the use of forward-looking terminology such as “may”, “will”, “expect”, “anticipate”, or “continue” or the negative thereof or other variations thereon or comparable terminology are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21B of the Securities Act of 1934, as amended. Actual results could differ materially from those indicated in such statements due to risks, uncertainties and changes with respect to a variety of market and other factors.

 

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Changes in Financial Condition

At September 30, 2010, First Defiance’s total assets, deposits and stockholders’ equity amounted to $2.04 billion, $1.59 billion and $241.0 million, respectively, compared to $2.06 billion, $1.58 billion and $234.1 million, respectively, at December 31, 2009.

Net loans receivable (excluding loans held for sale) declined $72.2 million to $1.51 billion from $1.58 billion at December 31, 2009. The decrease in loans is mainly attributable to the continued economic weakness in the market areas served by the Company. The Company is starting to see some signs of improvement as some businesses are showing stronger 2010 operating results and improved cash flows but the signs are more isolated than across the board. The variances in loans receivable between September 30, 2010 and December 31, 2009 include decreases in commercial real estate loans (down $29.9 million), commercial loans (down $6.8 million), home equity and improvement loans (down $10.2 million), construction loans (down $16.9 million), consumer loans (down $7.0 million) and one to four family residential real estate (down $14.0 million).

The investment securities portfolio increased $17.9 million to $157.3 million at September 30, 2010 from $139.4 million at December 31, 2009. The increase is the result of $47.5 million of securities being purchased during the first nine months of 2010 partially offset by $19.2 million of securities being matured or called in the period, principal pay downs of $13.3 million in CMOs and mortgage-backed securities, and $22,000 of securities being sold. There was an unrealized gain in the investment portfolio of $4.3 million at September 30, 2010 compared to an unrealized gain of $721,000 at December 31, 2009.

Deposits increased $10.4 million to $1.59 billion at September 30, 2010 compared to December 31, 2009. Interest-bearing demand deposits and money market accounts increased $44.0 million to $543.5 million, savings accounts increased $11.0 million to $141.2 million and non interest-bearing demand deposits increased $24.3 million to $213.4 million. These increases were mostly offset by a decline in retail time deposits of $66.8 million to $647.2 million.

FHLB advances decreased $30.0 million to $116.9 million at September 30, 2010 from $146.9 million at December 31, 2009. The decrease is the result of paying off a $10.0 million putable advance in the third quarter of 2010 and a $20.0 million LIBOR advance in the first quarter of 2010.

Stockholders’ equity increased from $234.1 million at December 31, 2009 to $241.0 million at September 30, 2010. The increase is primarily the result of recording net income of $5.8 million and a $2.4 million increase in the unrealized gain on available-for-sale securities, net of tax, partially offset by $1.4 million of accrued dividends on preferred stock.

 

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Average Balances, Net Interest Income and Yields Earned and Rates Paid

The following table presents for the periods indicated the total dollar amount of interest from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in thousands of dollars and rates, and the net interest margin. The table reports interest income from tax-exempt loans and investment on a tax-equivalent basis. All average balances are based upon daily balances (dollars in thousands).

 

     Three Months Ended September 30,  
     2010     2009  
     Average
Balance
     Interest(1)      Yield/
Rate(2)
    Average
Balance
     Interest(1)      Yield/
Rate(2)
 

Interest-earning assets:

                

Loans receivable

   $ 1,545,378       $ 22,266         5.72   $ 1,613,529       $ 23,812         5.85

Securities

     159,045         1,814         4.64        130,673         1,685         5.08   

Interest-earning deposits

     98,112         68         0.27        60,822         41         0.27   

FHLB stock and other

     21,376         225         4.18        21,376         258         4.79   
                                        

Total interest-earning assets

     1,823,911         24,373         5.31        1,826,400         25,796         5.60   

Non-interest-earning assets

     221,924              203,570         
                            

Total assets

   $ 2,045,835            $ 2,029,970         
                            

Interest-bearing liabilities:

                

Deposits

   $ 1,385,093       $ 4,667         1.34   $ 1,374,441       $ 6,163         1.78

FHLB advances

     123,566         1,187         3.81        146,941         1,267         3.42   

Subordinated debentures

     36,229         332         3.64        36,228         344         3.77   

Notes payable

     44,927         109         0.96        44,685         140         1.24   
                                        

Total interest-bearing liabilities

     1,589,815         6,295         1.57        1,602,295         7,914         1.96   

Non-interest bearing deposits

     200,207         —             175,928         —        
                                        

Total including non-interest bearing demand deposits

     1,790,022         6,295         1.40        1,778,223         7,914         1.77   

Other non-interest-bearing liabilities

     15,104              17,506         
                            

Total liabilities

     1,805,126              1,795,729         

Stockholders’ equity

     240,709              234,241         
                            

Total liabilities and stock- holders’ equity

   $ 2,045,835            $ 2,029,970         
                            

Net interest income; interest rate spread

      $ 18,078         3.74      $ 17,882         3.64
                                        

Net interest margin (3)

           3.94           3.88
                            

Average interest-earning assets to average interest-bearing liabilities

           115           114
                            

 

(1)

Interest on certain tax-exempt loans and securities is not taxable for Federal income tax purposes. In order to compare the tax-exempt yields on these assets to taxable yields, the interest earned on these assets is adjusted to a pre-tax equivalent amount based on the marginal corporate federal income tax rate of 35%.

(2)

Annualized

(3)

Net interest margin is net interest income divided by average interest-earning assets.

 

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     Nine Months Ended September 30,  
     2010     2009  
     Average
Balance
     Interest(1)      Yield/
Rate(2)
    Average
Balance
     Interest(1)      Yield/
Rate(2)
 

Interest-earning assets:

                

Loans receivable

   $ 1,552,393       $ 67,216         5.79   $ 1,600,878       $ 70,333         5.87

Securities

     152,318         5,364         4.79        126,883         5,145         5.36   

Interest-earning deposits

     107,608         198         0.25        63,093         89         0.19   

FHLB stock and other

     21,376         678         4.24        21,376         726         4.54   
                                        

Total interest-earning assets

     1,833,695         73,456         5.36        1,812,230         76,293         5.61   

Non-interest-earning assets

     218,060              202,008         
                            

Total assets

   $ 2,051,755            $ 2,014,238         
                            

Interest-bearing liabilities:

                

Deposits

   $ 1,393,747       $ 15,192         1.46   $ 1,366,645       $ 20,206         1.98

FHLB advances

     130,745         3,625         3.71        146,994         3,865         3.52   

Subordinated debentures

     36,229         982         3.62        36,241         1,139         4.20   

Notes payable

     45,731         329         0.96        42,446         433         1.36   
                                        

Total interest-bearing liabilities

     1,606,452         20,128         1.67        1,592,326         25,643         2.15   

Non-interest bearing deposits

     192,673         —             172,341         —        
                                        

Total including non-interest bearing demand deposits

     1,799,125         20,128         1.50        1,764,667         25,643         1.94   

Other non-interest-bearing liabilities

     14,871              17,659         
                            

Total liabilities

     1,813,996              1,782,326         

Stockholders’ equity

     237,759              231,912         
                            

Total liabilities and stock- holders’ equity

   $ 2,051,755            $ 2,014,238         
                            

Net interest income; interest rate spread

      $ 53,328         3.69      $ 50,650         3.46
                                        

Net interest margin (3)

           3.89           3.73
                            

Average interest-earning assets to average interest-bearing liabilities

           114           114
                            

 

(1)

Interest on certain tax-exempt loans and securities is not taxable for Federal income tax purposes. In order to compare the tax-exempt yields on these assets to taxable yields, the interest earned on these assets is adjusted to a pre-tax equivalent amount based on the marginal corporate federal income tax rate of 35%.

(2)

Annualized

(3)

Net interest margin is net interest income divided by average interest-earning assets.

 

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Results of Operations

Three Months Ended September 30, 2010 and 2009

On a consolidated basis, First Defiance’s net income for the quarter ended September 30, 2010 was $2.3 million compared to net income of $329,000 for the comparable period in 2009. Net income applicable to common shares was $1.8 million for the third quarter of 2010 compared to a loss of $184,000 for the comparable period in 2009. On a per share basis, basic and diluted earnings per common share for the three months ended September 30, 2010 were both $0.22, compared to basic and diluted earnings per common share of $(0.02) for the quarter ended September 30, 2009.

Net Interest Income.

First Defiance’s net interest income is determined by its interest rate spread (i.e. the difference between the yields on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.

As demand for new lending opportunities remains soft in 2010, the Company continues to invest some of its liquidity into investment securities.

Net interest income was $17.8 million for the quarter ended September 30, 2010 compared to $17.6 million for the same period in 2009. The tax-equivalent net interest margin was 3.94% for the quarter ended September 30, 2010 compared to 3.88% for the same period in 2009. The increase in margin between the 2009 and 2010 third quarters is due to a widening of the interest rate spread, which increased to 3.74% for the quarter ended September 30, 2010 compared to 3.64% for the same period in 2009. The increase in spread between the 2009 and 2010 third quarters occurred due to interest-earning asset yields decreasing by 29 basis points (5.31% in the third quarter of 2010 compared to 5.60% in the same period in 2009) which was more than offset by the cost of interest bearing liabilities between the two periods decreasing by 39 basis points (1.57% in the third quarter of 2010 compared to 1.96% in the same period in 2009).

