First Defiance Financial Corp.
Annual Report 2006

Plain-text annual report

0 6 A N N U A L R E P O R T 06 ANNUAL REPORT FIRST DEFIANCE FINANCIAL CORP. I I F R S T D E F A N C E F N A N C A L C O R P. I I First Defi ance Financial Corp. 601 Clinton Street Defi ance, OH 43512 www.fdef.com 419-782-5015 First Federal Bank of the Midwest 601 Clinton Street Defi ance, OH 43512 www.fi rst-fed.com 419-782-5015 First Insurance & Investments 419 Fifth Street, Suite 1200 Defi ance, OH 43512 www.fi rstii.com 419-784-5431 For investor relations information access www.fdef.com FIRST DEFIANCE FINANCIAL CORP. PROFILE First Defi ance Financial Corp., headquartered in Defi ance, OH is the holding company for First Federal Bank of the Midwest and First Insurance & Investments. First Federal Bank operates 26 full service branches and 36 ATMs in twelve counties in northwest Ohio. First Insurance & Investments is the largest property and casualty insurance company in the Defi ance, Ohio area, specializing in life and group health insurance as well as fi nancial planning. Chartered in 1935 as a mutual savings and loan company, First Federal converted to a Mutual Holding Company and issued its fi rst stock to the public and employees in 1993. In September 1995, First Federal converted to a full stock company, trading stock on the NASDAQ under the ticker symbol FDEF. At the same time, First Defi ance Financial Corp. was founded as the holding company for First Federal. The bank’s name was changed to First Federal Bank of the Midwest in 1999, to refl ect our desire to provide more comprehensive fi nancial products and services. In the same year, First Insurance & Investments was added to the growing list of fi nancial services. Since 2003, First Defi ance has acquired three banking offi ces, opened three de novo offi ces and acquired ComBanc, Inc, based in Delphos, Ohio in Allen County, and Genoa Savings and Loan, based near Toledo in Genoa, Ohio. TABLE OF CONTENTS Financial Highlights Chairman’s Letter to Shareholders A High Performing Community Bank Strategy Financial Information Shareholder Information We invite you to review the enclosed materials highlighting the past successes and future plans of First Defi ance Financial Corp. Safe Harbor Statement Statements contained in this Annual Report may not be based on historical facts and are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1993, as amended, and Section 21B of the Securities Act of 1934, as amended. Actual results could vary materially depending on risks and uncertainties inherent in general and local banking and insurance conditions, competitive factors specifi c to markets in which the Company and its subsidiaries operate, future interest rate levels, legislative and regulatory decisions or capital market conditions. The Company assumes no responsibility to update this information. For more details, please refer to the Company’s SEC fi lings, including its most recent Annual Report on from 10-K and quarterly reports on Form 10-Q. 1 2 6 11 Inside Back Cover SHAREHOLDER INFORMATION ANNUAL MEETING The Annual Meeting of Shareholders of First Defi ance Financial Corp. will be held on Tuesday, April 17, 2007 at 1:00 p.m. at the offi ce of First Federal Bank, 601 Clinton Street, Defi ance, Ohio 43512. INVESTOR INFORMATION Shareholders, investors and analysts interested in additional information about First Defi ance Financial Corp. may contact John C. Wahl, Chief Financial Offi cer, at the corporate offi ce, (419)782-5015. FIRST DEFIANCE ON THE WEB First Defi ance Financial Corp. is located on the Internet at www.fdef.com STOCK TRANSFER AGENT Shareholders with questions concerning the transfer of shares, lost certifi cates, dividend payments, dividend reinvestment, receipt of multiple dividend checks, duplicate mailings or changes of address should contact: Registrar and Transfer Company First Defi ance Financial Corp. Transfer Agent 10 Commerce Drive Cranford, NJ 07016-3573 Telephone: 800-368-5948 SECURITIES LISTING First Defi ance Financial Corp. common stock trades on the National Market System of the NASDAQ Stock Market under the symbol FDEF. As of March 2, 2007, there were approximately 2,075 stockholders of record and 7,155,562 shares outstanding. PRICE RANGE Year Ended December 31, 2006 First Quarter Second Quarter Third Quarter Fourth Quarter Year Ended December 31, 2005 First Quarter Second Quarter Third Quarter Fourth Quarter High $28.88 $30.29 $28.69 $30.70 High $29.90 $30.46 $31.44 $30.06 Low $25.39 $25.09 $25.18 $26.87 Low $26.00 $25.29 $26.21 $25.56 TOTAL RETURN PERFORMANCE 250 225 200 175 150 125 100 75 50 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 First Defi ance Financial Corp. NASDAQ Composite SNL NASDAQ Bank Index SNL Midwest Thrift Index DIVIDENDS POLICY Cash dividends on the common stock are declared quarterly and have been paid since First Defi ance and its predecessor, First Federal Savings and Loan, went public in 1993. The company’s Board of Directors has increased the quarterly rate annually since 1993. The current annual dividend rate is $1.00 per share. DIVIDEND REINVESTMENT PLAN Shareholders may automatically reinvest dividends in additional First Defi ance Financial Corp. common stock through the Dividend Reinvestment Plan, which also provides for purchase by voluntary cash contributions. For additional information, please contact the Registrar and Transfer Company at 800-368-5948. AUDITORS Crowe Chizek and Company 330 East Jeff erson Boulevard South Bend, Indiana 46624 GENERAL COUNSEL Vorys, Sater, Seymour and Pease LLP Suite 2100 Atrium Two 221 East Fourth Street Cincinnati, Ohio 45201 FIRST DEFIANCE FINANCIAL CORP 1 2006 FINANCIAL HIGHLIGHTS (In Thousands, Except Per Share Amounts) Summary of operating results Net interest income Provision for loan losses Non-interest income (excluding securities gains/losses) Securities gains (losses) Non-interest expense (excluding non-recurring items) Net income Acquisition-related and other signifi cant non-recurring items Core operating earnings 2006 $49,022 1,756 19,626 (2) 43,839 15,600 - 15,600 2005 % Change 3.7% 21.8% 33.5% NM 8.3% 30.3% NM 9.6% $47,282 1,442 14,703 1,222 40,466 11,970 3,476 14,229 Balance Sheet Data Total Assets Loans, net Deposits Stockholders’ equity Allowance for loan losses Key Ratios: Return on average equity - core earnings Return on average assets - core earnings Average net interest margin Effi ciency ratio - core earnings Share information: Basic earnings per share Diluted earnings per share Basic core earnings per share Diluted core earnings per share Dividends per common share Book value per common share Shares outstanding at end of period $1,527,879 1,226,310 1,138,445 159,825 13,579 $1,461,082 1,164,481 1,069,501 151,216 13,673 10.03% 1.04% 3.68% 63.31% $2.22 2.18 2.22 2.18 0.97 22.38 7,142 9.81% 1.04% 3.87% 64.63% $1.75 1.69 2.08 2.01 0.90 21.31 7,085 4.6% 5.3% 6.4% 5.7% -0.7% 2.2% 0.0% -4.9% 2.0% 26.9% 29.0% 6.7% 8.5% 7.8% 5.0% 0.8% Core earnings refl ect net income less the after-tax impact of acquisition-related and other signifi cant non-recurring transactions. NM -- % not meaningful TOTAL ASSETS (in millions) DEPOSITS (in millions) LOANS (in millions) CORE DILUTED EARNINGS PER SHARE 1,800 1,600 1,400 1,200 1,000 800 600 400 200 1,200 1,000 800 600 400 200 1,400 1,200 1,000 800 600 400 200 02 03 04 05 06 02 03 04 05 06 02 03 04 05 06 $2.50 $2.00 $1.50 $1.00 $0.50 $ – Discontinued Operations Core Net Income per Diluted Share TOTAL NON-INTEREST INCOME (excluding security gains, in millions) 25.0 20.0 15.0 10.0 5.0 – 02 03 04 05 06 02 03 04 05 06 2 2006 ANNUAL REPORT 2006 CHAIRMAN’S LETTER As I look back over 2006, I am extremely pleased with the way First Defi ance Financial Corp. responded to the unique economic conditions that developed over the course of the year. The unprecedented interest rate environment, which affected virtually the entire banking industry, presented an arduous challenge and I am happy to report that our eff orts resulted in another successful and profi table year for our shareholders. WILLIAM J. SMALL CHAIRMAN, PRESIDENT & CEO FIRST DEFIANCE FINANCIAL CORP. 3 As a result of ongoing infl ation fears, the Federal Reserve Open Market Committee raised rates through mid-year and continued to express concerns about infl ation through the third quarter. From a banking perspective, this type of rate and monetary policy environment created new dilemmas. Through the Fed’s 17 consecutive interest rate increases, banks benefi ted from rising yields on loan portfolios even as higher yields on short term Treasury notes drove up deposit costs. Once the Fed took a break from upward rate adjustments, banks no longer had the ability to off set the rising cost of funds, which continued to climb as maturing certifi cates of deposits repriced at higher rates. This put even more strain on already compressed net interest margins. FOCUS ON NON-INTEREST INCOME As a result of this rate environment, the challenge became fi nding ways to supplement net interest income, the revenue lifeline for banks, with other forms of revenue. Simply growing earning assets was no longer the answer to growing overall revenue. Companies that recognized this shift early and were able to come up with new and increased sources of non-interest income had the advantage of off setting the impact of the falling net interest margin with these other revenue sources. Our team chose to address this challenge by formulating our own High Performing Community Bank strategy, a clear and concise business plan that not only helps us address the current short- term rate environment issues, but also guides our decisions for long-term success. Using this strategy helped us focus on new ways to build our non-interest income in 2006: • The single largest new contribution to non- interest income last year was our overdraft privilege service. Overdraft privilege is tied to most of our retail checking account products and protects customers from having checks returned for non-sufficient funds. This program, which was implemented in March of 2006, resulted in an increase in pre-tax income totaling $2.6 million, net of program expenses and related charge - offs. We anticipate that this service will continue to generate similar returns in the future. its • The Trust Department restructured fee schedule early in 2006 resulting in approximately 12% more revenue for that department. • We completed a full service fee review during the last half of the year and have added some new fees to the schedule and implemented several that are eff ective as of the beginning of 2007. These changes keep us in line with fee schedules used by banks throughout our market area. increases • We continue to see signifi cant growth in debit card fee income, which increased by 25.1% in 2006. We expect fees will continue to grow in this area as we focus on getting more cards in customers’ hands and increasing the usage of those cards. First Insurance & Investments, our insurance and investment business unit, also grew revenue in a very challenging premium environment. Property and casualty premiums were fl at at best in 2006, but thanks to new business booked and strong quality performance related to loss control, we were able to increase revenue within this business unit. In February 2007, First Defi ance executed an agreement to acquire Huber, Harger, Welt & Smith, an insurance fi rm in the Bowling Green, Ohio area. The addition of this new insurance territory to the First Insurance & Investments market means we are able to expand our reach and continue to grow our non-interest income. 4 2006 ANNUAL REPORT MARKET GROWTH AND PRODUCT DEVELOPMENT—COMMUNITY BANK STYLE As the largest independent community bank in northwest Ohio, we believe it’s important to off er banking services when and where customers need them. In 2006, we divided our market into two separate geographic market areas with their own market presidents and retail administrators. This change in our internal structure helps us protect our reputation for true, local decision-making and enables us to deliver faster, close-to-home service to all of our customers throughout our 12-county footprint. In April, we relocated our Napoleon Woodlawn offi ce to the north side of Napoleon in a high traffi c retail area, and began off ering extended evening and weekend hours at that location and at our Findlay East banking center, which is similarly situated in a high traffi c retail location. In July we opened our 26th offi ce in the Shawnee area of Lima, giving us an excellent opportunity to grow deposits in that developing market. Innovative new product off erings were also a signifi cant part of our success in 2006. Remote Deposit Service, a product designed to attract commercial checking accounts, was introduced in November and has shown positive early results. The commercial checking accounts are an integral part of the funding plan for our loan growth and we believe this new product will be an important tool in helping us meet our aggressive deposit balance growth targets in 2007. We also promoted our CDARS (Certifi cate of Deposit Account Registry Service) product, which allows our customers to secure additional deposit insurance coverage through a pooling of their deposits with other institutions. The CDARS program received an additional boost in mid-year when the State of Ohio approved it for public fund deposits. These eff orts resulted in a year of earnings growth for our shareholders, despite all of the obstacles we faced. We are proud of that accomplishment, especially since our market footprint is frequently depicted as being part of the non-growth “rust belt” region of the United States. I often tell people that from an investment perspective, I feel we suff er from “geographic discrimination.” We recognize that northwest Ohio is not a high growth part of the country, but we also know that there is good economic diversity throughout our region and we work with many solid, well-run businesses that appreciate our banking philosophy. Our status as the largest community bank franchise in our market area and our reputation for putting our customers fi rst are signifi cant advantages. MOVING FORWARD —2007 Looking ahead, it will be imperative that we are creative in our approach to off ering relationship banking services that meet our customers’ needs and produce the returns expected by our investors. As part of our High Performing Community Bank strategy, we are focusing on customer and product profi tability measures to help guide our decisions. We are working hard to reach the full potential of our newer and larger markets such as Findlay, Toledo and Lima. We will continue to evaluate new market opportunities, including the possible entry into markets across state lines, such as in Fort Wayne, Indiana, where we already have a solid base of loan clients. We are combining our trust department and our investment services into a new wealth management group that we believe will better serve our customer base and be more effi cient. Continuing our focus on effi ciency, we have started construction of a new operations center to bring together all four of our back offi ce customer support service locations into one centralized location. We anticipate this project will be completed and become operational late in the fourth quarter of 2007. FIRST DEFIANCE FINANCIAL CORP. 5 We cannot control what happens in the overall economic and interest rate environment. What we can do, and will continue to do, is be prepared with a solid business plan that gives us the direction we need to face the economic forecast, as well as the fl exibility to adapt to changes as they develop. We have an outstanding team in place that understands our High Performing Community Bank strategy and what is needed to eff ectively implement it. I believe we were successful at meeting the challenges in 2006 and we are well prepared and well positioned for 2007 and beyond. Thank you for your confi dence and investment in First Defi ance Financial Corp. Sincerely, William J. Small Chairman, President, and CEO “ Our status as the largest community bank franchise in our market area and our reputation for putting our customers fi rst are signifi cant advantages.” 