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Impairment of Investment Securities | 9 Months Ended
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Sep. 30, 2012
Impairment of Investment Securities | Note 9 Impairment of Investment Securities As required by FASB ASC Topic 320, “Investments – Debt and Equity Securities,” credit related other-than-temporary impairment on debt securities is recognized in earnings while non-credit related other-than-temporary impairment on debt securities not expected to be sold is recognized in OCI. During the nine-months ended September 30, 2012 and 2011, no other-than-temporary impairment charges were recognized. For the nine-months ended September 30, 2012, $1.5 million in non-credit related gains on our trust preferred collateralized debt obligations that were determined to be impaired in previous periods was recorded in OCI. For the same period in 2011, $0.2 million in non-credit related losses for the same pool of securities was recorded in OCI. All of the securities for which other-than-temporary impairment was recorded were classified as available for sale securities. First Commonwealth utilizes the specific identification method to determine the net gain or loss on debt securities and the average cost method to determine the net gain or loss on equity securities. In the Condensed Consolidated Statements of Income, the “Changes in fair value on impaired securities” line represents the change in fair value of securities impaired in the current or previous periods. The change in fair value includes both non-credit and credit related gains or losses. Credit related losses occur when the entire amortized cost of the security will not be recovered. The “Non-credit related (gains) losses on securities not expected to be sold (recognized in other comprehensive income)” line represents the gains and losses on the securities resulting from factors other than credit. The non-credit related gain or loss is disclosed in the Condensed Consolidated Statements of Income and recognized through other comprehensive income. The “Net impairment losses” line represents the credit related losses recognized in total noninterest income for the related period. We review our investment portfolio on a quarterly basis for indications of impairment. This review includes analyzing the length of time and the extent to which the fair value has been lower than the cost, the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer and whether we are more likely than not to sell the security. We evaluate whether we are more likely than not to sell debt securities based upon our investment strategy for the particular type of security and our cash flow needs, liquidity position, capital adequacy, tax position and interest rate risk position. In addition, the risk of future other-than-temporary impairment may be influenced by additional bank failures, weakness in the U.S. economy, changes in real estate values and additional interest deferrals in our pooled trust preferred collateralized debt obligations. Our pooled trust preferred collateralized debt obligations are beneficial interests in securitized financial assets within the scope of FASB ASC Topic 325, “Investments – Other,” and are therefore evaluated for other-than-temporary impairment using management’s best estimate of future cash flows. If these estimated cash flows indicate that it is probable that an adverse change in cash flows has occurred, then other-than-temporary impairment would be recognized in accordance with FASB ASC Topic 320. There is a risk that First Commonwealth will record other-than-temporary impairment charges in the future. See Note 12, “Fair Values of Assets and Liabilities,” for additional information. The following table presents the gross unrealized losses and estimated fair values at September 30, 2012 by investment category and time frame for which securities have been in a continuous unrealized loss position:
|  | Less Than 12 Months |  |  | 12 Months or More |  |  | Total |
|  | Estimated Fair Value |  |  | Gross Unrealized Losses |  |  | Estimated Fair Value |  |  | Gross Unrealized Losses |  |  | Estimated Fair Value |  |  | Gross Unrealized Losses |
|  | (dollars in thousands) |
Obligations of U.S. Government Agencies: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Mortgage-Backed Securities – Residential |  | $ | 0 |  |  | $ | 0 |  |  | $ | 14 |  |  | $ | 0 | (a) |  | $ | 14 |  |  | $ | 0 |
Obligations of U.S. Government- Sponsored Enterprises: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Mortgage-Backed Securities – Residential |  |  | 26 |  |  |  | 0 | (a) |  |  | 0 |  |  |  | 0 |  |  |  | 26 |  |  |  | 0 |
Other Government-Sponsored Enterprises |  |  | 2,398 |  |  |  | (2 | ) |  |  | 0 |  |  |  | 0 |  |  |  | 2,398 |  |  |  | (2 | )
Pooled Trust Preferred Collateralized Debt Obligations |  |  | 0 |  |  |  | 0 |  |  |  | 22,996 |  |  |  | (29,647 | ) |  |  | 22,996 |  |  |  | (29,647 | )
Total Debt Securities |  |  | 2,424 |  |  |  | (2 | ) |  |  | 23,010 |  |  |  | (29,647 | ) |  |  | 25,434 |  |  |  | (29,649 | )
Equities |  |  | 0 |  |  |  | 0 |  |  |  | 0 |  |  |  | 0 |  |  |  | 0 |  |  |  | 0 |
Total Securities Available for Sale |  | $ | 2,424 |  |  | $ | (2 | ) |  | $ | 23,010 |  |  | $ | (29,647 | ) |  | $ | 25,434 |  |  | $ | (29,649 | )
(a) | Gross unrealized losses related to these types of securities are less than $1 thousand.