Total interest income decreased by $1.4 million or 5.6% to $24.1 million for the quarter ended September 30, 2010 from $25.5 million for the same period in 2009. The decrease in interest income was due to a decline in asset yields, mainly as a result of a drop in yields on securities which declined 44 basis points to 4.64% at September 30, 2010. Interest income from loans decreased to $22.2 million for the quarter ended September 30, 2010 compared to $23.8 million for the same period in 2009. This decrease is due to the decrease in loan balances coupled with a decline in yield which was 5.72% for the quarter ended September 30, 2010 and 5.85% for the same period in 2009.

Interest expense decreased by $1.6 million in the third quarter of 2010 compared to the same period in 2009, to $6.3 million from $7.9 million. This decrease was due to a 39 basis point decline in the average cost of interest-bearing liabilities in the third quarter of 2010 resulting from a $12.5 million decrease in the average balance of those liabilities in the third quarter of 2010. Interest expense related to interest-bearing deposits was $4.7 million in the third quarter of 2010 compared to $6.2 million for the same period in 2009. Expenses on FHLB advances and notes payable were $1.2 million and $109,000 respectively in the third quarter of 2010 compared to $1.3 million and $140,000 respectively for the same period in 2009. Interest expense recognized by the Company related to subordinated debentures was $332,000 in the third quarter of 2010 compared to $344,000 for the same period in 2009.

 

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Provision for Loan Losses.

The allowance for loan losses represents management’s assessment of the estimated probable credit losses in the loan portfolio at each balance sheet date. Management analyzes the adequacy of the allowance for loan losses regularly through reviews of the loan portfolio. Consideration is given to economic conditions, changes in interest rates and the effect of such changes on collateral values and borrower’s ability to pay, changes in the composition of the loan portfolio and trends in past due and non-performing loan balances. The allowance for loan losses is a material estimate that is susceptible to significant fluctuation and is established through a provision for loan losses based on management’s evaluation of the inherent risk in the loan portfolio. In addition to extensive in-house loan monitoring procedures, the Company utilizes an outside party to conduct an independent loan review of all commercial loan and commercial real estate loan relationships that exceed $750,000 of aggregate exposure over a twelve month period. Management utilizes the results of this outside loan review to assess the effectiveness of its internal loan grading system as well as to assist in the assessment of the overall adequacy of the allowance for loan losses associated with these types of loans.

The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable credit losses within the existing loan portfolio in the normal course of business. The allowance for loan loss is made up of two basic components. The first component is the specific allowance in which the Company sets aside reserves based on the analysis of individual credits. The second component is the general reserve. The general reserve is used to record loan loss reserves for groups of homogenous loans in which the Company estimates the losses incurred in the portfolios based on quantitative and qualitative factors. Due to the uncertainty of risks in the loan portfolio, the Company’s judgment on the amount of the allowance necessary to adsorb loans losses is approximate. Table 3 below presents the allocation of the specific and general components of the allowance by signification loan types.

In establishing specific reserves, First Federal analyzes all loans on its classified and special mention lists at least quarterly and makes judgments about the risk of loss based on the cash flow of the borrower, the value of any collateral and the financial strength of any guarantor in determining the amount of impairment of individual loans and the specific reserve to be recorded.

For purpose of the general reserve analysis, the loan portfolio is stratified into ten different loan pools based on loan type and by market area to allocate historic loss experience. The loss experience factor applied to the non-impaired loan portfolio was based upon historical losses of the most recent four quarters.

The stratification of the loan portfolio resulted in a quantitative general allowance of $12.7 million at September 30, 2010 compared to $10.5 million at December 31, 2009. The increase in the quantitative allowance was due to the increase in the historical loss factors relating to commercial real estate, residential and consumer loans.

 

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In addition to the quantitative analysis, a qualitative analysis is performed each quarter to provide additional general reserves on the non-impaired loan portfolio for various factors that have a bearing on its loss content, including but not limited to the following:

 

   

Changes in international, national and local economic and business conditions and developments, including the condition of various market segments;

 

   

Changes in the nature and volume of the loan portfolio;

 

   

Changes in the trends of the volume and severity of past due and classified loans; and changes in trends in the volume of non-accrual loans, troubled debt restructurings and other loan modifications;

 

   

The existence and effect of any concentrations of credit and changes in the level of such concentrations;

 

   

Changes in the value of underlying collateral for collateral dependent loans;

 

   

Changes in the political and regulatory environment;

 

   

Changes in lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices;

 

   

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

 

   

Changes in the quality and breadth of the loan review process.

The qualitative analysis at September 30, 2010 indicated a general reserve of $7.5 million compared with $8.7 million at December 31, 2009. This decrease was mainly driven by improved cash flow and operating results of borrowers in the first nine months of 2010. Management believes that the overall economy and operating environment has stabilized in our markets but still recognizes that high unemployment and declining real estate values in the Midwest remain a concern. While management has seen a reduction in unemployment in its market area, the majority of the counties it serves remain close to double digits. The unemployment rates for August 2010 for the following counties in Ohio were: Allen 10.3%, Defiance 10.9%, Fulton 9.7%, Hancock 8.6%, Henry 10.2%, Lucas 11.1%, Ottawa 9.9%, Paulding 10.5%, Putnam 8.4%, Seneca 10.3%, Williams 11.8% and Wood 9.1%. These rates compare to unemployment rates in December 2009 of the following counties in Ohio were: Allen 11.6%, Defiance 12.8%, Fulton 14.3%, Hancock 9.6%, Henry 13.9%, Lucas 12.3%, Ottawa 17.3%, Paulding 12.7%, Putnam 11.0%, Seneca 13.0%, Williams 14.9% and Wood 11.1%. The Company operates in two counties in Michigan, Hillsdale and Lenawee. The unemployment rate in Hillsdale county was 14.9% in August 2010 compared to 18.2% in December 2009, and the unemployment rate in Lenawee county was 14.7% in August 2010 compared to 16.6% in December 2009. The Company operates in one county in Indiana, Allen, which had an unemployment rate of 12.9% in August 2010 compared to 10.0% in December 2009. August 2010 was the latest available unemployment published information.

 

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As a result of the quantitative and qualitative analyses, along with the change in specific reserves, the Company’s provision for loan losses for the third quarter of 2010 was $5.2 million, compared to $8.1 million for the same period in 2009. The allowance for loan losses was $41.3 million and $36.5 million and represented 2.67% and 2.26% of loans, net of undisbursed loan funds and deferred fees and costs, as of September 30, 2010 and December 31, 2009, respectively. That increase was mainly the result of the decline in real estate values and some collateral dependent loans no longer have enough collateral value to support the outstanding balance. The increase is also attributed to substandard/doubtful loans increasing $13.2 million in the third quarter of 2010 mainly due to four credits which totaled $12.7 million as a result of declining cash flows. Management has expanded its credit monitoring functions even further beyond its traditionally strong focus. Additional asset review functions and more delinquent loan reporting requirements have been added to assist in this monitoring. Management will continually review credit concentrations by the industry and has placed lower limits on lending within certain types of loan categories. Management has also segmented the commercial real estate portfolio to track the general performance of these segments to further refine the predictive process of identifying potential problem loans. The provision was partially offset by charge offs of $2.5 million against specific reserves and $324,000 against general reserves and recoveries of $165,000, resulting in an increase to the overall allowance for loan loss of $2.5 million from June 30, 2010. In management’s opinion, the overall allowance for loan losses of $41.3 million as of September 30, 2010 is adequate.

Management also assesses the value of real estate owned as of the end of each accounting period and recognizes write-downs to the value of that real estate in the income statement if conditions dictate. In the third quarter of 2010, First Defiance recorded OREO write-downs that totaled $1.6 million compared to write-downs of $438,000 for the same period in 2009. These write-downs are primarily a result of management’s decision to decrease the liquidation values in an effort to spur interest in our market areas to sell these properties and to reflect the impact of writing down to new appraisal amounts received during the quarter. These amounts are included in other non-interest expense. Management believes that the values recorded at September 30, 2010 for real estate owned and repossessed assets represent the realizable value of such assets.

Total classified loans decreased to $127.6 million at September 30, 2010, compared to $128.9 million at December 31, 2009. At September 30, 2010, a total of $50.7 million of loans are classified as substandard for which a specific reserve is required. A total of $74.7 million in additional credits were classified as substandard at September 30, 2010 for which no reserve is required because of factors such as the level of collateral or the strength of guarantors. First Defiance also has classified $2.2 million of loans doubtful at September 30, 2010. By contrast, at December 31, 2009, a total of $46.3 million of loans were classified as substandard for which a specific reserve is required. A total of $78.0 million in additional credits were classified as substandard at December 31, 2009 for which no reserve is required because of factors such as the level of collateral or the strength of guarantors. First Defiance also had classified $4.6 million of loans doubtful at December 31, 2009.

First Defiance’s ratio of allowance for loan losses to non-performing loans was 89.56% at September 30, 2010 compared with 76.29% at December 31, 2009. Management monitors collateral values of all loans included on the watch list that are collateral dependent and believes that allowances for those loans at September 30, 2010 are appropriate.