6 2006 ANNUAL REPORT A HIGH PERFORMING COMMUNITY BANK STRATEGY At First Federal Bank, we believe by employing the “best and brightest” and following a clear, concise retail and commercial business plan that builds on our core values, we are on the path to becoming an even higher performing community bank. In 2006, we presented to all 400+ employees of our organization a strategic plan that introduced our distinct defi nition of a High Performing Community Bank and the steps we will take to reach that pinnacle. We developed goals for the year that were aligned with that vision, including effi ciency and process improvement opportunities, enhancement of our sales culture, and deposit growth strategies. With those targets in mind, we set out to make 2006 another rewarding year for the bank, for our shareholders, and for our customers. FIRST DEFIANCE FINANCIAL CORP. 7 ACHIEVING DEPOSIT GROWTH GOALS As part of First Federal Bank’s goal of improving the deposit mix while meeting the specifi c fi nancial needs of our customers, we concentrated on advantageous new relationship accounts in 2006, including Free PLUS and Premium Checking Accounts for retail customers. These accounts reward customers for multiple banking relationships with First Federal, boost customer loyalty and provide additional opportunities for us to build a stronger demand deposit base. The new products were promoted through corporate- wide quarterly campaigns that helped take our deposit balances to over $1.1 billion in 2006. And because we realize that the success of new products depends on how well our staff and customers know and understand them, all of our products and services are backed by newly- developed comprehensive product and sales training programs. On the commercial deposit side, we rolled out a revolutionary product that has the potential to fundamentally alter a business customer’s banking experience —Remote Deposit Service (RDS). RDS allows a business to scan and send retail checks directly to First Federal Bank without having to physically make a trip to the bank. Six weeks after the introduction of RDS, commercial cash deposits related to RDS had already grown to $2 million. RDS is another shining example of First Federal Bank’s unique ability to off er the resources and expertise of a larger bank, with the advantage of a personalized approach typically found only in smaller banks. MAXIMIZING MARKET GROWTH POTENTIAL First Federal Bank has expanded into new markets in recent years, through both acquisitions and organic growth initiatives. These new markets off er exciting potential and we intend to capitalize on the growing momentum there. In Lima, for example, we opened a new offi ce in the Shawnee area in July of 2006. In less than six months, deposits grew to over $5 million in that suburban location. Representatives from First Federal Bank and the Lima Area Chamber of Commerce celebrate the ribbon cutting of First Federal Bank’s Lima Shawnee offi ce. In Napoleon, we ushered in a new era of convenience as we opened a larger, more customer-friendly offi ce in a busy retail area of the community, and began off ering extended weekend and evening banking hours there and in our Findlay market, much to the delight of our customers. In the suburban Toledo market, we are viewed by our customers as a welcomed alternative to the larger regional banks, with faster turn-around times and more personal customer service. We will continue to tell the First Federal Bank story in our newest locations and capture increased deposit market share along the way. Mark Ferris, AVP, Commercial Loans (left), and Ken Wenner, VP of Commercial Deposit Sales assist Phillip Maag of Ayersville Telephone Company with Remote Deposit Service. Greg Wannemacher (left), President of Wannemacher Enterprises, Inc. discusses commercial services with Ron Elwer, Commercial Lender in Delphos. 8 2006 ANNUAL REPORT PROCESS IMPROVEMENT RESULTS IN HAPPY CUSTOMERS Continual process improvement is critical to achieving High Performing Bank status. Two of the areas we scrutinized in 2006 were our mortgage loan and new account opening processes. Through the diligent eff orts of multi-disciplinary teams, we dramatically reduced the paperwork required to open a new account for a customer, and further reduced the turn-around time for our mortgage loans. We also implemented a customer satisfaction survey, which identifi ed strengths and weaknesses and allowed us to pinpoint training needs. These changes translate to happier customers, happier employees and a higher performing bank. Laura Michalak, AVP, Retail Lender in Perrysburg (left) , Arlene Gerig, Re/Max Preferred, Shannon Doughty, homeowner and Judy Gorun, Re/Max Preferred gather on a chilly day to welcome Shannon into her new home. COMMUNITY BANK = COMMUNITY SUPPORT Our employees, our customers, and our communities know that First Federal Bank takes seriously its obligation to “give back.” In 2006, we donated over $350,000 to improve the lives of the citizens in our markets, to promote community pride and to educate students on fi nancial issues. Our employees have a reputation for rolling up their sleeves, volunteering their time and helping to raise funds for groups such as the American Cancer Society, participating in capital campaigns for new additions to youth centers and serving as members of the board of local non-profi t organizations. It’s all part of the enjoyment of working at First Federal, and part of the satisfaction of being a genuine community bank. INSURANCE AND INVESTMENT SOLUTIONS Insurance & Investments, we Through First have built a collection of insurance products that provide tailored solutions for individuals, families and businesses in our market. Led by an experienced team of professionals, the company off ers a full range of individual and group coverage options, property and casualty insurance, risk management and employee benefi t programs. Our ability to meet the varied needs of our customers has helped us grow to be the largest property and casualty insurance agency in the Defi ance, Ohio area. A robust line of investment products is also critical to our success. With an eye toward the thousands of Baby Boomers in our region nearing retirement, we will be developing a fresh approach to our fi nancial planning services by packaging all of our trust, investment and asset management options under one combined wealth management program in 2007. FIRST DEFIANCE FINANCIAL CORP. 9 Board of Directors: (L to R) Douglas A. Burgei, Samuel S. Strausbaugh, John U. Fauster, Dwain I. Metzger, Stephen L. Boomer, William J. Small, James L. Rohrs, Gerald W. Monnin, John L. Bookmyer, Peter A. Diehl, Thomas A. Voigt Executive Vice Presidents: (L to R): Jeff ery D. Vereecke, Gregory R. Allen, Rachel L. Ulrich, John C. Wahl, Dennis E. Rose FIRST DEFIANCE FINANCIAL CORP. BOARD OF DIRECTORS FIRST DEFIANCE FINANCIAL CORP. CORPORATE OFFICERS Dwain I. Metzger – 5,6 Farmer, Elida, Ohio Age 65, Director Since 2005 Gerald W. Monnin – 4,5,6 Retired Business Owner Defi ance, Ohio Age 68, Director Since 1997 James L. Rohrs – 1,3,8 President and Chief Operating Offi cer, First Federal Bank, Executive Vice President, First Defi ance Financial Corp. Age 59, Joined Company 1999, Director Since 2002 Samuel S. Strausbaugh – 2,3,8 Co-President, Chief Financial Offi cer, Defi ance Metal Products Defi ance, Ohio Age 43, Director Since 2006 Thomas A. Voigt – 4,5,6 Vice President, General Manager, Bryan Publishing Company, Bryan, Ohio Age 64, Director Since 1995 William J. Small – 1,3,7,8 Chairman, President, and Chief Executive Offi cer, First Defi ance Financial Corp. Age 56, Joined Company in 1994, Director Since 1998 Stephen L. Boomer – 1,2,4,6,7,8 Vice Chairman, First Defi ance Financial Corp. President, Arps Dairy, Defi ance, Ohio Age 56, Director Since 1994 John L. Bookmyer – 2,4 Executive Vice President, Blanchard Valley Health System, Findlay, Ohio Age 42, Director Since 2005 Douglas A. Burgei, D.V.M. – 3,5,6 Veterinarian, Napoleon, Ohio Age 52, Director Since 1995 Peter A. Diehl – 2,4,5 Retired Business Owner, Defi ance, Ohio Age 56, Director Since 1998 John U. Fauster, III, D.D.S. – 3,5,6 Retired Dentist, Defi ance, Ohio Age 69, Director Since 1975 William J. Small Chairman, President and Chief Executive Offi cer Joined Company in 1994 John C. Wahl Executive Vice President, Chief Financial Offi cer and Corporate Treasurer Age 46, Joined Company in 1994 James L. Rohrs President, Chief Operating Offi cer Joined Company in 1999 John W. Boesling Senior Vice President, Corporate Secretary Age 59, Joined Company in 1971 Rachel L. Ulrich Executive Vice President Age 41, Joined Company in 1996 Richard J. Mitsdarfer Senior Vice President, Chief Risk Offi cer Age 58, Joined Company in 2006 KEY FOR BOARD OF DIRECTORS: 1. Permanent Member of Executive Committee 2. Audit Committee 3. Investment Committee 4. Compensation Committee 5. Long Range Planning Committee 6. Corporate Governance Committee 7. Trust Committee 8. First Insurance & Investments Board of Directors 10 2006 ANNUAL REPORT FIRST FEDERAL BANK OF THE MIDWEST William J. Small Chairman and Chief Executive Offi cer James L. Rohrs President and COO Gregory R. Allen Executive Vice President, Southern Market Area President Dennis E. Rose, Jr. Executive Vice President, Operations Rachel L. Ulrich Executive Vice President, Human Resources Jeff ery D. Vereecke Executive Vice President, Retail Banking John C. Wahl Executive Vice President, Finance Chief Financial Offi cer John W. Boesling Senior Vice President, Secretary Patricia A. Cooper Senior Vice President, BSA, Security Lisa R. Christy Senior Vice President, Trust Timothy K. Harris Senior Vice President, Commercial Lending Nancy K. Kistler Senior Vice President, Loan Operations David J. Kondas Senior Vice President, Wealth Management Kathleen A. Miller Senior Vice President, Information Technology Richard J. Mitsdarfer Senior Vice President, Risk Management Eric A. Morman Senior Vice President, Commercial Lending Michael D. Mulford Senior Vice President, Credit Administration Patrick S. Rothgery Senior Vice President, Residential Lending Mary Beth K. Weisenburger Senior Vice President, Marketing Paul N. Windisch Senior Vice President, Business Development FIRST INSURANCE & INVESTMENTS, INC. Steven P. Grosenbacher President Kenneth G. Keller Executive Vice President, Group Health & Life Timothy S. Whetstone Executive Vice President, Secretary Lawrence H. Woods Executive Vice President, Property & Casualty COMMUNITY ADVISORY BOARDS DEFIANCE, OHIO FOSTORIA, OHIO Jean Hubbard The Hubbard Company Bryan Keller Keller Trucking Brad Mangas B.E. Mangas Construction Mike Koester Koester Corporation Rick Weaver Poggemeyer Design DELPHOS, OHIO Richard Thompson Thompson Seed Farm Robert J. Schulte, Jr. HR Services Timothy DeHaven DeHaven Garden Center FINDLAY, OHIO James Koehler Country Club Acres, Inc. Paul Kramer Kramer Enterprises, Inc. M. Michael Roberts dmh Toyota-Lift Dr. Alan Tong Cascade Women’s Health Steve Dandurand Corporate One Benefi t Agency, Inc. Peggy Frankart Fostoria Community Hospital Frank Kinn Business/Financial Consultant Lynn Radabaugh Maple Grove Quarry, Inc. Tom Reineke Reineke Ford HICKSVILLE, OHIO Larry Haver Mayor of Hicksville NAPOLEON, OHIO Greg Beck Beck Construction WAUSEON, OHIO Kerry Ackerman J and B Feed Company Jeff ery Spangler Holgate Metal Fab, Inc. Bill Fortier Aquatek Water Conditioning Kay Wesche Henry County Development Services Bradley Westhoven Midwest Wood Trim, Inc. Susan Witt Engineer, Gerken Paving OTTAWA, OHIO Leon Mann Trailite Sales, Inc. Steven McElrath BMW Services WILLIAMS COUNTY, OHIO Stacey Bock Midwest Community Health Associates Kevin Ellerbrock Kevin Ellerbrock Construction Walter Bumb D.D.S. Michael Headley H & W Automotive Parts, Inc. Kenneth Konst Farmer Robert Ramus Robert Ramus D.D.S. Mike Ruhe Ret. Supt., O-G Schools Dean Walther Optometrist PAULDING, OHIO Joseph Burkard Paulding County Prosecutor William Shugars Paulding School Administration LeRoy Feather Community Hospitals of Williams County Renee Isaac Educator Martin