At September 30, 2012, pooled trust preferred collateralized debt obligations accounted for almost all of the unrealized losses, while fixed income securities issued by U.S. Government-sponsored enterprises comprised less than one percent of total unrealized losses. There were no equity securities in an unrealized loss position at September 30, 2012. As of September 30, 2012, our corporate securities had an amortized cost and an estimated fair value of $10.8 million and $11.1 million, respectively, and were comprised of single issue trust preferred securities issued primarily by money center and large regional banks. As of December 31, 2011, the same portion of the portfolio had an amortized cost of $11.8 million and an estimated fair value of $11.4 million. There were no corporate securities in an unrealized loss position as of September 30, 2012, while as of December 31, 2011, there were $0.6 million in unrealized losses related to these investments. When unrealized losses exist, management reviews each of the issuer’s asset quality, earnings trend and capital position, to determine whether issues in an unrealized loss position were other-than-temporarily impaired. All interest payments on the corporate securities are being made as contractually required. The following table presents the gross unrealized losses and estimated fair values at December 31, 2011 by investment category and time frame for which securities have been in a continuous unrealized loss position:
|  | Less Than 12 Months |  |  | 12 Months or More |  |  | Total |
|  | Estimated Fair Value |  |  | Gross Unrealized Losses |  |  | Estimated Fair Value |  |  | Gross Unrealized Losses |  |  | Estimated Fair Value |  |  | Gross Unrealized Losses |
|  | (dollars in thousands) |
Obligations of U.S. Government Agencies: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Mortgage-Backed Securities – Residential |  | $ | 1,086 |  |  | $ | (6 | ) |  | $ | 16 |  |  | $ | 0 | (a) |  | $ | 1,102 |  |  | $ | (6 | )
Obligations of U.S. Government- Sponsored Enterprises: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Mortgage-Backed Securities – Residential |  |  | 25 |  |  |  | 0 | (a) |  |  | 0 |  |  |  | 0 |  |  |  | 25 |  |  |  | 0 |
Mortgage-Backed Securities – Commercial |  |  | 151 |  |  |  | (1 | ) |  |  | 0 |  |  |  | 0 |  |  |  | 151 |  |  |  | (1 | )
Other Government-Sponsored Enterprises |  |  | 55,969 |  |  |  | (132 | ) |  |  | 0 |  |  |  | 0 |  |  |  | 55,969 |  |  |  | (132 | )
Corporate Securities |  |  | 4,536 |  |  |  | (562 | ) |  |  | 0 |  |  |  | 0 |  |  |  | 4,536 |  |  |  | (562 | )
Pooled Trust Preferred Collateralized Debt Obligations |  |  | 0 |  |  |  | 0 |  |  |  | 22,927 |  |  |  | (31,785 | ) |  |  | 22,927 |  |  |  | (31,785 | )
Total Securities Available for Sale |  | $ | 61,767 |  |  | $ | (701 | ) |  | $ | 22,943 |  |  | $ | (31,785 | ) |  | $ | 84,710 |  |  | $ | (32,486 | )
(a) | Gross unrealized losses related to these types of securities are less than $1 thousand.