 

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At September 30, 2010, First Defiance had total non-performing assets of $57.3 million, compared to $61.4 million at December 31, 2009. Non-performing assets include loans that are 90 days past due and on non-accrual, restructured loans and real estate and other assets held for sale. Non-performing assets at September 30, 2010 and December 31, 2009 by category were as follows:

Table 1 – Nonperforming Assets

 

     September 30,
2010
     December 31,
2009
 
     (In thousands)  

Non-performing loans:

     

Residential

   $ 6,589       $ 5,349   

Construction

     169         675   

Commercial real estate

     23,421         24,042   

Commercial

     6,955         10,615   

Consumer

     34         59   

Home Equity and improvement

     209         451   

Restructured loans, still accruing

     8,784         6,715   
                 

Total non-performing loans

     46,161         47,906   

Real estate owned and repossessed assets

     11,127         13,527   
                 

Total non-performing assets

   $ 57,288       $ 61,433   
                 

The decrease in non-performing loans between December 31, 2009 and September 30, 2010 is primarily in commercial real estate and commercial loans. The combined balance of these types of non-performing loans was $4.3 million lower at September 30, 2010 compared to December 31, 2009 but was partially offset by a $1.2 million increase in non performing residential loans and a $2.1 million increase in restructured loans.

Non-performing loans in the residential, commercial real estate and commercial loan categories represent 4.92%, 3.59% and 1.96% of the total loans in those categories respectively at September 30, 2010 compared to 3.54%, 3.47% and 2.81% respectively for the same categories at December 31, 2009. With the level of non-performing loans increasing quarter over quarter, management believes that the current allowance for loan losses is appropriate and that the provision for loan losses recorded in the third quarter of 2010 is consistent with both charge-off experience and the risk inherent in the overall credits in the portfolio.

Asset quality ratios for First Defiance were as follows at September 30, 2010 and December 31, 2009:

Table 2 – Nonperforming Asset Ratios

 

     September 30,
2010
    December 31,
2009
 

Allowance for loan losses as a percentage of total loans*

     2.67     2.26

Allowance for loan losses as a percentage of non- performing assets

     72.17     59.49

Allowance for loan losses as a percentage of non- performing loans

     89.56     76.29

Total non-performing assets as a percentage of total assets

     2.81     2.99

Total non-performing loans as a percentage of total loans*

     2.98     2.96

 

*

Total loans are net of undisbursed loan funds and deferred fees and costs.

 

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First Federal’s Asset Review Committee meets monthly to review the status of work-out strategies for all criticized relationships, which include all non-accrual loans. Based on such factors as anticipated collateral values in liquidation scenarios, cash flow projections, assessment of net worth of guarantors and all other factors which may mitigate risk of loss, the Asset Review Committee makes recommendations regarding required allowances and proposed charge-offs which are approved by the Senior Loan Committee (in the case of charge-offs) or the Loan Loss Reserve Committee (in the case of specific allowances).

The following table discloses charge-offs, recoveries and provision expense for the quarter ended September 30, 2010 by loan category ($ in thousands). The decline in the commercial real estate general provision in the third quarter of 2010 was mainly due to a reduction in the related principal balances of $13.5 million from June 30, 2010.

Table 3 – Charge-offs, Recoveries and Provision by Category

 

Quarter Ended September 30, 2010    Commercial
Real Estate
    Commercial     Consumer     Residential     Construction     Home Equity and
improvement
    Total  

Allowance for loans individually evaluated

              

Beginning Specific Allocations

   $ 10,208      $ 4,275      $ 49      $ 3,892      $ 160      $ 327      $ 18,911   

Charge-Offs

     (647     (840     (12     (978     —          (69     (2,546

Recoveries

     —          —          —          —          —          —          —     

Provisions

     3,553        562        46        258        (11     377        4,785   
                                                        

Ending Specific Allocations

   $ 13,114      $ 3,997      $ 83      $ 3,172      $ 149      $ 635      $ 21,150   
                                                        

Allowance for loans collectively evaluated

              

Beginning General Allocations

   $ 9,729      $ 6,106      $ 446      $ 2,693      $ 54      $ 913      $ 19,941   

Charge-Offs

     (41     (2     (16     (186     —          (79     (324

Recoveries

     8        83        32        36        —          6        165   

Provisions

     (516     495        (18     446        (14     18        411   
                                                        

Ending General Allocations

   $ 9,180      $ 6,682      $ 444      $ 2,989      $ 40      $ 858      $ 20,193   
                                                        

The following table details net charge-offs and nonaccrual loans by loan type. For the three months ended and as of September 30, 2010, commercial real estate, which represented 49.8% of total loans, accounted for 25.1% of net charge-offs and 62.7% of nonaccrual loans, and commercial loans, which represented 23.9% of total loans, accounted for 28.1% of net charge-offs and 18.6% of nonaccrual loans. For the three months ended and as of September 30, 2009, commercial real estate, which represented 48.7% of total loans, accounted for 42.5% of net charge-offs and 65.6% of nonaccrual loans, and commercial loans, which represented 22.6% of total loans, accounted for 23.1% of net charge-offs and 15.7% of nonaccrual loans.

 

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Table 4 – Net Charge-offs and Non-accruals by Loan Type

 

     For the Three Months Ended September 30, 2010     As of September 30, 2010  
     Net
Charge-offs
    % of Total Net
Charge-offs
    Nonaccrual
Loans
     % of Total Non-
Accrual Loans
 
     (in thousands)        (in thousands)   

Residential

   $ 1,128        41.70   $ 6,589         17.63

Construction

     —          0.0     169         0.45

Commercial real estate

     680        25.14     23,421         62.66

Commercial

     759        28.06     6,955         18.61

Consumer

     (4     (0.15 %)      34         0.09

Home equity and improvement

     142        5.25     209         0.56
                                 

Total

   $ 2,705        100.0   $ 37,377         100.0
                                 
     For the Three Months Ended September 30, 2009     As of September 30, 2009  
     Net
Charge-offs
    % of Total Net
Charge-offs
    Nonaccrual
Loans
     % of Total Non-
Accrual Loans
 
     (in thousands)        (in thousands)   

Residential

   $ 720        27.24   $ 5,839         16.45

Construction

     —          0.0     194         0.55

Commercial real estate

     1,123        42.49     23,278         65.59

Commercial

     610        23.08     5,569         15.68

Consumer

     (6     (0.23 )%      45         0.14

Home equity and improvement

     196        7.42     565         1.59
                                 

Total

   $ 2,643        100.0   $ 35,490         100.0
                                 

 

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Credit Quality Profile

The following table discloses the period end balances for the loan portfolio by payment status as of September 30, 2010 and December 31, 2009.

Table 5 – Credit Quality Profile

 

     Total
Balance
     Current
and
Performing
     30 to 89
days past
due*
     Non
Accrual
Loans
     Troubled
Debt
Restructuring
     Non Accrual
%
    > 30 Days
Past  Due and
Non Accrual
%
 
     (dollars in thousands)   

September 30, 2010

                   

Residential

   $ 213,574       $ 200,573       $ 2,483       $ 6,589       $ 3,929         3.09     4.25

Construction

     31,722         31,553         —           169         —           0.53     0.53

Commercial real estate

     776,972         745,663         3,420         23,421         4,468         3.01     3.45

Commercial

     372,583         364,958         318         6,955         352         1.87     1.95

Consumer finance

     27,060         26,842         184         34         —           0.13     0.81

Home equity and improvement

     137,747         135,825         1,678         209         35         0.15     1.37
                                                             

Total loans

   $ 1,559,658       $ 1,505,414       $ 8,083       $ 37,377       $ 8,784         2.40     2.91
                                                             

Total Number of Loans

     20,406         19,977         187         202         40        

December 31, 2009

                   

Residential

   $ 227,592       $ 215,209       $ 4,333       $ 5,349       $ 2,701         2.35     4.25

Construction

     48,625         47,950         —           675         —           1.39     1.39

Commercial real estate

     806,890         775,604         3,280         24,042         3,964         2.98     3.39

Commercial

     379,408         367,592         1,151         10,615         50         2.80     3.10

Consumer finance

     34,105         33,669         377         59         —           0.17     1.28

Home equity and improvement

     147,977         145,481         2,045         451         —           0.30     1.69
                                                             

Total loans

   $ 1,644,597       $ 1,585,505       $ 11,186       $ 41,191       $ 6,715         2.51     3.18
                                                             

Total Number of Loans

     22,109         21,504         281         283         41        

 

*

There are 5 residential loans totaling $650,000 and 5 commercial real estate loans totaling $1,258,000 that are not included in the 30 to 89 days past due column as they are classified as troubled debt and are included in that category at September 30, 2010. At December 31, 2009, there was 1 such residential loan with a balance of $385,000.

 

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The table below is the credit risk profile trend for the last five quarters using the Company’s internally assigned loan grades. This table was created using data required to be compliant with the Company’s reporting on the thrift financial report.