Sostoi Attorney James (Chip) Wood Bryan Ford Lincoln Mercury FIRST DEFIANCE FINANCIAL CORP. 11 FINANCIAL INFORMATION TABLE OF CONTENTS Selected Consolidated Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Management’s Discussion and Analysis of Financial Conditions and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Management’s Report on Internal Control Over Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Reports of Independent Registered Public Accounting Firms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Consolidated Statements of Financial Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Consolidated Statements of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Consolidated Statements of Stockholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Consolidated Statements of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 12 2006 ANNUAL REPORT SELECTED CONSOLIDATED FINANCIAL DATA The following table sets forth certain summary consolidated fi nancial data at or for the periods indicated. In 2002, results of operations associated with First Defi ance’s former Leader Mortgage Subsidiary, including certain inter-company fi nancing transactions, are refl ected as discontinued operations. Continuing operations refl ect the results of First Federal, First Insurance and First Defi ance holding company expenses for all periods presented. This information should be read in conjunction with the Consolidated Financial Statements and notes thereto, and Management’s Discussion and Analysis and Results of Operations and Financial Condition. The Consolidated Balance Sheets as of December 31, 2006 and 2005 and the Consolidated Statements of Income for the years ended December 31, 2006, 2005 and 2004, are included elsewhere in this Annual Report. Financial Condition: Total assets Investment securities Loans held-to maturity, net Allowance for loan losses Nonperforming assets (1) Deposits and borrowers’ escrow balances FHLB advances Stockholders’ equity Share Information: Basic earnings per share, continuing ops. Basic earnings per share Diluted earnings per share, continuing ops. Diluted earnings per share Book value per common share Tangible book value per common share Cash Dividends per common share Weighted average diluted shares outstanding Shares outstanding end of period Operations: Interest income from continuing operations Interest expense from continuing operations Net interest income from continuing operations Provision for loan losses Non-interest income Non-interest expense Income before tax Federal income tax Income from continuing operations Discontinued operations, net of tax Cumulative eff ect of change in method of accounting for goodwill Net income As of and For the Year Ended December 31, 2006 2005 2004 2003 2002 (Dollars in Thousands, Except Per Share Amounts) $1,527,879 112,123 1,226,310 13,579 9,902 1,139,112 162,228 159,825 $1,461,082 114,854 1,164,481 13,673 5,356 1,070,106 180,960 151,216 $1,126,667 139,258 878,912 9,956 1,990 797,979 178,213 126,874 $1,040,599 171,035 735,255 8,844 2,949 729,227 164,522 124,269 $2.22 2.22 2.18 2.18 22.38 16.99 0.97 7,168 7,142 $93,065 44,043 49,022 1,756 19,624 43,839 23,051 7,451 15,600 – – 15,600 $1.75 1.75 1.69 1.69 21.34 15.81 0.90 7,096 7,085 $76,174 28,892 47,282 1,442 15,925 43,942 17,823 5,853 11,970 – – 11,970 $1.77 1.77 1.69 1.69 20.20 17.19 0.82 6,371 6,280 $54,731 20,381 34,350 1,548 13,996 31,200 15,598 4,802 10,796 – – 10,796 $2.00 2.00 1.91 1.91 19.64 16.39 0.65 6,319 6,328 $50,629 20,855 29,774 1,719 16,843 27,126 17,772 5,690 12,082 – – 12,082 $884,245 213,525 561,041 7,496 2,731 599,889 149,096 120,110 $1.01 2.37 0.97 2.28 18.73 18.17 0.54 6,609 6,412 $46,908 22,044 24,864 1,451 10,401 24,408 9,406 2,986 6,420 8,853 (194) 15,079 FIRST DEFIANCE FINANCIAL CORP. 13 Performance Ratios: Return on average assets Return on average equity Interest rate spread (2) Net interest margin (2) Ratio of operating expense from continuing operations to average total assets Effi ciency ratio – continuing operations Capital Ratios: Equity to total assets at end of period Tangible equity to tangible assets at end of period Average equity to average assets Asset Quality Ratios: Nonperforming assets to total assets at end of period (1) Allowance for loan losses to total loans receivable Net charge-off s to average loans As of and For the Year Ended December 31, 2006 2005 2004 2003 2002 (Dollars in Thousands, Except Per Share Amounts) 1.04% 10.03% 3.37% 3.68% 2.93% 63.31% 0.88% 8.26% 3.63% 3.87% 3.22% 70.18% 1.01% 8.57% 3.37% 3.60% 2.98% 65.91% 1.24% 9.97% 3.13% 3.42% 2.91% 60.31% 0.77% 5.39% 2.92% 3.38% 3.16% 69.40% 10.46% 10.35% 11.26% 11.94% 13.58% 8.15% 10.40% 7.88% 10.62% 9.74% 11.76% 10.17% 12.43% 13.23% 14.36% 0.63% 1.10% 0.15% 0.37% 1.16% 0.07% 0.18% 1.13% 0.05% 0.28% 1.19% 0.06% 0.31% 1.32% 0.10% (1) Nonperforming assets consist of non-accrual loans that are contractually past due 90 days or more; loans that are deemed impaired under the criteria of FASB Statement No. 114; and real estate, mobile homes and other assets acquired by foreclosure or deed-in-lieu thereof. (2) Interest rate spread represents the diff erence between the weighted average yield on interest-earnings assets and the weighted average rate on interest-bearing liabilities. Net interest margin represents net interest income as a percentage of average interest-earnings assets. Interest income on tax-exempt securities and loans has been adjusted to a tax-equivalent basis using the statutory federal income tax rate of 35%. 14 2006 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s discussion and analysis of fi nancial condition and results of operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could diff er materially from those projected in such forward-looking statements. The following section presents information to assess the fi nancial condition and results of operations of First Defi ance Financial Corp. This section should be read in conjunction with the consolidated fi nancial statements and the supplemental fi nancial data contained elsewhere in this Annual Report. OVERVIEW First Defi ance is a unitary thrift holding company which conducts business through its subsidiaries, First Federal Bank of the Midwest and First Insurance & Investments. First Federal is a federally chartered savings bank that provides fi nancial services to communities based in northwest Ohio where it operates 26 full service banking centers in 12 northwest Ohio counties. On January 21, 2005, First Defi ance acquired ComBanc, Inc., headquartered in Delphos, Ohio in a transaction valued at $38.3 million including acquisition costs. ComBanc’s subsidiary, the Commercial Bank, operated four banking offi ces in Delphos, Lima and Elida, Ohio. On April 8, 2005, First Defi ance acquired The Genoa Savings and Loan Company (Genoa), in an $11.2 million transaction. Genoa operated offi ces in Genoa, Oregon, Perrysburg and Maumee Ohio. The acquired Maumee offi ce was merged with First Federal’s existing Maumee offi ce. First Defi ance acquired $117.5 million of loans and $163.7 million of deposits in the ComBanc acquisition and $66.9 million of loans and $76.8 million of deposits in the Genoa transaction. For more details on the ComBanc and Genoa acquisitions, see Note 3 – Acquisitions in the Notes to the Financial Statements. First Federal provides a broad range of fi nancial services including checking accounts, savings accounts, certifi cates of deposit, real estate mortgage loans, commercial loans, consumer loans, home equity loans and trust services through its extensive branch network. 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 offi ce in Defi ance, Ohio while investment and annuity products are sold through registered investment representatives located at four of First Federal’s banking center locations. FINANCIAL CONDITION Assets at December 31, 2006 totaled $1.53 billion compared to $1.46 billion at December 31, 2005, an increase of $66.8 million or 4.6%. The majority of First Defi ance’s asset growth was in loans, which increased by $61.8 million, or 5.3% to $1.23 billion at December 31, 2006 after allowance for loan losses, from $1.16 billion at December 31, 2005. The increase in assets was primarily funded through growth in deposits, which increased by $68.9 million or 6.4%, to $1.14 billion at December 31, 2006 from $1.07 billion at December 31, 2005. SECURITIES The securities portfolio declined $2.7 million to $112.1 million at December 31, 2006. The activity in the portfolio in 2006 included $17.6 million of purchases, $17.0 million of amortization and maturities, $3.1 million of sales and a net decrease of $112,000 in market value. The decline in market value in 2006 was attributable primarily to rising interest rates and that decline is believed to be temporary. Management utilizes its securities portfolio for liquidity purposes. The investment portfolio has declined from a high of $213.5 million at the end of 2002 as maturing securities have been used to fund loan growth. Management does not believe the securities portfolio will decline further from the level it was at on December 31, 2006. FIRST DEFIANCE FINANCIAL CORP. 15 LOANS Gross Loans receivable increased by $61.7 million or 5.2% to $1.24 billion at December 31, 2006 from $1.18 billion at December 31, 2005. The most signifi cant growth occurred in commercial loans, which increased by $61.6 million between December 31, 2005 and December 31, 2006, and in commercial real estate loans, which increased by $27.9 million. First Defi ance also experienced $9.8 million of growth in its home equity and improvement loans. One-to-four family residential loans and construction loans declined by $26.1 million between the end of 2005 and the end of 2006 and consumer fi nance loans declined by $11.5 million. The majority of First Defi ance’s lending activity that is retained in the loan portfolio is to small and mid-sized businesses in the form of commercial and commercial real estate loans. The combined commercial and commercial real estate portfolios totaled $812.8 million and $799.6 million at December 31, 2006 and 2005 respectively and accounted for approximately 65.5% and 61.3% of First Defi ance’s loan portfolio at the end of those respective periods. First Defi ance believes it has been able to establish itself as a leader in its market area in the commercial and commercial lending area by hiring experienced lenders and providing a high level of customer service to its commercial lending clients. The one-to-four family residential portfolio, including residential construction loans, totaled $261.7 million at December 31, 2006, down from $287.9 million at the end of 2005. At the end of 2006 those loans comprised 21.1% of the total loan portfolio, down from 24.4% at December 31, 2005. The decline in the mortgage portfolio refl ects the Company’s strategy of selling the majority of its fi xed rate mortgage production in the secondary market, most of it with servicing retained. During 2006 a signifi cant number of loans in the portfolio were refi nanced with loans that were sold. The level of residential loan production did not change signifi cantly between 2005 and 2006. Home equity and home improvement loans grew to $122.8 million at December 31, 2006, or 9.9% of the portfolio, up from $113.0 million at the end of 2005, or 9.6% of total loans. The growth in this portion of the portfolio is the result of customers utilizing existing lines of credit as well as focused marketing eff orts of this product. Consumer fi nance loans were just $43.8 million at December 31, 2006, down from $55.3 million at the end of 2005. These loans comprised just 3.5% and 4.7% of the total portfolio at December 31, 2006 and 2005 respectively. A portion of the decline in balances is the result of First Defi ance selling its $2.1 million credit card portfolio late in the 2006 second quarter. The balance of the decline refl ects the Company’s strategy of not pricing aggressively in this highly competitive segment of the market. 16 2006 ANNUAL REPORT ALLOWANCE 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. Lending activities contain risks of loan losses. Management analyzes the adequacy of the allowance for loan losses regularly through reviews of the performance of the loan portfolio. Consideration is given to economic conditions, changes in interest rates and the eff ect 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 signifi cant fl uctuation 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 $250,000 of aggregate exposure. Management utilizes the results of this outside loan review to assess the eff ectiveness 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 this type of loan. At December 31, 2006, the allowance for loan losses was $13.6 million compared to $13.7 million at December 31, 2005. The reduction of the allowance in 2006 is the result of a higher than normal level of loan charge-off s as management attempted to resolve credit issues that were previously identifi ed in the portfolio and reserved for. Those balances represented 1.10% and 1.16% of outstanding loans as of December 31, 2006 and December 31, 2005 respectively. In determining the appropriate level for the allowance for loan losses, First Defi ance evaluates all loans in its portfolio. While allowances are frequently required for loans classifi ed as substandard, it is possible for a relationship to be graded as substandard based on the fi nancial performance of the credit for which no allowance is required because of other factors such as value of collateral or creditworthiness of guarantors. At December 31, 2006, a total of $10.4 million of loans are classifi ed as substandard for which some level of reserve ranging between 20% and 50% of the outstanding balance is required. A total of $25.7 million in additional credits were classifi ed as substandard at December 31, 2006 for which no reserve is required. First Defi ance also has classifi ed $379,000 as doubtful at December 31, 2006. First Defi ance also utilizes a general reserve percentage for loans not otherwise classifi ed which ranges from 0.062% for mortgage loans to 1.50% for consumer