As of September 30, 2012, the book value of our pooled trust preferred collateralized debt obligations totaled $52.7 million with an estimated fair value of $23.1 million, which includes securities comprised of 339 banks and other financial institutions. Two of our pooled securities are senior tranches and the remainders are mezzanine tranches, three of which have no senior class remaining in the issue. Two of the pooled issues, representing $2.9 million of the $52.7 million book value, remain above investment grade. At the time of initial issue, the subordinated tranches ranged in size from approximately 7% to 35% of the total principal amount of the respective securities and no more than 5% of any pooled security consisted of a security issued by any one institution. As of September 30, 2012, after taking into account management’s best estimates of future interest deferrals and defaults, six of our securities had no excess subordination in the tranches we own and seven of our securities had excess subordination which ranged from 10% to 566% of the current performing collateral. The following table provides information related to our pooled trust preferred collateralized debt obligations as of September 30, 2012:
Deal |  | Class |  | Book Value |  |  | Fair Value |  |  | Unrealized Gain (Loss) |  |  | Moody’s/ Fitch Ratings |  | Number of Banks |  |  | Deferrals and Defaults as a % of Current Collateral |  |  | Excess Subordination as a % of Current Performing Collateral |
(dollars in thousands) |
Pre TSL I |  | Senior |  | $ | 1,009 |  |  | $ | 993 |  |  | $ | (16 | ) |  | Aa3/A |  |  | 17 |  |  |  | 38.98 | % |  |  | 213.61 | %
Pre TSL IV |  | Mezzanine |  |  | 1,830 |  |  |  | 645 |  |  |  | (1,185 | ) |  | Caa2/CCC |  |  | 6 |  |  |  | 27.07 |  |  |  | 95.96 |
Pre TSL V |  | Mezzanine |  |  | 53 |  |  |  | 55 |  |  |  | 2 |  |  | C/– |  |  | 3 |  |  |  | 100.00 |  |  |  | 0.00 |
Pre TSL VII |  | Mezzanine |  |  | 4,114 |  |  |  | 3,419 |  |  |  | (695 | ) |  | Ca/C |  |  | 17 |  |  |  | 45.50 |  |  |  | 0.00 |
Pre TSL VIII |  | Mezzanine |  |  | 1,794 |  |  |  | 1,016 |  |  |  | (778 | ) |  | C/C |  |  | 34 |  |  |  | 48.43 |  |  |  | 0.00 |
Pre TSL IX |  | Mezzanine |  |  | 2,259 |  |  |  | 811 |  |  |  | (1,448 | ) |  | Ca/C |  |  | 47 |  |  |  | 25.88 |  |  |  | 9.64 |
Pre TSL X |  | Mezzanine |  |  | 1,447 |  |  |  | 1,118 |  |  |  | (329 | ) |  | Ca/C |  |  | 51 |  |  |  | 38.24 |  |  |  | 0.00 |
Pre TSL XII |  | Mezzanine |  |  | 5,516 |  |  |  | 2,696 |  |  |  | (2,820 | ) |  | Ca/C |  |  | 73 |  |  |  | 34.04 |  |  |  | 0.00 |
Pre TSL XIII |  | Mezzanine |  |  | 12,418 |  |  |  | 4,714 |  |  |  | (7,704 | ) |  | Ca/C |  |  | 63 |  |  |  | 37.50 |  |  |  | 13.84 |
Pre TSL XIV |  | Mezzanine |  |  | 13,069 |  |  |  | 4,570 |  |  |  | (8,499 | ) |  | Ca/C |  |  | 61 |  |  |  | 40.08 |  |  |  | 32.10 |
MMCap I |  | Senior |  |  | 1,898 |  |  |  | 1,841 |  |  |  | (57 | ) |  | A3/A |  |  | 17 |  |  |  | 48.60 |  |  |  | 565.56 |
MMCap I |  | Mezzanine |  |  | 849 |  |  |  | 455 |  |  |  | (394 | ) |  | Ca/C |  |  | 17 |  |  |  | 48.60 |  |  |  | 14.50 |
MM Comm IX |  | Mezzanine |  |  | 6,440 |  |  |  | 718 |  |  |  | (5,722 | ) |  | Ca/CC |  |  | 30 |  |  |  | 39.29 |  |  |  | 0.00 |
Total |  |  |  | $ | 52,696 |  |  | $ | 23,051 |  |  | $ | (29,645 | ) |  |  |  |  |  |  |  |  |  |  |  |  |  |
Lack of liquidity in the market for trust preferred collateralized debt obligations, credit rating downgrades and market uncertainties related to the financial industry are factors contributing to the impairment on these securities. On a quarterly basis we evaluate our debt securities for other-than-temporary impairment. During the nine-months ended September 30, 2012 and 2011, there were no credit related other-than-temporary impairment charges recognized on our pooled trust preferred collateralized debt obligations. When evaluating these investments we determine a credit related portion and a