Table 6 – Credit Risk Profile Trend

 

Commercial Real Estate  
       3 rd  Qtr  2010      2 nd  Qtr  2010      1 st  Qtr  2010      4 th  Qtr  2009      3 rd  Qtr  2009  

Grade

              

Pass

   $ 677,645       $ 686,323       $ 690,172       $ 698,903       $ 695,848   

Special Mention

     29,398         46,272         41,401         35,780         30,672   

Substandard/Doubtful

     69,929         57,926         65,876         72,207         75,914   
                                            

Total by Exposure

   $ 776,972       $ 790,521       $ 797,449       $ 806,890       $ 802,434   
                                            

 

Commercial  
       3 rd  Qtr  2010      2 nd  Qtr  2010      1 st  Qtr  2010      4 th  Qtr  2009      3 rd  Qtr  2009  

Grade

              

Pass

   $ 303,479       $ 307,791       $ 294,765       $ 322,152       $ 333,797   

Special Mention

     34,764         24,172         23,029         22,441         12,479   

Substandard/Doubtful

     34,340         32,318         35,129         34,815         25,605   
                                            

Total by Exposure

   $ 372,583       $ 364,281       $ 352,923       $ 379,408       $ 371,881   
                                            

 

Residential  
       3 rd  Qtr  2010      2 nd  Qtr  2010      1 st  Qtr  2010      4 th  Qtr  2009      3 rd  Qtr  2009  

Grade

              

Pass

   $ 184,247       $ 191,796       $ 196,452       $ 203,649       $ 212,140   

Special Mention

     9,455         4,778         5,372         3,897         3,769   

Substandard/Doubtful

     19,872         21,029         20,275         20,046         18,049   
                                            

Total by Exposure

   $ 213,574       $ 217,603       $ 222,099       $ 227,592       $ 233,958   
                                            

 

Construction  
       3 rd  Qtr  2010      2 nd  Qtr  2010      1 st  Qtr  2010      4 th  Qtr  2009      3 rd  Qtr  2009  

Grade

              

Pass

   $ 29,243       $ 40,652       $ 42,129       $ 45,091       $ 50,655   

Special Mention

     403         403         403         2,768         2,850   

Substandard/Doubtful

     2,076         2,278         3,837         766         100   
                                            

Total by Exposure

   $ 31,722       $ 43,333       $ 46,369       $ 48,625       $ 53,605   
                                            

 

Consumer  
       3 rd  Qtr  2010      2 nd  Qtr  2010      1 st  Qtr  2010      4 th  Qtr  2009      3 rd  Qtr  2009  

Grade

              

Pass

   $ 26,882       $ 28,832       $ 31,600       $ 33,935       $ 36,132   

Special Mention

     —           —           —           —           —     

Substandard/Doubtful

     178         129         118         170         284   
                                            

Total by Exposure

   $ 27,060       $ 28,961       $ 31,718       $ 34,105       $ 36,416   
                                            

 

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Home Equity and Improvement  
       3 rd  Qtr  2010      2 nd  Qtr  2010      1 st  Qtr  2010      4 th  Qtr  2009      3 rd  Qtr  2009  

Grade

              

Pass

   $ 136,499       $ 140,223       $ 143,371       $ 147,076       $ 148,805   

Special Mention

     —           —           —           —           —     

Substandard/Doubtful

     1,248         746         1,455         901         1,574   
                                            

Total by Exposure

   $ 137,747       $ 140,969       $ 144,826       $ 147,977       $ 150,379   
                                            

 

Total  
       3 rd Qtr 2010      2 nd Qtr 2010      1 st Qtr 2010      4 th Qtr 2009      3 rd Qtr 2009  

Grade

              

Pass

   $ 1,357,995       $ 1,395,617       $ 1,398,489       $ 1,450,806       $ 1,477,377   

Special Mention

     74,020         75,625         70,205         64,886         49,770   

Substandard/Doubtful

     127,643         114,426         126,690         128,905         121,526   
                                            

Total by Exposure

   $ 1,559,658       $ 1,585,668       $ 1,595,384       $ 1,644,597       $ 1,648,673   
                                            

The following table sets forth the activity in First Defiance’s allowance for loan losses during the periods indicated .

Table 7 – Allowance for Loan Loss Activity

 

     For the Quarter Ended  
     3 rd 2010      2nd 2010      1st 2010      4th 2009      3rd 2009  
     (Dollars in Thousands)  

Allowance at beginning of period

   $ 38,852       $ 38,980       $ 36,547       $ 31,248       $ 25,840   

Provision for credit losses

     5,196         5,440         6,889         8,470         8,051   

Charge-offs:

              

Residential

     1,164         1,135         326         884         744   

Commercial real estate

     688         1,243         3,191         1,912         1,152   

Commercial

     842         3,153         735         354         658   

Consumer finance

     28         16         25         75         39   

Home equity and improvement

     148         156         399         135         196   
                                            

Total charge-offs

     2,870         5,703         4,676         3,360         2,789   

Recoveries

     165         135         220         189         146   
                                            

Net charge-offs

     2,705         5,568         4,456         3,171         2,643   
                                            

Ending allowance

   $ 41,343       $ 38,852       $ 38,980       $ 36,547       $ 31,248   
                                            

The following table sets forth information concerning the allocation of First Defiance’s allowance for loan losses by loan categories at the dates indicated.

 

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Table 8 – Allowance for Loan Loss Allocation by Loan Category

 

     September 30, 2010     June 30, 2010     March 31, 2010     December 31, 2009     September 30, 2009  
     Amount      Percent of
total  loans
by category
    Amount      Percent of
total  loans
by category
    Amount      Percent of
total  loans
by category
    Amount      Percent of
total  loans
by category
    Amount      Percent of
total  loans
by category
 

Residential

   $ 6,161         13.69   $ 6,585         13.72   $ 6,093         13.92   $ 5,827         13.84   $ 5,395         14.19

Construction

     189         2.03     214         2.73     717         2.91     221         2.96     113         3.25

Commercial real estate

     22,294         49.82     19,939         49.85     19,354         49.98     18,876         49.06     16,107         48.67

Commercial

     10,679         23.89     10,381         22.97     10,672         22.12     9,444         23.07     7,183         22.56

Consumer

     527         1.74     494         1.83     402         1.99     515         2.07     618         2.21

Home equity and improvement

     1,493         8.83     1,239         8.89     1,742         9.08     1,664         9.00     1,832         9.12
                                                                                     
   $ 41,343         100.00   $ 38,852         100.00   $ 38,980         100.00   $ 36,547         100.00   $ 31,248         100.00
                                                                                     

Key Asset Quality Ratio Trends

Table 9 – Key Asset Quality Ratio Trends

 

     3rd Qtr 2010     2nd Qtr 2010     1st Qtr 2010     4th Qtr 2009     3rd Qtr 2009  

Allowance for loan losses / loans*

     2.67     2.47     2.47     2.26     1.92

Allowance for loan losses to net charge-offs

     1,528.39     697.77     874.78     1,152.54     1,182.29

Allowance for loan losses / non-performing assets

     72.17     72.68     73.05     59.49     63.23

Allowance for loan losses / non-performing loans

     89.56     95.41     96.03     76.29     78.00

Non-performing assets / loans plus REO*

     3.67     3.37     3.36     3.77     3.03

Non-performing assets / total assets

     2.81     2.62     2.59     2.99     2.45

Net charge-offs / average loans (annualized)

     0.70     1.44     1.14     0.79     0.66

 

*

Total loans are net of undisbursed funds and deferred fees and costs.

Non-Interest Income .

Total non-interest income increased $1.9 million to $7.5 million in the third quarter of 2010 compared to the same period in 2009 due primarily to an increase in mortgage banking income.

Service Fees. Service fees and other charges decreased by $276,000 or 7.7% in the 2010 third quarter compared to the same period in 2009. The decrease is a result of lower NSF fee income in the third quarter of 2010 of $368,000 compared to the same period in 2009 mainly due to the effect of Reg-E which took effect July 1, 2010 for new customers and August 15, 2010 for existing customers.

First Federal’s overdraft privilege program generally provides for the automatic payment of modest overdraft limits on all accounts deemed to be in good standing when the account is accessed using paper-based check processing, a teller withdrawal, a point-of-sale terminal, an ACH transaction, or an ATM. To be in good standing, an account must be brought to a positive balance within a 30-day period. Overdraft limits are established for all customers without discrimination using a risk assessment approach for each account classification. The approach includes a systematic review and evaluation of the normal deposit flows made to each account classification to establish reasonable and prudent negative balance limits that would be routinely repaid by normal, expected and reoccurring deposits. The risk assessment by portfolio approach assumes a minimal degree of undetermined credit risk associated with unidentified individual accounts that are overdrawn for 30 or more days. Accounts overdrawn for more than 60 days are automatically charged off. Fees are charged as a one-time fee per occurrence and the fee charged for an item that is paid is equal to the fee charged for a non-sufficient fund item that is returned.

 

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Overdrawn balances, net of allowance for losses, are reflected as loans on First Defiance’s balance sheet. The fees charged for this service are established based both on the return of processing costs plus a profit, and on the level of fees charged by competitors in the Company’s market area for similar services. These fees are considered to be compensation for providing a service to the customer and therefore deemed to be noninterest income rather than interest income. Beginning on July 1, 2010 for new customers and August 15, 2010 for existing customers, federal rules will prohibit a financial institution from assessing a fee to complete an ATM withdrawal or one-time debit card transaction which will cause an overdraft unless the customer consents in advance (“opts-in”). Fee income recorded for the quarters ending September 30, 2010 and 2009 related to the overdraft privilege product, net of adjustments to the allowance for uncollectible overdrafts, were $1.9 million and $2.3 million, respectively. Accounts charged off are included in noninterest expense. The allowance for uncollectible overdrafts was $77,000 at September 30, 2010, $114,000 at December 31, 2009 and $104,000 at September 30, 2009.

Mortgage Banking Activity. Total revenue from the sale and servicing of mortgage loans increased $1.3 million to $2.3 million for the third quarter of 2010 compared to $1.0 million for the same period of 2009. This increase was primarily due to higher loan origination volume for the quarter, the result of higher refinancing activity due to lower interest rates on conforming saleable mortgage-based products in the third quarter of 2010 compared to the same period in 2009. Gains realized from the sale of mortgage loans increased in the third quarter of 2010 to $2.9 million from $1.5 million in the third quarter of 2009. Mortgage loan servicing revenue increased $36,000 in the third quarter of 2010 compared to the third quarter of 2009. The increase in gains were partially offset by expense increases of $284,000 for the amortization of mortgage servicing rights due to the higher refinance activity during the third quarter of 2010. The Company recorded a negative valuation adjustment of $527,000 on mortgage servicing rights in the third quarter of 2010 compared to a negative valuation adjustment of $772,000 in the third quarter of 2009. This was driven by a steady decrease in market mortgage rates late in the second quarter of 2010 and into the third quarter of 2010. This decrease in rates increased the assumed prepayment speed of the mortgage servicing rights.