loans. General reserves for commercial and commercial real estate loans, the largest category in First Defi ance’s portfolio, are established at 1.10% of the outstanding balance. The reserve percentage utilized for these loans is based on both historical losses in the Company’s portfolio, national statistics on loss percentages and empirical evidence regarding the strength of the economy in First Defi ance’s general market area. First Defi ance’s ratio of allowance for loan losses to non-performing loans dropped from 276.1% at the end of 2005 to 186.4% at December 31, 2006. Through its due diligence prior to making the 2005 acquisitions, management was aware of the existence of non-performing loans in both portfolios. At December 31, 2006, First Defi ance had total non-performing assets of $9.7 million, compared to $5.4 million at December 31, 2005. Non-performing assets include loans that are 90 days past due and all real estate owned and other foreclosed assets. Non-performing assets at December 31, 2006 and 2005 by category were as follows: Non-performing loans: Single-family residential Non-residential and multi-family residential real estate Commercial Consumer fi nance Total non-performing loans Real estate owned and repossessed assets Total non-performing assets December 31, 2006 2005 (In Thousands) $2,029 5,206 - 48 7,283 2,392 $9,675 $2,648 1,917 287 100 4,952 404 $5,356 FIRST DEFIANCE FINANCIAL CORP. 17 The 2006 total non-performing assets included $3.8 million related to either the ComBanc or Genoa acquisitions. The balance of non-performing assets which were either originated by First Defi ance or acquired in the 2003 RFC branch acquisition were $5.9 million compared to $2.1 million of non-performing assets at December 31, 2005. While the level of classifi ed loans has increased, year over year, management believes that the current allowance for loan losses is appropriate and that the provision for loan losses recorded in 2006 is consistent with both charge-off experience and the strength of the overall credits in the portfolio. Non-performing loans in the single-family residential, non-residential and multi-family residential real estate and commercial loan categories represent .81%, .90% and 0% of the total loans in those categories respectively at December 31, 2006 compared to 0.94%, 0.35% and 0.17% respectively for the same categories at December 31, 2005. LOANS ACQUIRED WITH IMPAIRMENT Certain loans acquired in the ComBanc and Genoa acquisitions had evidence that the credit quality of the loan had deteriorated since its origination and in management’s assessment at the acquisition date it was probable that First Defi ance would be unable to collect all contractually required payments due. In accordance with American Institute of Certifi ed Public Accountants Statement of Position 03-3 – Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3), these loans were recorded based on management’s estimate of the fair value of the loans. At the acquisition date of January 21, 2005, loans with a contractual receivable of $3.4 million were acquired from Combanc which were deemed impaired. Those loans were recorded at a net realizable value of $2.1 million. On April 8, 2005, loans with contractual receivable totals of $1.5 million were acquired from Genoa which were deemed impaired. Those loans were recorded at a net realizable value of $735,000. As of December 31, 2006, the total contractual receivable for those loans was $4.1 million and the recorded value was $2.4 million. HIGH LOAN-TO-VALUE MORTGAGE LOANS The majority of First Defi ance’s mortgage loans are collateralized by one-to-four-family residential real estate, have loan-to- value ratios of 80% or less, and are made to borrowers in good credit standing. First Federal usually requires residential mortgage loan borrowers whose loan-to-value is greater than 80% to purchase private mortgage insurance (PMI). First Federal does originate and retain a limited number of residential mortgage loans with loan-to-value ratios that exceed 80% where PMI is not required if the borrower possesses other demonstrable strengths. The loan-to-value ratios on these loans are generally limited to 85% and exceptions must be approved by First Federal’s senior loan committee. Management monitors the balance of one-to-four family residential loans, including home equity loans and committed lines of credit, that exceed certain loan to value standards (90% for owner occupied residences, 85% for non-owner occupied residences and one-to-four family construction loans, 75% for developed land and 65% for raw land). Total loans that exceed those standards at December 31, 2006 totaled $33.1 million. These loans are generally paying as agreed. First Defi ance does not make interest-only fi rst-mortgage residential loans, nor does it have residential mortgage loan products, or other consumer products that allow negative amortization. GOODWILL AND INTANGIBLE ASSETS Goodwill remained fl at at $35.0 million at December 31, 2006 after the ComBanc and Genoa acquisitions added $12.4 million and $4.3 million respectively to Goodwill in 2005. No impairment of goodwill was recorded in 2006. Core deposit intangibles and other intangible assets decreased $720,000 during 2006 to $3.4 million from $4.1 million at the end of 2005, due to the amortization. 18 2006 ANNUAL REPORT DEPOSITS Total deposits at December 31, 2006 were $1.14 billion compared to $1.07 billion at December 31, 2005, an increase of $68.9 million or 6.4%. Non-interest bearing checking grew by $2.8 million, money market and interest bearing checking accounts grew by $29.4 million, certifi cates of deposit increased by $44.9 million while savings declined by $8.3 million. Management periodically utilizes brokered certifi cates of deposit to supplement its funding needs. At December 31, 2006 the balance of brokered CDs totaled $17.6 million, down from $37.0 million at December 31, 2005. During that same period, retail deposits greater than $100,000 also declined, to $140.4 million from $161.3 million. BORROWINGS FHLB advances totaled $162.2 million at December 31, 2006 compared to $180.1 million at December 31, 2005. The balance at the end of 2006 includes $90.0 million of convertible advances with rates ranging from 4.71% to 5.84%. These advances are all callable by the FHLB, at which point they would convert to a three-month LIBOR advance if not paid off . Those advances have fi nal maturity dates ranging from 2010 to 2013. In addition, First Defi ance has advances totaling $27 million that are callable by the FHLB only if the three-month LIBOR rate exceeds a strike rate ranging from 7.5% to 8.0%. The rate on those advances ranges from 3.48% to 5.14%. First Defi ance also has $12.1 million outstanding at the FHLB under a series of fi xed-rate loans and $33.1 million borrowed on an overnight basis at December 31, 2006. First Defi ance also has $30.4 million of securities that have been sold at December 31, 2006 with agreements to repurchase, an increase of this type of funding of $4.7 million over December 31, 2005. In October 2005, the Company issued $20.6 million of Subordinated Debentures. These debentures were issued to an unconsolidated affi liated trust that purchased them with the proceeds from a $20 million issue of trust preferred securities to an outside party. The proceeds of the Subordinated Debentures were used for general corporate purposes. The Subordinated Debentures have a rate equal to three-month LIBOR plus 1.38%, or 6.74% at December 31, 2006. CAPITAL RESOURCES Total shareholders’ equity increased $8.6 million to $159.8 million at December 31, 2006. This increase is primarily the result of the Company’s $15.6 million of net income. The increase was off set by $6.8 million of dividends ($0.97 per share declared) and a $576,000 net of tax adjustment to initially apply FAS No. 158, Employers Accounting for Defi ned Benefi t Pension Plans and other Post Retirement Plans, which is included in other comprehensive income. In 2003 the Company’s board of directors authorized the repurchase of 640,000 shares. A total of 106,020 shares were repurchased in 2006 under that program at an average cost of $26.06, thus reducing shareholders equity by $2.8 million. A total of 310,758 shares remain to be purchased under the authorization. Also during 2006, a total of 203,595 stock options were exercised by employees, resulting in a $2.3 million increase in shareholders equity. In exercising those options, certain employees paid their option exercise price by returning shares to the Company, which reduced equity by approximately $1.1 million. A total of 41,381 shares were returned to the Company in conjunction with option exercises at an average price of $26.38 per share. FIRST DEFIANCE FINANCIAL CORP. 19 RESULTS OF OPERATIONS SUMMARY First Defi ance reported net income of $15.6 million for the year ended December 31, 2006 compared to $12.0 million and $10.8 million for the years ended December 31, 2005 and 2004 respectively. On a diluted per share basis, First Defi ance earned $2.18 in 2006, $1.69 in 2005 and $1.69 in 2004. The 2005 net income amount includes $3.5 million of acquisition related costs that were incurred as part of the ComBanc and Genoa acquisitions. These costs included such items as the expense to terminate data processing contracts, severance agreements with employees who were not retained, and other costs resulting from the acquisition or related transition eff orts. After tax, these costs amounted to $2.3 million, or $.32 per share. The 2004 results included a $1.9 million pretax charge to refl ect fi nal settlement of certain contingent liabilities related to the 2002 sale of the Company’s former Leader Mortgage subsidiary to US Bancorp. After tax, that amount was $1.25 million or $0.20 per diluted share. Excluding these non-operating items, core earnings were $15.6 million, $14.2 million and $12.0 million for the years ended December 31, 2006, 2005 and 2004 respectively. On a diluted per share basis, core earnings amounted to $2.18, $2.01 and $1.89 for those three periods. A reconciliation of GAAP earnings to core earnings is as follows: GAAP Net Income One-time acquisition related charges Settlement of contingent liability Tax eff ect Core Operating Earnings Basic earnings per share: GAAP Core Operating Earnings Diluted earnings per share: GAAP Core Operating Earnings Year Ended December 31, 2006 2005 2004 (In Thousands, Except Per Share Amounts) $15,600 − − − $15,600 $2.22 $2.22 $2.18 $2.18 $11,970 3,476 − (1,217) $14,229 $1.75 $2.08 $1.69 $2.01 $10,796 − 1,927 (674) $12,049 $1.77 $2.07 $1.69 $1.89 20 2006 ANNUAL REPORT NET INTEREST INCOME First Defi ance’s net interest income is determined by its interest rate spread (i.e. the diff erence 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. Net interest income was $49.0 million for the year ended December 31, 2006 compared to $47.3 million and $34.4 million for the years ended December 31, 2005 and 2004 respectively. The tax-equivalent net interest margin was 3.68%, 3.87% and 3.62% for the years ended December 31, 2006, 2005 and 2004 respectively. The decrease in margin between 2006 and 2005 is due to a declining interest rate spread, which decreased to 3.37% for the year ended December 31, 2006 compared to 3.63% for 2005. The decline in spread between 2005 and 2006 occurred due to interest-earning asset yields increasing by just 75 basis points (to 6.95% in 2006 from 6.20% in 2005) while the cost of interest bearing liabilities between the two periods increased by 101 basis points (to 3.58% in 2006 from 2.57% in 2005). The margin compression resulting from narrowing spreads was slightly off set by an $8.3 million increase in non-interest bearing deposits and an $18.9 million increase in average equity. Management anticipates the margin compression will continue into 2007 as they expect the cost of funding will continue to rise as certifi cates of deposit continue to reprice at higher rates, while asset yields have appeared to have peaked since the Federal Reserve Open Market Committee stopped raising rates in mid 2006. The increase in margin between 2004 and 2005 was due to an improved interest rate spread, which increased to 3.63% for the year ended December 31, 2005 compared to 3.39% for 2004. The improved spread resulted from a 51 basis point improvement in the yield on interest-earning assets (to 6.20% in 2005 from 5.71% in 2004) while the cost of interest bearing liabilities between the two periods increased by just 26 basis points (to 2.58% in 2005 from 2.32% in 2004). Margin also improved in 2005 as a result of the improved mix between loans and investment securities, the $30.5 million increase in the average balance of non-interest bearing deposits and a $19.1 million increase in average equity for the year. Total interest income increased by $16.9 million, or 22.1% to $93.1 million for the year ended December 31, 2006 from $76.2 million for the year ended December 31, 2005. The increase in interest income was due to an increase in the average balance in loans receivable, to $1.21 billion for the twelve months of 2006 compared to $1.09 billion for 2005. In addition to the increase in loan balances, the average yield on loans increased to 7.13% for 2006 compared to 6.40% in 2005, a 73 basis point improvement. Interest income from loans increased to $86.2 million for 2006 compared to $69.7 million in 2005 which represented growth of 23.7%. During the same period the average balance of investment securities dropped to $116.7 million for 2006 from $121.5 million for the year ended December 31, 2005. Interest income from the investment portfolio increased $372,000 to $5.6 million in 2006 from $5.3 million in 2005. The increase is due to the 42 basis point increase in the yield as lower yielding securities matured in 2006. The tax equivalent yield on the investment portfolio was 5.30% in 2006 compared to 4.88% in 2005. Interest expense increased by $15.2 million in 2006 compared to 2005, to $44.0 million from $28.9 million. This increase was due to a $106.8 million increase in the average balance of interest bearing liabilities in 2006 compared to 2005 