non-credit related portion of other-than-temporary impairment. The credit related portion is recognized in earnings and represents the difference between book value and the present value of future cash flows. The non-credit related portion is recognized in OCI and represents the difference between the fair value of the security and the amount of credit related impairment. A discounted cash flow analysis provides the best estimate of credit related other-than-temporary impairment for these securities. Additional information related to the discounted cash flow analysis follows: Our pooled trust preferred collateralized debt obligations are measured for other-than-temporary impairment within the scope of FASB ASC Topic 325 by determining whether it is probable that an adverse change in estimated cash flows has occurred. Determining whether there has been an adverse change in estimated cash flows from the cash flows previously projected involves comparing the present value of remaining cash flows previously projected against the present value of the cash flows estimated at September 30, 2012. We consider the discounted cash flow analysis to be our primary evidence when determining whether credit related other-than-temporary impairment exists. Results of a discounted cash flow test are significantly affected by other variables such as the estimate of future cash flows, credit worthiness of the underlying banks and determination of probability of default of the underlying collateral. The following provides additional information for each of these variables:
• |  | Estimate of Future Cash Flows – Cash flows are constructed in an INTEX cash flow model which includes each deal’s structural features. For collateral issued by financial institutions with over $15 billion in asset size, we consider the alternative cost of funding and if that rate is less than the current rate being paid, we incorporate a prepayment in our estimate of future cash flows. The prepayment rates used are 20% in years 2 and 3 and a 2% prepayment rate thereafter. The modeled cash flows are then used to estimate if all the scheduled principal and interest payments of our investments will be returned.
• |  | Credit Analysis – A quarterly credit evaluation is performed for each of the 339 banks comprising the collateral across the various pooled trust preferred securities. Our credit evaluation considers all evidence available to us and includes the nature of the issuer’s business, its years of operating history, corporate structure, loan composition, loan concentrations, deposit mix, asset growth rates, geographic footprint and local economic environment. Our analysis focuses on profitability, return on assets, shareholders’ equity, net interest margin, credit quality ratios, operating efficiency, capital adequacy and liquidity.
• |  | Probability of Default – A probability of default is determined for each bank and is used to calculate the expected impact of future deferrals and defaults on our expected cash flows. Each bank in the collateral pool is assigned a probability of default for each year until maturity. Currently, any bank that is in default is assigned a 100% probability of default and a 0% projected recovery rate. All other banks in the pool are assigned a probability of default based on their unique credit characteristics and market indicators with a 10% projected recovery rate. For the majority of banks currently in deferral we assume the bank continues to defer and will eventually default and, therefore, a 100% probability of default is assigned. However, for some deferring collateral there is the possibility that they become current on interest or principal payments at some point in the future and in those cases a probability that the deferral will ultimately cure is assigned. The probability of default is updated quarterly. As of September 30, 2012, default probabilities for performing collateral ranged from 0.33% to 75%.