Loss on Sale or Write-Down of Securities . Non-interest income also includes investment securities gains or losses. In the third quarter of 2010, First Defiance recognized other-than-temporary impairment (“OTTI”) charges of $190,000 for certain impaired investment securities, where in management’s opinion, the value of the investment will not be fully recovered. The OTTI charge related to two Trust Preferred Collateralized Debt Obligation (“CDO”) investments with a remaining book value of $860,000 and preferred stock in Fannie Mae and Freddie Mac with a remaining combined book value of $35,000. In the third quarter of 2009, First Defiance recognized OTTI charges of $994,000 for certain impaired investment securities, where in management’s opinion, the value of the investment will not be recovered. The OTTI charge related to five CDOs with a remaining book value of $2.2 million. In the third quarter of 2009, nine available for sale securities were sold for a gain of $154,000.

 

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Non-Interest Expense.

Non-interest expense increased to $17.1 million for the third quarter of 2010 compared to $14.8 million for the same period in 2009.

Compensation and Benefits . Compensation and benefits increased to $7.1 million for the quarter ended September 30, 2010 from $6.6 million for the same period in 2009. The increase is mainly attributable to a reduction in variable compensation in the third quarter of 2009 due to the performance of the Company not meeting its target as well as a reduction in employees.

FDIC insurance premium . FDIC insurance expense increased to $907,000 in the third quarter of 2010 from $649,000 in the same period of 2009. This was the result of the FDIC rate increases and higher insured deposits.

Other Non-Interest Expenses . Other non-interest expenses (including state franchise tax, data processing, amortization of intangibles and other) increased by $1.6 million to $7.3 million for the quarter ended September 30, 2010 from $5.7 million for the same period in 2009. Increases between the 2010 and 2009 third quarters include an increase in credit, collection and OREO expenses of $1.1 million for other real estate owned and repossessed assets, $410,000 of losses related to the buy-back of secondary market sold loans and $40,000 of expenses incurred related to the core system conversion scheduled for the fourth quarter of 2010. The following table below shows the quarterly ending balances of these major expense categories.

Table 10 – Key Quarterly Non-Interest Expense Variances

 

3 Months Ended    9-30-10      6-30-10      3-31-10      12-31-09      9-30-09  

Credit and Collection Expense

   $ 282,278       $ 355,559       $ 349,435       $ 300,065       $ 344,255   

REO Expenses

     2,054,818         698,710         798,394         351,436         863,245   

Loss on Secondary Market Buy-Backs

     409,848         90,704         —           280,955         —     

Core Conversion Costs

     39,584         346,189         71,106         —           —     

Credit and collection expenses are mainly legal costs incurred in the normal course of collecting a debt. REO expenses are mainly the write-downs taken primarily due to a change in the value of the foreclosed asset as well as costs to maintain the property such as real estate taxes and repairs. Loss on secondary market buy-backs are those losses or expenses the Company is required to reimburse Fannie Mae or Freddie Mac for sold loans not meeting certain underwriting criteria. Core conversion expenses are mainly consulting expenses, deconversion fees and training costs.

The efficiency ratio, considering tax equivalent interest income and excluding securities gains and losses, for the third quarter of 2010 was 66.42% compared to 60.90% for the third quarter of 2009.

Income Taxes.

First Defiance computes federal income tax expense in accordance with ASC Topic 740, Subtopic 942, which resulted in an effective tax rate of 22.70% for the quarter ended September 30, 2010 compared to (12.67)% for the same period in 2009. The increase in the effective tax rate for the quarter ended September 30, 2010 is mainly due to the increase in net income as a result of a lower provision expense in the third quarter of 2010 compared to the same period in 2009.

 

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Nine Months Ended September 30, 2010 and 2009

On a consolidated basis, First Defiance’s net income for the nine months ended September 30, 2010 was $5.8 million compared to income of $6.6 million for the comparable period in 2009. Net income applicable to common shares was $4.3 million for the nine months ended September 30, 2010 compared to $5.1 million for the comparable period in 2009. On a per share basis, basic and diluted earnings per common share for the nine months ended September 30, 2010 were both $0.53 compared to basic and diluted earnings per common share of $0.63 for the nine months ended September 30, 2009.

Net Interest Income.

Net interest income was $52.4 million for the nine months ended September 30, 2010 compared to $49.8 million for the same period in 2009. For the nine month period ended September 30, 2010, total interest income was $72.5 million, a $2.9 million decrease from the same period in 2009. Despite average earning assets increasing $21.5 million in the first nine months of 2010, the average yield declined 25 basis points as a result of a lower rate environment.

Interest expense decreased by $5.5 million to $20.1 million for the nine months ended September 30, 2010 compared to $25.6 million in the first nine months of 2009. While the average balance of interest-bearing liabilities increased by $14.1 million between the first nine months of 2009 and 2010, the expense associated with the higher balance was more than offset by a decline in the average cost of interest-bearing deposits for the nine months ending September 30, 2010, to 1.50%, a 44 basis point decrease from the 1.94% average cost in the first nine months of 2009. This decline is the result of the continued low rate environment which has given management opportunities to re-price on the liability side.

Provision for Loan Losses.

The provision for loan losses was $17.5 million for the nine months ended September 30, 2010, compared to $14.8 million during the nine months ended September 30, 2009. The year over year increase was primarily the result of the deterioration of a number of large credits in the commercial loan portfolio along with a decline in the overall economy in the Company’s primary market area. Charge-offs for the first nine months of 2010 were $13.2 million and recoveries of previously charged off loans totaled $520,000 for net charge-offs of $12.7 million. By comparison, $8.5 million of charge-offs were recorded in the same period of 2009 and $360,000 of recoveries were realized for net charge-offs of $8.1 million.

Non-Interest Income .

Total non-interest income decreased to $20.0 million for the nine months ended September 30, 2010 from $20.7 million recognized in the same period of 2009.

Service Fees. Service fees and other charges decreased by $133,000 or 1.3% in the nine months ended September 30, 2010 compared to the same period in 2009. The decrease is the result of Reg-E as described above.

 

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Mortgage Banking Activity. Total revenue from the sale and servicing of mortgage loans decreased 33.4% to $5.1 million for the nine months ended September 30, 2010 from $7.7 million for the same period of 2009. Gains realized from the sale of mortgage loans decreased $2.0 million to $5.3 million for the first nine months of 2010 from $7.3 million during the same period of 2009. Mortgage loan servicing revenue increased $154,000 in the first nine months of 2010 compared to the same period of 2009. The decrease in gains were partially offset by expense decreases of $991,000 for the amortization of mortgage servicing rights in the first nine months of 2010 when compared to the same period of 2009. The Company recorded a negative valuation adjustment of $777,000 in the first nine months of 2010 compared to a positive adjustment of $917,000 in the same period of 2009. The mortgage servicing rights valuation was driven by a steady decline in market mortgage rates late in the second quarter of 2010 and into the third quarter of 2010.

Insurance and Investment Sales Commission. Insurance and investment sales commission income decreased $107,000, to $3.8 million for the nine months ended September 30, 2010, from $3.9 million during the same period of 2009. This is the result of receiving less contingent commission income in the first nine months of 2010 compared to the same period of 2009. In 2010, $104,000 was received compared to $432,000 in 2009.

Loss on Securities. Non-interest income was reduced in the first nine months of 2010 by $325,000 as First Defiance recognized $331,000 of other-than-temporary impairment charges for certain impaired investment securities partially offset by the gain on sale of $6,000 from available for sale securities. In the first nine months of 2009, $2.5 million of OTTI charges were recorded on impaired investments, partially offset by the $279,000 gain recorded from the sale of available for sale securities.

Non-Interest Expense.

Non-interest expense increased to $47.0 million for the first nine months of 2010 compared to $45.9 million for the same period in 2009. The year-to-date 2010 amount includes $53,000 of non-recurring costs associated with the acquisition of a group medical benefits line of business in May 2010.

Compensation and Benefits . Compensation and benefits decreased to $20.2 million for the first nine months ended September 30, 2010 from $21.5 million for the same period in 2009. A significant part of this decrease relates to management’s decision to preemptively reduce staff levels as well as to allow attrition to reduce staffing levels. The Company had 502 full-time equivalent employees as of September 30, 2010 compared to 520 as of September 30, 2009.

Occupancy . Occupancy costs decreased $637,000 in the first nine months of 2010. This decrease can be attributed to the cost savings from closing several branches in January 2010 as previously announced in the Company’s 2009 10-K.

Other Non-Interest Expenses . Other non-interest expenses (including state franchise tax, data processing, amortization of intangibles and other) increased by $2.8 million to $18.6 million for the first nine months of 2010 from $15.8 million for the same period in 2009. Significant increases between the first nine months of 2010 and 2009 include an increase in credit, collection and OREO expenses of $1.8 million for other real estate owned and repossessed assets and $457,000 of expenses related to the core system conversion that will take place later in 2010. These costs were partially offset by a decrease in office supply expense (down $53,000) and country club memberships (down $32,000) as a direct result of management’s cost control initiative.