as well as a 101 basis point increase in the average cost of those liabilities. The balance of interest-bearing deposits increased by $66.1 million between December 31, 2005 and December 31, 2006. Of that growth, $44.9 million was in certifi cates of deposit, which have a higher cost than transaction accounts. Interest expense related to these interest-bearing deposits was $33.3 million in 2006 and $20.6 million in 2005. Expenses on FHLB advances and other interest bearing funding sources were $8.9 million in 2006 and $7.6 million in 2005. First Defi ance issued $20.6 million of junior subordinated debentures in the fourth quarter of 2005 in conjunction with a trust preferred off ering by an unconsolidated affi liated subsidiary. Interest expense recognized by the Company related to those subordinated debentures was $1.3 million in 2006 compared to just $201,000 in 2005. Total interest income increased by $21.4 million, or 39.2% to $76.2 million for the year ended December 31, 2005 from $54.7 million for the year ended December 31, 2004. The increase in income was due to an increase in the average balance in loans receivable, to $1.09 billion for the twelve months of 2005 compared to $806.9 million for 2004. During the same period the average balance of investment securities dropped to $121.5 million for 2005 from $152.3 million for the year ended December 31, 2004. In addition to the increase in loan balances, the average yield on loans increased to 6.40% for 2005 compared to 5.87% for 2004, a 53 basis point improvement. FIRST DEFIANCE FINANCIAL CORP. 21 Interest expense increased by $8.5 million in 2005 compared to 2004, to $28.9 million from $20.4 million. This increase was due to a $232.9 million increase in the average balance of interest bearing deposits in 2005 compared to 2004 as well as a 36 basis point increase in the cost of those deposits. Total interest bearing deposits acquired in the acquisitions was $217.8 million. For the year, the balance of interest-bearing deposits increased by $230.8 between December 31, 2004 and December 31, 2005. Of that growth, $182.4 million was in certifi cates of deposit. Interest expense on interest-bearing deposits was $20.6 million in 2005 and $12.9 million in 2004. Expenses on FHLB advances and other interest bearing funding sources were not signifi cantly diff erent between 2004 and 2005. First Defi ance issued $20.6 million of junior subordinated debentures in conjunction with a trust preferred off ering by an unconsolidated affi liated subsidiary. Interest expense recognized by the Company related to those subordinated debentures was $201,000 in 2005. The following table shows an analysis of net interest margin on a tax equivalent basis for the years ended December 31, 2006, 2005 and 2004: Year Ended December 31, 2006 2005 2004 Average Balance Interest (1) Yield/ Rate (2) Average Balance Interest (1) Yield/ Rate (2) Average Balance Interest (1) Yield/ Rate (2) (Dollars in Thousands) Interest-Earning Assets: Loans receivable Securities Interest-earning deposits Dividends on FHLB stock $1,209,498 116,718 3,483 17,926 Total interest-earning assets Non-interest-earning assets 1,347,625 148,136 Total Assets $1,495,761 86,237 7.13% 6,217 5.30% 165 4.74% 1,042 5.81% 93,661 6.95% $1,089,942 121,510 10,410 16,352 1,238,214 126,583 $1,364,797 69,732 5,873 364 829 76,798 6.40% 4.88% 3.50% 5.07% 6.20% 47,360 7,499 43 612 55,514 5.87% 4.92% 1.76% 4.12% 5.69% $806,880 152,316 2,447 14,839 976,482 94,321 $1,070,803 $1,006,468 181,869 20,398 20,619 $33,273 3.31% 8,878 4.88% 584 2.86% 1,308 6.34% $ 932,036 167,427 19,639 3,441 $20,615 7,602 474 201 2.21% 4.54% 2.41% 5.84% $699,087 169,463 10,608 − $12,950 7,317 114 − 1.85% 4.32% 1.07% − 1,229,354 44,043 3.58% 1,122,543 28,892 2.57% 879,158 20,381 2.32% 95,044 − 86,741 − 56,241 − 44,043 3.33% 1,324,398 15,815 1,340,213 155,548 28,892 2.39% 1,209,284 10,530 1,219,814 144,983 $1,364,797 20,381 2.18% 935,399 9,484 935,399 125,920 $1,070,803 $49,618 3.37% $47,906 3.68% 109.6% 3.63% 3.87% 110.3% $35,133 3.37% 3.60% 111.1% stockholders’ equity $1,495,761 Net interest income; interest rate spread (3) Net interest margin (4) Average interest-earning assets to average interest- bearing liabilities (1) Interest on certain tax exempt loans (amounting to $48,000, $47,000 and $29,000 in 2006, 2005 and 2004 respectively) and tax-exempt securities ($1.1 million, $1.2 million and $1.5 million in 2006, 2005 and 2004) is not taxable for Federal income tax purposes. The average balance of such loans was $1.0 million, $1.0 million and $722,000 in 2006, 2005 and 2004 while the average balance of such securities was $25.2 million, $25.1 million and $32.8 million in 2006, 2005 and 2004 respectively. 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) At December 31, 2006, the yields earned and rates paid were as follows: loans receivable, 6.84%; securities, 5.09%; FHLB stock, 6.05%; total interest-earning assets, 6.69%; deposits, 3.24%; FHLB advances, 5.05%; other borrowings, 2.98%; total interest-bearing liabilities, 3.46%; and interest rate spread, 3.23%. (3) Interest rate spread is the diff erence in the yield on interest-earning assets and the cost of interest-bearing liabilities. (4) Net interest margin is net interest income divided by average interest-earning assets. Interest-Bearing Liabilities: Interest-bearing deposits FHLB advances Other borrowings Subordinated debentures Total interest-bearing liabilities Non-interest bearing demand deposits Total including non- interest- bearing demand deposits Other non-interest liabilities Total Liabilities Stockholders’ equity Total liabilities and 22 2006 ANNUAL REPORT The following table describes the extent to which changes in interest rates and changes in volume of interest-related assets and liabilities have aff ected First Defi ance’s interest income and expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) change in rate (change in rate multiplied by prior year volume), and (iii) total change in rate and volume. The combined eff ect of changes in both rate and volume has been allocated proportionately to the change due to rate and the change due to volume. Year Ended December 31, Increase (decrease) due to rate 2006 vs. 2005 Increase (decrease) due to volume Increase (decrease) due to rate 2005 vs. 2004 Increase (decrease) due to volume Total increase (decrease) (In Thousands) $8,428 561 227 129 $9,345 $10,898 594 91 19 $11,602 $8,077 (217) (426) 84 $7,518 $1,760 682 19 1,088 $3,549 $16,505 344 (199) 213 $16,863 $12,658 1,276 110 1,107 $15,151 $1,712 $4,567 (135) 75 150 $4,657 $2,821 372 214 − $3,407 $17,805 (1,491) 246 67 $16,627 $4,844 (87) 146 201 $5,104 Total increase (decrease) $22,372 (1,626) 321 217 $21,284 $7,665 285 360 201 $8,511 $12,773 Interest-Earning Assets Loans Securities Interest-earning deposits FHLB stock Total interest-earning assets Interest-Bearing Liabilities Deposits FHLB advances Term notes Subordinated Debentures Total interest-bearing liabilities Increase in net interest income Provision for Loan Losses – First Defi ance’s provision for loan losses was $1.8 million for the year ended December 31, 2006 compared to $1.4 million and $1.5 million for the years ended December 31, 2005 and 2004 respectively. Provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level deemed appropriate by management to absorb probable losses in the loan portfolio. Factors considered by management include identifi able risk in the portfolios; historical experience; the volume and type of lending conducted by First Defi ance; the amount of non- performing assets, including loans which meet the FASB Statement No. 114 defi nition of impaired; the amount of assets graded by management as substandard, doubtful, or loss; general economic conditions, particularly as they relate to First Defi ance’s market areas; and other factors related to the collectability of First Defi ance’s loan portfolio. See also Allowance for Loan Losses in Management’s Discussion and Analysis and Note 7 to the audited fi nancial statements. Non-interest Income – Non-interest income increased by $3.7 million or 23.2% in 2006 to $19.6 million from $15.9 million for the year ended December 31, 2005. In 2004, $14.0 million of non-interest income was recognized. Most of the increase in 2006 was in service fees and other charges, which increased to $9.3 million for the year ended December 31, 2006 from $5.6 million for 2005, an increase of $3.7 million or 66.0%. The implementation of an overdraft privilege product in 2006 was the primary reason for the increase in service fees. Service fee income was $4.2 million in 2004. Non-interest income also includes investment securities gains or losses. In 2006, First Defi ance realized a $2,000 loss on securities compared to $1.2 million and $1.4 million of gains in 2005 and 2004 respectively. In 2005 and 2004, management took advantage of favorable prices in the bond portfolio resulting from lower long-term interest rates. Generally in those years, as investments were sold out of the investment portfolio, the related proceeds were used to fund loan growth or they were reinvested in shorter-term securities in order to position the Company for an eventual overall rate increase. There was only a minor amount of sales activity in the investment portfolio in 2006. FIRST DEFIANCE FINANCIAL CORP. 23 Mortgage banking income includes gains from the sale of mortgage loans, fees for servicing mortgage loans for others, and an off set for amortization of mortgage servicing rights, and adjustments for impairment in the value of mortgage servicing rights. Mortgage banking income totaled $3.4 million, $3.3 million and $2.8 million in 2006, 2005 and 2004 respectively. The modest growth in 2006 over 2005 was primarily attributable to a $154,000 increase in mortgage servicing fees resulting from a $63 million increase in the portfolio of mortgage loans serviced for others and gains from sale of mortgage loans, which increased $133,000 in 2006 from 2005. Those increases were off set by a reduction in the recovery of previously recorded mortgage servicing rights impairment reserves, which resulted in $417,000 of income in 2005 compared with just $2,000 in 2006. The $574,000 of growth in 2005 compared with 2004 was primarily attributable to that recapture of $417,000 of previously recorded mortgage servicing rights impairment and a $295,000 increase in mortgage servicing fees, the result of a $139 million increase in the portfolio of mortgage loans serviced. Gains from the sale of mortgage loans totaled $2.3 million for both 2005 and 2004. Mortgage servicing rights impairment adjustments in 2004 resulted in impairment expense of $1,000. The balance of the impairment allowance stands at just $80,000 at the end of 2006. See Note 8 to the fi nancial statements. Non-interest Expense – Total non-interest expense for 2006 was $43.8 million compared to $43.9 million for the year ended December 31, 2005 and $31.2 million for the year ended December 31, 2004. The 2005 total includes $3.5 million of acquisition related charges while the 2004 amount includes a charge of $1.9 million related to the fi nal settlement of a contingent liability related to First Defi ance’s 2002 sale of its Leader Mortgage subsidiary. Non-interest expense, excluding the acquisition related charges in 2005 and the settlement of the contingency in 2004, was $40.4 million and $29.3 million respectively for those two years. Compensation and benefi ts increased by $706,000 in 2006 compared to 2005, to $24.2 million in 2006 from $23.4 million in 2005. A portion of the increase in compensation was due to having a full year of compensation and benefi ts costs associated with the Genoa acquisition compared to just under nine months in 2005 and $268,000 related to the expensing of stock options in accordance with FAS No. 123R, Share-Based Payment which is a new item in 2006. The balance of the increase in compensation and benefi ts resulted from general staffi ng increases and cost of living pay increases. Also in 2006, occupancy costs increased to $5.1 million from $4.7 million in 2005, and data processing increased to $3.7 million from $3.2 million. The majority of these increases were a result of the acquisitions and other growth initiatives. First Defi ance’s other non-interest expense category also increased to $8.9 million in 2006 from $7.1 million in 2005. Increases in that category resulted from higher levels of advertising (up $235,000), printing and offi ce supplies (up $134,000), postage (up $136,000) and bad check charge-off s and other related deposit account losses (up $94,000). Overdraft protection fees were $372,000 in 2006, which was a new expense related to the overdraft privilege product. The increase in non-interest expense in 2005 from 2004 was primarily due to a $6.0 million increase in compensation and benefi ts expense, mostly due to staffi ng increases from the acquisitions, the addition of staff in central operations to service the larger branch network and increases to the cost of First Defi ance’s health insurance. Occupancy costs, data processing costs, state franchise tax and amortization of intangibles including core deposit intangibles and customer relationship intangibles increased $1.4 million, $800,000, $400,000 and $600,000, respectively. The majority of these increases were a result of the growth due to the acquisitions. The 2005 non-interest expense included $3.5 million of acquisition related costs. Of these costs, $1.05 million related to the ComBanc acquisition and $2.45 related to the Genoa acquisition. For ComBanc, the most signifi cant costs included $471,000 in severance and other termination payments to employees not retained and $222,000 related to the cancellation of certain contracts. For Genoa, the most signifi cant costs included $1.3 million for the termination of a long-term data processing contract and other long-term contracts and lease arrangements and $364,000 for severance and other payments to employees not retained. Income Taxes – Income taxes amounted to $7.5 million in 2006 compared to $5.9 million in 2005 and $4.8 million in 2004. The eff ective tax rates for those years were 32.3%, 32.8%, and 30.8% respectively. The tax rate is lower than the statutory 35% tax rate for the Company because of investments in tax-exempt securities and in Bank Owned Life Insurance (BOLI). The earnings on such investments are not subject to federal income tax. The increase in the eff ective tax rate in 2005 compared to 2004 is primarily the result of lower levels of interest income from tax-exempt securities in 2005 compared to 2004 and a reduction in earnings from BOLI. See note 17 to the fi nancial statements. 