Our credit evaluation provides a basis for determining deferral and default probabilities for each underlying piece of collateral. Using the results of the credit evaluation, the next step of the process is to look at pricing of senior debt or credit default swaps for the issuer (or where such information is unavailable, for companies having similar credit profiles as the issuer). The pricing of these market indicators provides the information necessary to determine appropriate default probabilities for each bank. In addition to the above factors, our evaluation of impairment also includes a stress test analysis which provides an estimate of excess subordination for each tranche. We stress the cash flows of each pool by increasing current default assumptions to the level of defaults which results in an adverse change in estimated cash flows. This stressed breakpoint is then used to calculate excess subordination levels for each pooled trust preferred security. The results of the stress test allows management to identify those pools that are at a greater risk for a future break in cash flows so that we can monitor banks in those pools more closely for potential deterioration of credit quality. Our cash flow analysis as of September 30, 2012, indicates that no credit related other-than-temporary impairment has occurred on our pooled trust preferred securities during the nine-months ended September 30, 2012. Based upon the analysis performed by management, it is probable that six of our pooled trust preferred securities will experience principal and interest shortfalls and therefore appropriate other-than-temporary charges were recorded in prior periods. These securities are identified in the table on page 17 with 0% “Excess Subordination as a Percentage of Current Performing Collateral.” For the remaining securities listed in that table, our analysis as of September 30, 2012 indicates it is probable that we will collect all contractual principal and interest payments. During 2008, 2009 and 2010, other-than-temporary impairment charges were recognized on all of our pooled trust preferred securities, except for PreTSL I, PreTSL IV and MMCap I-Senior. Our cash flow analysis as of September 30, 2012, for all of these impaired securities indicates that it is now probable we will collect principal and interest in excess of what was estimated at the time other-than-temporary impairment charges were recorded. This change can be attributed to improvement in the underlying collateral for these securities and has resulted in our current book value being below the present value of estimated future principal and interest payments. The excess for each bond of the present value of future cash flows over our current book value ranges from 14% to 144% and will be recognized as an adjustment to yield over the remaining life of these securities. During the three- and nine-months ended September 30, 2012, $0.4 million and $0.9 million, respectively, of the excess was recognized as an adjustment to yield on these securities. The following provides a cumulative roll forward of credit losses recognized in earnings for debt securities held and not intended to be sold:
|  | For the Three-Months Ended September 30, |  |  | For the Nine-Months Ended September 30, |
|  | 2012 |  |  | 2011 |  |  | 2012 |  |  | 2011 |
|  | (dollars in thousands) |
Balance, beginning (a) |  | $ | 44,230 |  |  | $ | 44,850 |  |  | $ | 44,736 |  |  | $ | 44,850 |
Credit losses on debt securities for which other-than-temporary impairment was not previously recognized |  |  | 0 |  |  |  | 0 |  |  |  | 0 |  |  |  | 0 |
Additional credit losses on debt securities for which other-than-temporary impairment was previously recognized |  |  | 0 |  |  |  | 0 |  |  |  | 0 |  |  |  | 0 |
Increases in cash flows expected to be collected, recognized over the remaining life of the security (b) |  |  | (436 | ) |  |  | 0 |  |  |  | (942 | ) |  |  | 0 |
Balance, ending |  | $ | 43,794 |  |  | $ | 44,850 |  |  | $ | 43,794 |  |  | $ | 44,850 |
(a) | The beginning balance represents credit related losses included in other-than-temporary impairment charges recognized on debt securities in prior periods.
(b) | Represents the increase in cash flows recognized in interest income during the period.
In the third quarter of 2012 and 2011, no other-than-temporary impairment charges were recorded on equity securities. On a quarterly basis, management evaluates equity securities for other-than-temporary impairment by reviewing the severity and duration of decline in estimated fair value, research reports, analysts’ recommendations, credit rating changes, news stories, annual reports, regulatory filings, impact of interest rate changes and other relevant information. As of September 30, 2012 and 2011, there are no equity securities in an unrealized loss position.

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