 

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Table 11 – Key Year-To-Date Non-Interest Expense Variances

 

9 Months Ended    9-30-10      9-30-09  

Credit and Collection Expense

   $ 987,272       $ 816,781   

REO Expenses

     3,551,922         1,893,393   

Core Conversion Costs

     456,879         —     

Credit and collection expenses are mainly legal costs incurred in the normal course of collecting a debt. REO expenses are mainly the write-downs taken primarily due to a change in the value of the foreclosed asset as well as costs to maintain the property such as real estate taxes and repairs. Core conversion expenses are mainly consulting expenses, deconversion fees and training costs.

The efficiency ratio for the first nine months of 2010 was 63.75% compared to 62.36% for the same period of 2009.

Liquidity

As a regulated financial institution, First Federal is required to maintain appropriate levels of “liquid” assets to meet short-term funding requirements.

First Defiance had $17.2 million of cash provided by operating activities during the first nine months of 2010. The Company’s cash used in operating activities resulted from the origination of loans held for sale mostly offset by the proceeds on the sale of loans.

At September 30, 2010, First Defiance had $95.3 million in outstanding loan commitments and loans in process to be funded generally within the next nine months and an additional $256.2 million committed under existing consumer and commercial lines of credit and standby letters of credit. Also at that date, First Defiance had commitments to sell $92.3 million of loans held-for-sale. Also, the total amount of certificates of deposit that are scheduled to mature by September 30, 2011 is $404.8 million. First Defiance believes that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If First Defiance requires funds beyond its internal funding capabilities, advances from the FHLB of Cincinnati and other financial institutions are available.

Liquidity risk arises from the possibility that we may not be able to meet our financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, our Board of Directors has established an Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates our Asset/Liability Committee (“ALCO”) as the body responsible for meeting these objectives. The ALCO reviews liquidity on a monthly basis and approves significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company’s Chief Financial Officer and Controller.

 

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ALCO uses an economic value of equity (“EVE”) analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis calculates the net present value of First Federal’s assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. The likelihood of a decrease in rates as of September 30, 2010 was considered to be remote given the current interest rate environment and therefore, was not included in this analysis. The results of this analysis are reflected in the following tables for the nine months ended September 30, 2010 and the year-ended December 31, 2009.

 

September 30, 2010
Economic Value of Equity
 

Change in Rates

  $ Amount     $ Change     % Change  
    (Dollars in Thousands)        
+ 400 bp     285,204        (12,744     (4.28 %) 
+ 300 bp     289,973        (7,974     (2.68 %) 
+ 200 bp     294,296        (3,652     (1.23 %) 
+ 100 bp     297,269        (679     (0.23 %) 
        0 bp     297,948        —          —     

 

December 31, 2009
Economic Value of Equity
 

Change in Rates

  $ Amount     $ Change     % Change  
    (Dollars in Thousands)        
+ 300 bp     263,012        (9,820     (3.60 %) 
+ 200 bp     267,908        (4,924     (1.80 %) 
+ 100 bp     270,927        (1,905     (0.70 %) 
        0 bp     272,932        —          —     

Capital Resources

First Federal is required to maintain specified amounts of capital pursuant to regulations promulgated by the OTS. The capital standards generally require the maintenance of regulatory capital sufficient to meet a tangible capital requirement, a core capital requirement, and a risk-based capital requirement. The following table sets forth First Federal’s compliance with each of the capital requirements at September 30, 2010 (in thousands).

 

     Core Capital     Risk-Based Capital  
     Adequately
Capitalized
    Well
Capitalized
    Adequately
Capitalized
    Well
Capitalized
 

Regulatory capital

   $ 211,594      $ 211,594      $ 233,072      $ 233,072   

Minimum required regulatory capital

     79,036        98,794        136,397        170,496   
                                

Excess regulatory capital

   $ 132,558      $ 112,800      $ 96,675      $ 62,576   
                                

Regulatory capital as a percentage of assets (1)

     10.71     10.71     13.67     13.67

Minimum capital required as a percentage of assets

     4.00     5.00     8.00     10.00
                                

Excess regulatory capital as a percentage of assets

     6.71     5.71     5.67     3.67
                                

 

(1)

Core capital is computed as a percentage of adjusted total assets of $2.0 billion. Risk-based capital is computed as a percentage of total risk-weighted assets of $1.7 billion.

 

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Critical Accounting Policies

First Defiance has established various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of its financial statements. The significant accounting policies of First Defiance are described in the footnotes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K. Certain accounting policies involve significant judgments and assumptions by management, which have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. Those policies, which are identified and discussed in detail in the Company’s Annual Report on Form 10-K, include the Allowance for Loan Losses, Valuation of Securities, Valuation of Goodwill and the Valuation of Mortgage Servicing Rights. There have been no material changes in assumptions or judgments relative to those critical policies during the first nine months of 2010.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

As discussed in detail in the 2009 Annual Report on Form 10-K, First Defiance’s ability to maximize net income is dependent on management’s ability to plan and control net interest income through management of the pricing and mix of assets and liabilities. Because a large portion of assets and liabilities of First Defiance are monetary in nature, changes in interest rates and monetary or fiscal policy affect its financial condition and can have significant impact on the net income of the Company. First Defiance does not use off-balance sheet derivatives to enhance its risk management, nor does it engage in trading activities beyond the sale of mortgage loans.

First Defiance monitors its exposure to interest rate risk on a monthly basis through simulation analysis which measures the impact changes in interest rates can have on net income. The simulation technique analyzes the effect of a presumed 100 and 200 basis point shift in interest rates and takes into account prepayment speeds on amortizing financial instruments, loan and deposit volumes and rates, non-maturity deposit assumptions and capital requirements. The results of the simulation indicate that in an environment where interest rates rise or fall 100 basis points (which is consistent with management’s estimate of the range of potential interest rate fluctuations) over a 12 month period, using September 30, 2010 amounts as a base case, First Defiance’s net interest income would be impacted by less than the board mandated guidelines of 10%.

First Defiance will be monitoring its exposure to interest rate risk on a more robust basis on a quarterly basis going forward. By using multiple simulation techniques to analyze the effect of a presumed 100, 200, 300 and 400 basis point shift in interest rates taking into consideration account level prepayment speeds on amortizing financial instruments, loan and deposit volumes and rates, non-maturity deposit assumptions and capital requirements.

Item 4. Controls and Proced ures

Disclosure controls are procedures designed to ensure that information required to be disclosed in the Company’s reports filed under the Exchange Act, such as this report, are recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls are also designed to ensure that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

An evaluation was carried out under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of September 30, 2010. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. No changes occurred in the Company’s internal controls over financial reporting during the quarter ended September 30, 2010 that materially affected, or are reasonably likely to materially affect, the internal controls over financial reporting.

 

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FIRST DEFIANCE FINANCIAL CORP.

PART II-OTHER INFORMATION

 

Item 1. Legal Pro ceedings

First Defiance is not engaged in any legal proceedings of a material nature.

 

Item 1A. Risk Fa ctors

There are no material changes from the risk factors set forth under Part I, Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The risk factors described in the Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties not currently known to the Company or that management currently deems to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results. Moreover, the Company undertakes no obligation and disclaims any intention to publish revised information or updates to forward looking statements contained in such risk factors or in any other statement made at any time by the Company or any of its directors, officers, employees or other representatives, unless and until any such revisions or updates are expressly required to be disclosed by securities laws or regulations.

 

Item 2. Unr egistered Sales of Equity Securities and Use of Proceeds

First Defiance did not have any common stock repurchases during the first nine months of 2010, but has 93,124 shares that may be purchased under a plan announced by the Board of Directors on July 18, 2003. Participation in the CPP prohibits the Company from repurchasing any of its common shares without the prior approval of the U.S. Treasury until the earlier of December 5, 2011 or the date the U.S. Treasury’s preferred stock is redeemed or transferred to an unaffiliated third party.

 

Item 3. Defaul ts upon Senior Securities

Not applicable.

 

Item 4. Remov ed and Reserved

 

Item 5. Other I nformation

Not applicable.

 

61


Table of Contents

 

Item 6. Exhibits

Exhibit 10.1 First Federal Bank of the Midwest Executive Group Life Plan – Post Separation, as amended

Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act

Exhibit 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act

Exhibit 32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act

Exhibit 32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act

 

62


Table of Contents

 

FIRST DEFIANCE FI NANCIAL CORP.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed by the undersigned thereunto duly authorized.

 

 

First Defiance Financial Corp. (Registrant)

Date: November 2, 2010

 

By:

 

/s/ William J. Small

   

William J. Small

   

Chairman, President and Chief Executive Officer

Date: November 2, 2010

 

By:

 

/s/ Donald P. Hileman

   

Donald P. Hileman

   

Executive Vice President and Chief Financial Officer

 

63

 

EXHIBIT 10.1

First Federal Bank of the Midwest

Amended and Restated

Executive Group Life Plan - Post Separation

First Federal Bank of the Midwest, a federal stock savings bank located in Defiance, Ohio (the “Bank”), established this Executive Group Life Plan – Post Separation (the “Plan”), effective June 30, 2010. On September 30, 2010, the Bank amended and restated the Plan, effective as of June 30, 2010, as set forth herein.

The purpose of the Plan is to attract, retain, and reward Employees (as defined below), by dividing the death proceeds of certain Policies (as defined below), purchased and owned by the Bank on the lives of Participants (as defined below), with the Beneficiaries (as defined below) designated by each Participant. The Bank will pay premiums due on Policies purchased under the Plan from its general assets and Participants will include the value of the insurance coverage provided by the Policies in their gross income each year during which the Policies are in effect. By Participating in this Plan, a Participant agrees that his participation in the First Federal Bank of the Midwest Executive Group Life Plan dated April 28, 2003 is automatically terminated and he shall not be entitled to any benefits thereunder.