24 2006 ANNUAL REPORT CONCENTRATIONS OF CREDIT RISK Financial institutions such as First Defi ance generate income primarily through lending and investing activities. The risk of loss from lending and investing activities includes the possibility that losses may occur from the failure of another party to perform according to the terms of the loan or investment agreement. This possibility is known as credit risk. Lending or investing activities that concentrate assets in a way that exposes the Company to a material loss from any single occurrence or group of occurrences increases credit risk. Diversifying loans and investments to prevent concentrations of risks is one manner a fi nancial institution can reduce potential losses due to credit risk. Examples of asset concentrations would include multiple loans made to a single borrower and loans of inappropriate size relative to the total capitalization of the institution. Management believes adherence to its loan and investment policies allows it to control its exposure to concentrations of credit risk at acceptable levels. First Defi ance’s loan portfolio is concentrated geographically in its northwest Ohio market area. There are no industry concentrations that exceed 10% of the Company’s loan portfolio. LIQUIDITY AND CAPITAL RESOURCES The Company’s primary source of liquidity is its core deposit base, raised through First Federal’s branch network, along with unused wholesale sources of funding and its capital base. These funds, along with investment securities, provide the ability to meet the needs of depositors while funding new loan demand and existing commitments. Cash generated from operating activities was $22.7 million, $16.6 million and $16.3 million in 2006, 2005 and 2004 respectively. The adjustments to reconcile net income to cash provided by or used in operations during the periods presented consist primarily of proceeds from the sale of loans (less the origination of loans held for sale), the provision for loan losses, depreciation expense, the origination, amortization and impairment of mortgage servicing rights, ESOP expense related to the release of ESOP shares in accordance with AICPA SOP 93-6 and increases and decreases in other assets and liabilities. In a typical year, the primary investing activity of First Defi ance is lending, which is funded with cash provided from operating and fi nancing activities, as well as proceeds from payment on existing loans and proceeds from maturities of investment securities. In 2005, First Defi ance completed the acquisitions of ComBanc and Genoa. In the case of the ComBanc acquisition, which was purchased with a combination of stock and cash, First Defi ance realized an increase in cash of $52.7 million after netting the cash that was acquired from ComBanc. ComBanc’s cash level was high because they liquidated their investment portfolio in advance of the acquisition closing date. In the case of the Genoa acquisition, the acquisition resulted in a net reduction in cash of $612,000 after netting Genoa’s cash balances against the purchase price. In considering the more typical investing activities, during 2006, $16.6 million and $3.1 million was generated from the maturity or sale of available-for-sale investment securities, respectively, while $68.7 million was used to fund loan growth and $17.6 million was used to purchase available-for-sale investment securities. During 2005, $27.9 million and $24.2 million was generated from the maturity or sale of available-for-sale investment securities, respectively, while $104.1 million was used fund loan growth and $30.3 million was used to purchase available-for-sale investment securities. During 2004, $42.8 million and $20.7 million was generated from the maturity of investment securities and sale of available-for-sale investment securities, respectively, while $144.7 million was used to fund loan growth and $34.3 million was used to purchase available-for-sale investment securities. FIRST DEFIANCE FINANCIAL CORP. 25 Principal fi nancing activities include the gathering of deposits, the utilization of FHLB advances, and the sale of securities under agreements to repurchase such securities and borrowings from other banks. In addition, First Defi ance also purchased common stock for its treasury. For 2006, total deposits increased by $69.3 million, including $88.3 million of growth in retail deposit balances. The amount of deposits acquired from CD brokers or other out of market sources declined in 2006 by $19.4 million. For 2005, total deposits (excluding deposits acquired in the acquisitions) increased by $31.9 million, including $44.4 million of growth in retail deposit balances. The amount of deposits acquired from CD brokers or other out of market sources declined in 2005 by $12.5 million. For the year ended December 31, 2004, deposits increased by $69.1 million, including $58.6 million of growth in retail deposits generated by the First Federal Bank branch network, and $10.5 million in net growth in deposits acquired from CD brokers or other out of market sources. Also in 2006, Short- term advances from the FHLB increased by $4.6 million and there were no borrowings on lines of credit from other banks. Also securities sold under repurchase arrangements increased by $4.7 million. In 2005, First Defi ance issued $20.6 million of subordinated debentures to an unconsolidated affi liated trust and that trust issued $20 million of trust preferred stock to outside investors. The result of obtaining the trust preferred funding was that borrowings on lines of credit from other banks of $3 million were paid off . Short-term advances from the FHLB did increase by $2 million in 2005. Also securities sold under repurchase arrangements increased by $7.3 million. In 2004, First Defi ance borrowed $15.5 million in short-term advances from the FHLB and $3.0 million on from other fi nancial institutions under short-term lines of credit. The Company repurchased $3.9 million, $1.5 million, $4.7 million of common stock for treasury in 2006, 2005 and 2004 respectively. For additional information about cash fl ows from First Defi ance’s operating, investing and fi nancing activities, see the Consolidated Statements of Cash Flows included in the Consolidated Financial Statements. At December 31, 2006, First Defi ance had the following commitments to fund deposit, advance and borrowing obligations: Contractual Obligations Savings, checking and demand accounts Certifi cates of deposit FHLB overnight advances FHLB fi xed advances including interest (1) Subordinated debentures Securities sold under repurchase agreements Lease obligations Total $486,822 651,623 33,100 159,589 20,619 30,424 4,258 Maturity Dates by Period at December 31, 2006 Less than 1 year $486,822 571,963 33,100 7,331 − 30,424 320 1-3 years 4-5 years (In Thousands) $ − 75,756 − 22,658 − − 457 $ − 3,447 − 73,591 − − 362 After 5 years $ − 457 − 56,009 20,619 − 3,119 Total contractual cash obligations $1,386,435 $1,129,960 $98,871 $ 77,400 $80,204 (1) Includes principal payments of $129,092 and interest payments of $30,497 26 2006 ANNUAL REPORT At December 31, 2006, First Defi ance had the following commitments to fund loan or line of credit obligations: Commitments Residential real estate loans in process Commercial loans in process One-to-four family mortgage loan originations Multifamily originations Other real estate originations Nonmortgage loan originations Consumer lines of credit Commercial lines of credit Total loan commitments Standby letters of credit Total Commitments Amount of Commitment Expiration by Period Total Amounts Committed Less than 1 year 1-3 years 4-5 years $43,910 8,518 5,329 3,693 25,725 10,235 93,536 69,403 260,349 $43,910 8,518 2,405 3,693 2,868 3,124 3,443 68,573 136,534 16,869 13,005 (In Thousands) $ − − 615 − 4,603 − 20,036 58 25,312 3,864 $ − − 133 − 1,358 4,743 15,222 − 21,456 − After 5 years $ − − 2,176 − 16,896 2,368 54,835 772 77,047 − $277,218 $149,539 $29,176 $21,456 $77,047 In addition to the above commitments, at December 31, 2006 First Defi ance had commitments to sell $7.2 million of loans held for sale to Freddie Mac. To meet its obligations, management can adjust the rate of savings certifi cates to retain deposits in changing interest rate environments; it can sell or securitize mortgage and non-mortgage loans; and it can turn to other sources of fi nancing including FHLB advances, the Federal Reserve Bank, bank lines and brokered certifi cates of deposit. At December 31, 2006 First Defi ance had $50.8 million capacity under its agreements with the FHLB and other banks. First Defi ance is subject to various capital requirements of the Offi ce of Thrift Supervision. At December 31, 2006, First Federal had capital ratios that exceeded the standard to be considered “well capitalized”. For additional information about First Federal’s capital requirements, see Note 16 to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES First Defi ance has established various accounting policies which govern the application of accounting principles generally accepted in the United States in the preparation of its fi nancial statements. The signifi cant accounting policies of First Defi ance are described in the footnotes to the consolidated fi nancial statements. Certain accounting policies involve signifi cant 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. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could diff er from these judgments and estimates, which could have a material impact on the carrying value of assets and liabilities and the results of operations of First Defi ance. Allowance for Loan Losses: First Defi ance believes the allowance for loan losses is a critical accounting policy that requires the most signifi cant judgments and estimates used in preparation of its consolidated fi nancial statements. In determining the appropriate estimate for the allowance for loan losses, management considers a number of factors relative to both specifi c credits in the loan portfolio and macro-economic factors relative to the economy of the United States as a whole and the economy of the northwest Ohio region in which the Company does business. FIRST DEFIANCE FINANCIAL CORP. 27 Factors relative to specifi c credits that are considered include a customer’s payment history, a customer’s recent fi nancial performance, an assessment of the value of collateral held, knowledge of the customer’s character, the fi nancial strength and commitment of any guarantors, the existence of any customer or industry concentrations, changes in a customer’s competitive environment, and any other issues that may impact a customer’s ability to meet his obligations. Economic factors that are considered include levels of unemployment and infl ation, specifi c plant or business closings in the Company’s market area, the impact of strikes or other work stoppages, the impact of weather or environmental conditions, especially relative to agricultural borrowers and other matters that may have an impact on the economy as a whole. In addition to the identifi cation of specifi c customers who may be potential credit problems, management considers its historical losses, the results of independent loan reviews, an assessment of the adherence to underwriting standards, the loss experience being reported by other fi nancial institutions operating in the Company’s market area, and other factors in providing for loan losses that have not been specifi cally classifi ed. While management believes its allowance for loan losses is conservatively determined based on the above factors, it does not believe the allowances to be excessive or unnecessary. Refer to the section titled “Allowance for Loan Losses” and Note 2, Statement of Accounting Policies for a further description of the Company’s estimation process and methodology related to the allowance for loan losses. Valuation of Mortgage Servicing Rights: First Defi ance believes the valuation of mortgage servicing rights is a critical accounting policy that requires signifi cant estimates in preparation of its consolidated fi nancial statements. First Defi ance recognizes as separate assets the value of mortgage servicing rights, which are acquired through loan origination activities. First Defi ance does not purchase any mortgage servicing rights. Key assumptions made by management relative to the valuation of mortgage servicing rights include the stratifi cation policy used in valuing servicing, assumptions relative to future prepayments of mortgages, the potential value of any escrow deposits maintained or ancillary income received as a result of the servicing activity and discount rates used to value the present value of a future cash fl ow stream. In assessing the value of the mortgage servicing rights portfolio, management utilizes a third party that specializes in valuing servicing portfolios. That third party reviews key assumptions with management prior to completing the valuation. Prepayment speeds are determined based on projected median prepayment speeds for 15 and 30 year mortgage backed securities. Those speeds are then adjusted up or down based on the size of the loan. The discount rate used in this analysis is the pretax yield generally required by purchasers of bulk servicing rights as of the valuation date. The value of mortgage servicing rights is especially vulnerable in a falling interest rate environment. Refer also to the section entitled Mortgage Servicing Rights and Note 2, Statement of Accounting Policies, and Note 8, Mortgage Banking, for a further description of First Defi ance’s valuation process, methodology and assumptions along with sensitivity analyses. 28 2006 ANNUAL REPORT QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK ASSET/LIABILITY MANAGEMENT A signifi cant portion of the Company’s revenues and net income is derived from net interest income and, accordingly, the Company strives to manage its interest-earning assets and interest-bearing liabilities to generate an appropriate contribution from net interest income. Asset and liability management seeks to control the volatility of the Company’s performance due to changes in interest rates. The Company attempts to achieve an appropriate relationship between rate sensitive assets and rate sensitive liabilities. First Defi ance does not presently use off balance sheet derivatives to enhance its risk management. First Defi ance monitors interest rate risk on a monthly basis through simulation analysis that measures the impact changes in interest rates can have on net interest income. The simulation technique analyzes the eff ect of a presumed 100 basis point shift in interest rates (which is consistent with management’s estimate of the range of potential interest rate fl uctuations) and takes into account prepayment speeds on amortizing fi nancial 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 100 basis points over a 12 month period, First Defi ance’s net interest income would increase by just 1.19% over the base case scenario. Were interest rates to fall by 100 basis points during the same 12-month period, the simulation indicates that net interest income would decrease by only 0.30%. It should be noted that other areas of First Defi ance’s income statement, such as gains from sales of mortgage loans and amortization of mortgage servicing rights are also impacted by fl uctuations in interest rates but are not considered in the simulation of net interest income. The majority of First Defi ance’s lending activities are in the non-residential real estate and commercial loan areas. While such loans carry higher credit risk than residential mortgage lending, they tend to be more rate sensitive than residential mortgage loans. The balance of First Defi ance’s non-residential and multi-family real estate loan portfolio was $579.9 million, which is split between $105.1 million of fi xed-rate loans and $474.8 million of adjustable-rate loans at December 31, 2006. The commercial loan portfolio increased to $232.9 million, which is split between $82.4 million of fi xed-rate loans and $150.5 million of adjustable-rate loans at December 31, 2006. Certain of the loans classifi ed as adjustable have fi xed rates for an initial term that may be as long as fi ve years. The maturities on fi xed-rate loans are generally less than 7 years. First Defi ance also has signifi cant balances of home equity and improvement loans ($122.8 million at December 31, 2006) which fl uctuate with changes in the prime lending rate; and consumer loans ($43.8 million at December 31, 2006) which tend to have a shorter duration than residential mortgage loans. Also, to limit its interest rate risk, (as well as to provide liquidity) First Federal sells a majority of its fi xed-rate mortgage originations into the secondary market. In addition to the simulation analysis, First Federal also prepares an “economic value of equity” (“EVE”) analysis. This analysis calculates the net present value of First Federal’s assets and liabilities in rate shock environments that range from –300 basis points to +300 basis points. The results of this analysis are refl ected in the following table. Change in Rates $ Amount $ Change % Change Ratio Change December 31, 2006 Economic Value of Equity Economic Value of Equity as % of Present Value of Assets + 300 bp + 200 bp + 100 bp 0 bp -100 bp -200 bp -300 bp (Dollars in Thousands) 172,982 183,727 195,048 205,286 213,078 218,372 223,151 (32,304) (21,559) (10,238) – 7,792 13,086 17,865 (15.74%) (10.50%) (4.99%) – 3.80% 6.37% 8.70% 12.04% 12.57% 13.11% 13.56% 13.86% 14.01% 14.13% (152) bp (99) bp (45) bp – 30 bp 45 bp 57 bp FIRST DEFIANCE FINANCIAL CORP. 29 Based on the above analysis, in the event of a 200 basis point increase in interest rates as of December 31, 2006, First Federal would experience a 10.50% decrease in its economic value of equity. If rates would fall by 200 basis points its economic value of equity would increase by 6.37%. During periods of rising rates, the value of monetary assets declines. Conversely, during periods of falling rates, the value of monetary assets increases. It should be noted that the amount of change in value of specifi c assets and liabilities due to changes in rates is not the same in a rising rate environment as in a falling rate environment. Based on the EVE analysis, the change in the economic value of equity in both rising and falling rate environments is relatively low because both its assets and liabilities have relatively short durations and the durations are fairly closely matched. The average duration of its assets at December 31, 2006 was 1.66 years while the average duration of its liabilities was 1.18 years. In evaluating First Federal’s exposure to interest rate risk, certain shortcomings inherent in each of the methods of analysis presented must be considered. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in diff erent degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fl uctuate in advance of changes in market rates while interest rates on other types of fi nancial instruments may lag behind current changes in market rates. Furthermore, in the event of changes in rates, prepayments and early withdrawal levels could diff er signifi cantly from the assumptions in calculating the table and the results therefore may diff er from those presented. FORWARD LOOKING INFORMATION This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended. It is intended that such forward-looking statements are covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. This statement is included for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations are generally identifi able by use of the words believe, expect, intend, anticipate, estimate, project, may or similar expressions. The presentation and discussion of the provision and allowance for loan losses, statements concerning future profi tability or future growth and projections about interest rate simulations included in the Asset/Liability Management section are examples of inherently forward-looking statements in that they involve judgements and statements of belief as to the outcome of future events. The ability of management to predict results or the actual eff ect of future strategies is inherently uncertain. Factors which could have a material adverse aff ect on operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, both nationally and within the region that First Defi ance operates, legislative or regulatory changes, monetary and fi scal policy of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or make-up of the loan and investment portfolios, demand for loan and deposit products, competition, demand for fi nancial products in the First Defi ance market areas and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning First Defi ance and its business, including additional factors that could materially aff ect its fi nancial results and fi nancial condition are included in its fi lings with the Securities and Exchange Commission. 30 2006 ANNUAL REPORT MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of First Defi ance Financial Corp. is responsible for establishing and maintaining adequate internal control over fi nancial reporting. First Defi ance’s internal control over fi nancial reporting is a process designed under the supervision of First Defi ance’s chief executive offi cer and chief fi nancial offi cer to provide reasonable assurance regarding the reliability of fi nancial reporting and the preparation of First Defi ance’s fi nancial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles. First Defi ance’s management assessed the eff ectiveness of its internal control over fi nancial reporting as of December 31, 2006 based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in “Internal Control–Integrated Framework.” Based on the assessment, management determined that, as of December 31, 2006, First Defi ance’s internal control over fi nancial reporting is eff ective based on those criteria. Management’s assessment of the eff ectiveness of First Defi ance’s internal control over fi nancial reporting as of December 31, 2006 has been audited by Crowe Chizek and Company LLC, an independent registered public accounting fi rm, as stated in their report which follows under the heading Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting. WILLIAM J. SMALL Chairman, President and Chief Executive Offi cer JOHN C. WAHL Executive Vice President and Chief Financial Offi cer FIRST DEFIANCE FINANCIAL CORP. 31 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING Board of Directors and Stockholders First Defi ance Financial Corp. Defi ance, Ohio We have audited management’s assertion, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that First Defi ance Financial Corp. (the Company) maintained eff ective internal control over fi nancial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining eff ective internal control over fi nancial reporting and for its assessment of the eff ectiveness of internal control over fi nancial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the eff ectiveness of the Company’s internal control over fi nancial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether eff ective internal control over fi nancial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over fi nancial reporting, evaluating management’s assessment, testing and evaluating the design and operating eff ectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over fi nancial reporting is a process designed to provide reasonable assurance regarding the reliability of fi nancial reporting and the preparation of fi nancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over fi nancial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly refl ect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of fi nancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material eff ect on the fi nancial statements. Because of its inherent limitations, internal control over fi nancial reporting may not prevent or detect misstatements. Also, projections of any evaluation of eff ectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that First Defi ance Financial Corp. maintained eff ective internal control over fi nancial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, First Defi ance Financial Corp. maintained, in all material respects, eff ective internal control over fi nancial reporting as of December 31, 2006 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of fi nancial condition of First Defi ance Financial Corp. as of December 31, 2006, and the related consolidated statements of income, stockholders’ equity and cash fl ows for the year then ended and our report dated March 12, 2007 expressed an unqualifi ed opinion on those consolidated fi nancial statements. Cleveland, Ohio March 12, 2007 32 2006 ANNUAL REPORT REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders First Defi ance Financial Corp. Defi ance, Ohio We have audited the accompanying consolidated statements of fi nancial condition of First Defi ance Financial Corp. as of December 31, 2006 and 2005 and the related consolidated statements of income, stockholders’ equity and cash fl ows for the years then ended. These consolidated fi nancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated fi nancial statements based on our audits. The consolidated fi nancial statements of First Defi ance Financial Corp. for the year ended December 31, 2004 were audited by other auditors whose report dated March 8, 2005 expressed an unqualifi ed opinion on those statements. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated fi nancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated fi nancial statements. An audit also includes assessing the accounting principles used and signifi cant estimates made by management, as well as evaluating the overall fi nancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated fi nancial statements referred to above present fairly, in all material respects, the fi nancial position of First Defi ance Financial Corp. as of December 31, 2006 and 2005, and the results of its operations and its cash fl ows for the years then ended in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the eff ectiveness of the Company’s internal control over fi nancial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 12, 2007 expressed an unqualifi ed opinion thereon. As disclosed in Note 2, during 2006 the Company adopted new accounting guidance for post-retirement benefi ts. Cleveland, Ohio March 12, 2007 FIRST DEFIANCE FINANCIAL CORP. 33 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON CONSOLIDATED FINANCIAL STATEMENTS The Board of Directors First Defi ance Financial Corp. We have audited the accompanying consolidated statements of income, changes in stockholders’ equity, and cash fl ows of First Defiance Financial Corp. and subsidiaries for the year ended December 31, 2004. These fi nancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these fi nancial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the fi nancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the fi nancial statements. An audit also includes assessing the accounting principles used and signifi cant estimates made by management, as well as evaluating the overall fi nancial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the fi nancial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash fl ows of First Defiance Financial Corp. and subsidiaries for the year ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Cleveland, Ohio March 8, 2005 34 2006 ANNUAL REPORT CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION Assets Cash and cash equivalents: Cash and amounts due from depository institutions Interest-bearing deposits Securities available-for-sale, carried at