Article 1

Definitions

Whenever used in the Plan, the following terms shall have the meanings specified:

 

1.1

Bank’s Interest ” has the meaning set forth in Section 3.1.

 

1.2

Base Salary ” means the current annual base salary of the Participant as of the date of the Participant’s death or in the year prior to the Participant’s Separation from Service, as applicable.

 

1.3

Beneficiary ” has the meaning given to it Article 7.

 

1.4

Beneficiary Designation Form ” means the form established from time to time by the Plan Administrator on which a Participant may designate one or more Beneficiaries.

 

1.5

Board ” means the Board of Directors of the Bank, as from time to time constituted.

 

1.6

Cause ” means the personal dishonesty, willful misconduct, breach of fiduciary duty involving personal profit, intentional failure to perform stated duties, willful violation of any law, rule or regulation (other than traffic violations or similar offenses) or final cease-and-desist order or material breach of any provision of the Plan. For purposes of this paragraph, no act or failure to act on the Participant’s part shall be considered “willful” unless done, or omitted to be done, by the Participant not in good faith and without reasonable belief that the Participant’s action or omission was in the best interest of the Bank.


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

1.7

Code ” means the Internal Revenue Code of 1986, as amended.

 

1.8

Election Form ” means the form established from time to time by the Plan Administrator on which an eligible Employee indicates acceptance of participation in the Plan.

 

1.9

Employee ” means an active employee of the Bank or an affiliate who is also a member of a select group of management or highly compensated employees with the meaning of the Employee Retirement Income Security Act of 1974.

 

1.10

Insurer ” means the insurance company issuing a Policy on the life of a Participant.

 

1.11

Net Death Proceeds ” means, with respect to a Participant, the total death proceeds payable pursuant to the Participant’s Policy minus the greater of (i) the cash surrender value of such Policy or (ii) the aggregate premiums paid by the Bank on such Policy.

 

1.12

Participant ” means an Employee who becomes a participant in the Plan pursuant to Article 2.

 

1.13

Participant’s Interest ” means the benefit set forth in Section 3.2.

 

1.14

Plan Administrator ” means the plan administrator described in Article 12.

 

1.15

Policy ” or “ Policies ” means the individual life insurance policy or policies purchased by the Plan Administrator for purposes of insuring a Participant’s life under the Plan.

 

1.16

Separation from Service ” means termination of the Participant’s employment with the Bank for any reason other than by reason of death.

Article 2

Participation

 

2.1

Selection by Plan Administrator . Participation in the Plan shall be limited to those Employees of the Bank selected by the Plan Administrator, in its sole discretion, to participate in the Plan.

 

2.2

Enrollment Requirements . As a condition to participation, each selected Employee shall complete, execute and return to the Plan Administrator (i) an Election Form and (ii) a Beneficiary Designation Form, and (iii) comply with such other enrollment requirements as the Plan Administrator, in its sole discretion, may establish from time to time..

 

2.3

Eligibility; Commencement of Participation . Provided that an Employee selected to participate in the Plan has met all enrollment requirements set forth in the Plan and, to the extent applicable, required by the Plan Administrator, the Employee will become a Participant once a Policy on such Employee have been issued by the Insurer(s).

 


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

2.4

Termination of Participation . The rights of a Participant and the Participant’s Beneficiary under the Plan may be terminated in accordance with Article 11.

Article 3

Policy Ownership/Interests

 

3.1

Bank’s Interest . The Bank shall own all Policies and shall have the right to exercise all incidents of ownership with respect to the Policies and may terminate any Policy or all Policies without the consent of the Participant. The Bank shall be the beneficiary of any proceeds payable under a Policy after a Participant’s Interest is determined pursuant to Section 3.2.

 

3.2

Participant’s Interest . A Participant, or a Participant’s assignee, shall have the right to designate a Beneficiary to receive a benefit equal to the lesser of (i) two (2) times the Participant’s Base Salary or (ii) the Net Death Proceeds, which shall be payable in a lump sum within ninety (90) days following the Participant’s death. The Participant shall also have the right to elect and change settlement options with respect to the Participant’s Interest by providing written notice to the Bank and the Insurer.

Article 4

Premiums and Imputed Income

The Bank shall pay all premiums due on all Policies and shall impute income to Participants under the “economic benefit” regime described in Treasury Regulation §1.61-22(d)(3)(ii) or any subsequent applicable authority.

Article 5

Comparable Coverage

 

5.1

Insurance Policies . Subject to the provisions of Article 11, the Bank will provide the benefits described in the Plan through Policies purchased at the commencement of the Plan or, if later, the Participant’s commencement of participation in the Plan

 

5.2

Offer to Purchase . If the Bank discontinues a Policy on a Participant, the Bank shall give the Participant at least thirty (30) days prior written notice to purchase such Policy. The purchase price shall be the fair market value of the Policy, as determined under Treasury Regulation §1.61-22(g)(2) or any subsequent applicable authority.

Article 6

General Limitations

 

6.1

Removal . Notwithstanding any provision of the Plan to the contrary, a Participant’s rights in the Plan and the right of the Participant’s Beneficiary to the Participant’s Interest shall terminate if the Participant is subject to a final removal or prohibition order issued by an appropriate federal banking agency pursuant to Section 8(e) of the Federal Deposit Insurance Act.

 


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

6.2

Suicide or Misstatement . No benefits shall be payable to a Beneficiary under the Plan if a Participant commits suicide within two (2) years after the date of the Plan (or, if later, the issuance of the Policy), or if the Insurer denies coverage (i) for a material misstatement of fact made by the Participant on any Policy application purchased by the Bank under the Plan, or (ii) for any other reason; provided, however that the Bank shall make commercially reasonable efforts to cause the Insurer to pay the denied claim.

 

6.3

Termination for Cause . Notwithstanding any provision of the Plan to the contrary, a Participant shall forfeit any right to a benefit under the Plan if the Bank terminates the Participant’s employment for Cause.

Article 7

Beneficiaries

 

7.1

Beneficiary . A Participant shall have the right, at any time, to designate a Beneficiary to receive any benefits payable under the Plan upon the death of the Participant. The Beneficiary designated under the Plan may be the same as or different from the beneficiary designated under any other plan of the Bank in which the Participant participates.

 

7.2

Beneficiary Designation; Change . The Participant shall designate a Beneficiary by completing, signing and returning a Beneficiary Designation Form to the Plan Administrator or its designated agent. Any beneficiary designation shall be deemed automatically revoked if the designated Beneficiary predeceases the Participant or if the Participant names a spouse as Beneficiary and the marriage is subsequently dissolved. A Participant shall have the right to change a prior designation of a Beneficiary by completing, signing and returning a new Beneficiary Designation Form to the Plan Administrator, subject to such rules and procedures, as in effect from time to time, with respect to the changing of a prior designation of a Beneficiary. Upon the receipt by the Plan Administrator of a new Beneficiary Designation Form, all prior Beneficiary designations previously filed by the Participant shall be cancelled. The Plan Administrator shall be entitled to rely on the last Beneficiary Designation Form returned to it by the Participant prior to the Participant’s death.

 

7.3

No Beneficiary Designation . If a Participant dies without designating a Beneficiary, or if all of a Participant’s designated Beneficiaries predecease the Participant, the Participant’s surviving spouse shall be the designated Beneficiary and, if the Participant has no surviving spouse, the Participant's estate shall be the Beneficiary.

 


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

 

7.4

Facility of Payment . If the Plan Administrator determines, in its sole discretion, that a benefit is to be paid to a minor, to a person declared incompetent, or to a person incapable of handling the disposition of that person’s property, the Plan Administrator may direct payment of such benefit to the guardian, legal representative or person having the care or custody of such minor, incompetent person or incapable person. The Plan Administrator may require proof of incompetence, minority or guardianship as it may deem appropriate prior to distribution of the benefit. Any payment of a benefit shall be a payment for the account of the Participant and the Participant’s Beneficiary, as the case may be, and shall be a complete discharge of any liability under the Plan for such payment amount.

Article 8

Assignment

Any Participant may assign, without consideration, all of such Participant’s Interest in the Plan to any person, entity or trust. In the event a Participant shall transfer all of such Participant’s Interest, then all of that Participant's Interest in the Plan shall be vested in his or her transferee, subject to such transferee executing agreements binding him or her to the provisions of the Plan, which such transferee shall be substituted as a party hereunder, and that Participant shall have no further interest in the Plan.

Article 9

Insurer

The Insurer shall be bound only by the terms of its given Policy. The Insurer shall not be bound by or deemed to have notice of the provisions of the Plan. The Insurer shall have the right to rely on the Plan Administrator’s representations with regard to any definitions, interpretations or Policy interests as specified under the Plan.

Article 10

Claims And Review Procedure

 

10.1

Claims Procedure . A Participant or Beneficiary (“claimant”) who has not received benefits under the Plan that he or she believes should be paid shall make a claim for such benefits as follows:

 

  10.1.1

Initiation – Written Claim . The claimant initiates a claim by submitting to the Plan Administrator a written claim for the benefits. If such a claim relates to the contents of a notice received by the claimant, the claim must be made within sixty (60) days after such notice was received by the claimant. All other claims must be made within one hundred eighty (180) days of the date on which the event that caused the claim to arise occurred. The claim must state with particularity the determination desired by the claimant.

 


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

 

  10.1.2

Timing of Plan Administrator Response . The Plan Administrator shall respond to such claimant within ninety (90) days after receiving the claim. If the Plan Administrator determines that special circumstances require additional time for processing the claim, the Plan Administrator can extend the response period by an additional ninety (90) days by notifying the claimant in writing, prior to the end of the initial ninety (90) day period, that an additional period is required. The notice of extension must set forth the special circumstances and the date by which the Plan Administrator expects to render its decision.

 

  10.1.3

Notice of Decision . If the Plan Administrator denies part or the entire claim, the Plan Administrator shall notify the claimant in writing of such denial. The Plan Administrator shall write the notification in a manner calculated to be understood by the claimant. The notification shall set forth:

 

  (a)

The specific reasons for the denial;

  (b)

A reference to the specific provisions of the Plan on which the denial is based;

  (c)

A description of any additional information or material necessary for the claimant to perfect the claim and an explanation of why it is needed;

  (d)

An explanation of the Plan’s review procedures and the time limits applicable to such procedures; and

  (e)

A statement of the claimant’s right to bring a civil action under ERISA Section 502(a) following an adverse benefit determination on review.

 

10.2

Review Procedure . If the Plan Administrator denies part or all of the claim, the claimant shall have the opportunity for a full and fair review by the Plan Administrator of the denial, as follows:

 

  10.2.1

Initiation – Written Request . To initiate the review, the claimant, within sixty (60) days after receiving the Plan Administrator’s notice of denial, must file with the Plan Administrator a written request for review.

 

  10.2.2

Additional Submissions – Information Access . The claimant shall then have the opportunity to submit written comments, documents, records and other information relating to the claim. The Plan Administrator shall also provide the claimant, upon request and free of charge, reasonable access to, and copies of, all documents, records and other information relevant (as defined in applicable ERISA regulations) to the claimant’s claim for benefits.

 

  10.2.3

Considerations on Review . In considering the review, the Plan Administrator shall take into account all materials and information the claimant submits relating to the claim, without regard to whether such information was submitted or considered in the initial benefit determination.

 


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

 

  10.2.4

Timing of Plan Administrator’s Response . The Plan Administrator shall respond in writing to such claimant within sixty (60) days after receiving the request for review. If the Plan Administrator determines that special circumstances require additional time for processing the claim, the Plan Administrator can extend the response period by an additional sixty (60) days by notifying the claimant in writing, prior to the end of the initial sixty (60) day period, that an additional period is required. The notice of extension must set forth the special circumstances and the date by which the Plan Administrator expects to render its decision.

 

  10.2.5

Notice of Decision . The Plan Administrator shall notify the claimant in writing of its decision on review. The Plan Administrator shall write the notification in a manner calculated to be understood by the claimant. The notification shall set forth:

 

  (a)

The specific reasons for the denial;

  (b)

A reference to the specific provisions of the Plan on which the denial is based;

  (c)

A statement that the claimant is entitled to receive, upon request and free of charge, reasonable access to, and copies of, all documents, records and other information relevant (as defined in applicable ERISA regulations) to the claimant’s claim for benefits; and

  (d)

A statement of the claimant’s right to bring a civil action under ERISA Section 502(a).

Article 11

Amendment And Termination

The Bank may amend or terminate the Plan at any time; however, no such amendment or termination shall reduce or eliminate the rights of a Participant without the Participant’s written consent. The Participant may waive or cease participation in the Plan by providing written notice to the Bank. If the Participant waives or ceases participation in the Plan, any designation of a Beneficiary by the Participant shall terminate and neither the Participant nor the Participant’s Beneficiary shall have any rights with respect to the Participant’s Interest. Nothing in the foregoing shall be construed as preventing the Bank from continuing to maintain a Policy for its own benefit.

Notwithstanding the foregoing, if any Participant Separates from Service prior to January 1, 2011, the Participant’s participation in the Plan will cease as of such date, any designation of a Beneficiary by the Participant shall terminate and neither the Participant nor the Participant’s Beneficiary shall have any rights with respect to the Participant’s Interest.

Article 12

Administration

 

12.1

Plan Administrator Duties . This Plan shall be administered by a Plan Administrator which shall consist of the Board, or such committee or persons as the Board may designate to serve as the plan administrator. The Plan Administrator or its designee shall also have the discretion and authority to (i) make, amend, interpret and enforce all appropriate rules and regulations for the administration of the Plan and (ii) decide or resolve any and all questions including interpretations of the Plan, as may arise in connection with the Plan.

 


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

 

12.2

Agents . In the administration of the Plan, the Plan Administrator or its designee may employ agents and delegate to them such administrative duties as it sees fit, (including acting through a duly appointed representative), and may from time to time consult with counsel who may be counsel to the Bank.

 

12.3

Binding Effect of Decisions . The decision or action of the Plan Administrator or its designee with respect to any question arising out of or in connection with the administration, interpretation and application of the Plan and the rules and regulations promulgated hereunder shall be final and conclusive and binding upon all persons having any interest in the Plan.

 

12.4

Indemnity of Plan Administrator . The Bank shall indemnify and hold harmless the Plan Administrator or its designee against any and all claims, losses, damages, expenses or liabilities arising from any action or failure to act with respect to the Plan, except in the case of willful misconduct by the Plan Administrator or its designee.

 

12.5

Information . To enable the Plan Administrator or its designee to perform its functions, the Bank shall supply full and timely information to the Plan Administrator or its designee on all matters relating to the Separation from Service or death of its Participants, and such other pertinent information as the Plan Administrator or its designee may reasonably require.

Article 13

Miscellaneous

 

13.1

Binding Effect . This Plan shall bind each Participant and the Bank, their Beneficiaries, survivors, executors, administrators, assigns, and transferees.

 

13.2

No Guarantee of Employment . This Plan is not an employment policy or contract. It does not give a Participant the right to remain an Employee of the Bank, nor does it interfere with the Bank's right to discharge a Participant. It also does not require a Participant to remain an Employee nor interfere with a Participant's right to terminate employment at any time.

 

13.3

Applicable Law . The Plan and all rights hereunder shall be governed by and construed according to the laws of the State of Ohio, without regard to any conflicts of law principles, except to the extent preempted by the laws of the United States of America.

 

13.4

Successors . The term “Bank” as used in the Plan shall be deemed to refer to any successor or survivor company.

 


First Federal Bank of the Midwest

Executive Group Life Plan - Post Separation

 

 

 

 

13.5

Notice . Any notice or filing required or permitted to be given to the Plan Administrator under the Plan shall be sufficient if in writing and hand-delivered, or sent by registered or certified mail, to the address below:

Donald P. Hileman EVP

Director of Human Resources

601 Clinton Street

Defiance, Ohio 43512

Such notice shall be deemed given as of the date of delivery or, if delivery is made by mail, as of the date shown on the postmark or the receipt for registration or certification.

Any notice or filing required or permitted to be given to a Participant under the Plan shall be sufficient if in writing and hand-delivered, or sent by mail, to the last known address of the Participant.

 

13.6

Entire Agreement . This Plan, along with a Participant’s Election Form, Beneficiary Designation Form and any agreement in writing between the Bank and any Participant, constitute the entire agreement between the Bank and the Participant as to the subject matter hereof. No rights are granted to the Participant under the Plan other than those specifically set forth herein.

IN WITNESS WHEREOF, the Bank adopts the Plan as of the date indicated above.

First Federal Bank of the Midwest

 

 

By

 

/s/ Donald P. Hileman

 

Title

 

EVP

 

 

EXHIBIT 31.1

CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT

I, William J. Small, certify that;

 

1.

I have reviewed this Quarterly Report on Form 10-Q of First Defiance Financial Corp;

 

2.

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.

The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

  (a)

Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

  (b)

Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

 

  (c)

Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

  (d)

Disclosed in this report any changes in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and


 

5.

The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

 

  (a)

All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

  (b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 

Date: November 2, 2010

 

/s/ William J. Small

 

William J. Small

 

Chairman, President and Chief Executive Officer

 

EXHIBIT 31.2

CERTIFICATION OF THE CHIEF FINANCIAL OFFICER

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT

I, Donald P. Hileman, certify that;

 

1.

I have reviewed this Quarterly Report on Form 10-Q of First Defiance Financial Corp;

 

2.

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.

The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

  (a)

Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

  (b)

Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

 

  (c)

Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

  (d)

Disclosed in this report any changes in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and


 

5.

The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

 

  (a)

All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

  (b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 

Date: November 2, 2010

 

/s/ Donald P. Hileman

 

Donald P. Hileman

 

Executive Vice President and Chief Financial Officer

 

EXHIBIT 32.1

CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER

PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of First Defiance Financial Corp. (the “Company”) on Form 10-Q for the period ending September 30, 2010 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, William J. Small, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and in connection with this quarterly report on Form 10-Q that:

 

1.

The Report fully complies with the requirements of sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, and

 

2.

The information contained in the report fairly presents, in all material respects, the company’s financial condition and results of operations.

 

Date: November 2, 2010

 

/s/ William J. Small

 

William J. Small

 

Chief Executive Officer

A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.

 

EXHIBIT 32.2

CERTIFICATION OF THE CHIEF FINANCIAL OFFICER

PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of First Defiance Financial Corp. (the “Company”) on Form 10-Q for the period ending September 30, 2010 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Donald P. Hileman, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and in connection with this quarterly report on Form 10-Q that:

 

1.

The Report fully complies with the requirements of sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, and

 

2.

The information contained in the report fairly presents, in all material respects, the company’s financial condition and results of operations.

 

Date: November 2, 2010

 

/s/ Donald P. Hileman

 

Donald P. Hileman

 

Chief Financial Officer

A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.