fair value Securities held-to-maturity, carried at amortized cost (fair value $1,492 and $1,845 at December 31, 2006 and 2005 respectively) Loans receivable, net of allowance of $13,579 and $13,673 at December 31, 2006 and 2005, respectively Loans held for sale Mortgage servicing rights Accrued interest receivable Federal Home Loan Bank stock Bank owned life insurance Premises and equipment Real estate and other assets held for sale Goodwill Core deposit and other intangibles Other assets Total assets Liabilities and Stockholders’ Equity Deposits Noninterest-bearing Interest-bearing Total Advances from the Federal Home Loan Bank Short term borrowings and other interest-bearing liabilities Subordinated debentures Advance payments by borrowers Deferred taxes Other liabilities Total liabilities Stockholders’ equity: Preferred stock, no par value per share: 5,000 shares authorized; no shares issued Common stock, $.01 par value per share: 20,000 shares authorized; 11,703 and 11,701 shares issued and 7,142 and 7,085 shares outstanding, respectively Additional paid-in capital Stock acquired by ESOP Accumulated other comprehensive income (loss), net of tax of $(362) and $(13), respectively Retained earnings Treasury stock, at cost, 4,561 and 4,616 shares respectively Total stockholders’ equity December 31, 2006 2005 (In Thousands) $47,668 2,355 50,023 110,682 1,441 1,226,310 3,426 5,529 6,984 18,586 25,326 34,899 2,392 35,090 3,397 3,794 $44,066 5,190 49,256 113,079 1,775 1,164,481 5,282 5,063 6,207 17,544 24,346 32,429 404 35,084 4,117 2,015 $1,527,879 $1,461,082 $106,328 1,032,117 1,138,445 162,228 30,424 20,619 667 1,295 14,376 1,368,054 117 110,285 (628) (671) 120,112 (69,390) 159,825 $103,498 966,003 1,069,501 180,960 25,748 20,619 605 795 11,638 1,309,866 117 108,626 (1,053) (22) 112,041 (68,493) 151,216 Total liabilities and stockholders’ equity $1,527,879 $1,461,082 See accompanying notes. FIRST DEFIANCE FINANCIAL CORP. 35 Years Ended December 31, 2006 2005 2004 (In Thousands, Except Per Share Amount) $86,213 $69,708 $47,345 4,511 1,134 165 1,042 4,081 1,192 364 829 5,205 1,526 43 612 93,065 76,174 54,731 33,273 8,885 1,308 577 44,043 49,022 1,756 47,266 9,303 3,389 4,531 526 (2) 312 980 585 20,615 7,625 201 451 28,892 12,950 7,317 – 114 20,381 47,282 34,350 1,442 45,840 1,548 32,802 5,603 3,345 4,185 – 1,222 282 765 523 4,215 2,771 4,052 – 1,426 225 947 360 19,624 15,925 13,996 24,152 5,103 3,689 – – 10,895 43,839 23,051 7,451 $15,600 $ 2.22 $ 2.18 $ 0.97 23,446 4,651 3,247 3,476 – 9,122 17,422 3,294 2,363 – 1,927 6,194 43,942 31,200 17,823 5,853 15,598 4,802 $11,970 $10,796 $ 1.75 $ 1.69 $ 0.90 $ 1.77 $ 1.69 $ 0.82 CONSOLIDATED STATEMENTS OF INCOME Interest income Loans Investment securities: Taxable Tax-exempt Interest-bearing deposits FHLB stock dividends Total interest income Interest expense Deposits Federal Home Loan Bank advances and other Subordinated debentures Notes payable Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Noninterest income Service fees and other charges Mortgage banking income Insurance commissions Gain on sale of non-mortgage loans Gain (loss) on sale or write-down of securities Trust income Income from bank owned life insurance Other noninterest income Total noninterest income Noninterest expense Compensation and benefi ts Occupancy Data processing Acquisition related charges Settlement of contingent liability Other noninterest expense Total noninterest expense Income before income taxes Federal income taxes Net income Earnings per share: Basic Diluted Dividends declared per share See accompanying notes. 36 2006 ANNUAL REPORT CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Common Stock Treasury Stock Additional Paid-In Capital Stock Accumulated Other Acquired by Comprehensive Income (Loss) ESOP Total Retained Stockholders Equity Earnings Balance at January 1, 2004 Comprehensive income: Net income Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of $(1,015) (a) Total comprehensive income ESOP shares released Amortization of deferred compensation of Management Recognition Plan, including income tax benefi t of $12 Shares issued under stock option plan, including income tax benefi t of $553 Acquisition of common stock for treasury Dividends declared Balance at December 31, 2004 Comprehensive income: Net income Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of ($1,160) (a) Total comprehensive income ESOP shares released Shares issued to acquire ComBanc, Inc. Amortization of deferred compensation of Management Recognition Plan, including income tax benefi t of $4 Shares issued under stock option plan, including income tax benefi t of $261 Acquisition of common stock for treasury Dividends declared Balance at December 31, 2005 Comprehensive income: Net income Change in net unrealized gains and losses on available-for-sale securities, net of income taxes of ($39) (a) Total comprehensive income Adjustment to initially apply SFAS No. 158, net of tax of ($310) ESOP shares released Stock option expense Amortization of deferred compensation of Management Recognition Plan, including income tax benefi t of $4 Shares issued under stock option plan, including income tax benefi t of $481 Acquisition of common stock for treasury Dividends declared $110 $(66,257) $87,107 $(1,904) $4,017 $101,196 $124,269 (In Thousands) – – – – – – – – – – – 1,938 (4,691) – – – – – 845 425 19 553 – – – – – – – 10,796 10,796 (1,886) – – – – – – – – (383) – (5,011) (1,886) 8,910 1,270 19 2,108 (4,691) (5,011) 110 (69,010) 88,524 (1,479) 2,131 106,598 126,874 – – – 7 – – – – – – – – – 186 924 18,911 – 1,878 (1,547) – 6 261 – – – – 426 – – – – – – 11,970 11,970 (2,153) – – – – – – – – – – (317) – (6,210) (2,153) 9,817 1,350 19,104 6 1,822 (1,547) (6,210) 117 (68,493) 108,626 (1,053) (22) 112,041 151,216 – – – – – – – – – – – – – – – 3,046 (3,943) – – – – 901 268 4 486 – – – – – 425 – – – – – – 15,600 15,600 (73) (576) – – – – – – – – – – – (703) – (6,826) (73) 15,527 (576) 1,326 268 4 2,829 (3,943) (6,826) Balance at December 31, 2006 $117 $(69,390) $110,285 $(628) $(671) $120,112 $159,825 (a) Net of reclassifi cation adjustments. Reclassifi cation adjustments represent net unrealized gains (losses) as of December 31 of the prior year on securities available-for-sale that were sold during the current year. The reclassifi cation adjustment was -0- in 2006, $1.3 million ($884,000 after tax) in 2005 and $1.82 million ($1.18 after tax) in 2004. See accompanying notes. FIRST DEFIANCE FINANCIAL CORP. 37 Years Ended December 31, 2006 2005 2004 (In Thousands) $15,600 $11,970 $10,796 1,756 2,738 532 612 (2) 720 (2,950) – (104) (1,042) 1,326 2 870 140,828 268 (137,624) (980) (2,616) 1,804 21,738 358 16,649 3,073 2,229 213 (17,551) – (5,317) – – – – 4,929 (73,060) (68,477) 1,442 2,396 1,152 784 (417) 755 (2,426) 6 (116) (835) 1,350 (1,222) 249 112,731 – (114,332) (765) 1,285 2,574 16,581 357 27,882 24,160 475 1,286 (30,271) – (5,296) (5,000) – 52,687 (612) – (104,103) 1,548 1,798 564 704 1 110 (2,523) 19 – (610) 1,270 (1,426) 90 106,620 – (101,391) (947) (136) (234) 16,253 403 42,850 20,747 996 2 (34,262) 5,000 (2,202) – 318 – – – (144,660) (38,435) (110,808) CONSOLIDATED STATEMENTS OF CASH FLOWS Operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses Provision for depreciation Net amortization of premium and discounts on loans, securities, deposits and debt obligations Amortization of mortgage servicing rights Net impairment (recovery) of mortgage servicing rights Amortization of intangibles Gain on sale of loans Amortization of Management Recognition Plan deferred compensation Gain on sale of property, plant and equipment FHLB stock dividends Release of ESOP shares (Gains) loss on sales or write-down of securities Deferred federal income tax Proceeds from sale of loans Stock option expense Origination of loans held for sale Income from bank owned life insurance Change in interest receivable and other assets Change in accrued interest and other liabilities Net cash provided by operating activities Investing activities Proceeds from maturities of held-to-maturity securities Proceeds from maturities of available-for-sale securities Proceeds from sale of available-for-sale securities Proceeds from sale of real estate and other assets held for sale Proceeds from sale of offi ce properties and equipment Purchases of available-for-sale securities Proceeds from sale of Federal Home Loan Bank stock Purchases of offi ce properties and equipment Investment in bank owned life insurance Proceed from insurance death benefi t Net cash received for acquisition of ComBanc, Inc. Net cash paid for acquisition of Genoa Savings and Loan Co. Proceeds from sale of non-mortgage loans Net increase in loans receivable Net cash used in investing activities (CONTINUED) 38 2006 ANNUAL REPORT CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Financing activities Net increase in deposits Repayment of Federal Home Loan Bank long-term advances Net increase in Federal Home Loan Bank short-term advances Net increase (decrease) in short-term line of credit Proceeds from Federal Home Loan Bank long-term advances Increase (decrease) in securities sold under repurchase agreements Proceeds from issuance of subordinated debentures Purchase of common stock for treasury Cash dividends paid Proceeds from exercise of stock options Excess tax benefi t from exercise of stock options Net cash provided by fi nancing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental cash fl ow information Interest paid Income taxes paid Stock options exercised using common stock for treasury Transfers from loans to other real estate owned and other assets held for sale Years Ended December 31, 2006 2005 2004 69,291 (68,206) 4,600 – 45,000 4,676 – (2,852) (6,741) 1,257 481 47,506 767 49,256 $50,023 $43,197 $5,956 $1,091 31,931 (2,457) 2,000 (3,000) – 7,334 20,619 (1,547) (5,852) 1,561 - 69,090 (1,809) 15,500 3,000 – (463) – (4,691) (4,889) 1,555 - 50,589 77,293 28,735 20,521 (17,262) 37,783 $49,256 $20,521 $28,327 $5,053 – $20,432 $4,149 – $4,217 $605 $690 First Defi ance acquired all of the capital stock ComBanc Inc. and the Genoa Savings and Loan Company for $38.3 million and $11.2 million respectively in 2005. In conjunction with the acquisitions, liabilities were assumed as follows: Fair value of assets acquired Purchase price Liabilities assumed See accompanying notes. ComBanc $213,927 (38,339) $175,588 Genoa $88,077 (11,212) Total $302,004 (49,551) $76,865 $252,453 FIRST DEFIANCE FINANCIAL CORP. 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION First Defi ance Financial Corp. (First Defi ance) is a holding company that conducts business through its two wholly owned subsidiaries, First Federal Bank of the Midwest, Defi ance Ohio (First Federal) and First Insurance & Investments (First Insurance). All signifi cant intercompany transactions and balances are eliminated in consolidation. First Federal is primarily engaged in attracting deposits from the general public through its offi ces and using those and other available sources of funds to originate loans primarily in the counties in which its offi ces are located. First Federal’s traditional banking activities include originating and servicing residential, commercial and consumer loans and providing a broad range of depository and trust services. First Insurance & Investments is an insurance agency that does business in the Defi ance, Ohio area off ering property and casualty, group health, and life insurance and investment and annuity products. 2. STATEMENT OF ACCOUNTING POLICIES Use of Estimates The preparation of consolidated fi nancial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that aff ect the amounts reported in the consolidated fi nancial statements and accompanying notes. Actual results could diff er from those estimates. Signifi cant areas where First Defi ance uses estimates are the determination of the allowance for loan losses, the valuation of mortgage servicing rights and goodwill, and the determination of post-retirement benefi ts. Earnings Per Share Basic earnings per share is net income divided by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share include the dilutive eff ect of additional potential common shares issuable under stock options and stock grants. Unreleased shares held by the Company’s Employee Stock Ownership Plan are not included in average shares for purposes of calculating earnings per share. As shares are released for allocation, they are included in the average shares outstanding. Also see note 18. Comprehensive Income Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on available for sale investment securities and the net unrecognized actuarial losses and unrecognized prior service costs associated with the Company’s Defi ned Benefi t Postretirement Medical Plan. All items included in other comprehensive income are reported net of tax. See also notes 5 and 15. Cash and Cash Equivalents Cash and cash equivalents include amounts due from banks and overnight investments with the Federal Home Loan Bank (FHLB). Cash and amounts due from depository institutions includes required balances at the FHLB and Federal Reserve of approximately $130,000 and $100,000, respectively, at December 31, 2006. Net cash fl ows are reported for customer loan and deposit transactions, interest bearing deposits in other fi nancial institutions, and repurchase agreements. Investment Securities Management determines the appropriate classifi cation of debt securities at the time of purchase and evaluates such designation as of each balance sheet date. Debt securities are classifi ed as held-to-maturity when First Defi ance has the positive intent and ability to hold the securities to maturity and are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity. Debt securities not classifi ed as held-to-maturity and equity securities are classifi ed as available for sale. Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of tax, reported in other comprehensive income until realized. Realized gains and losses, and unrealized losses judged to be other-than-temporary, are included in gains (losses) on securities. Realized gains and losses on securities sold are based on the specifi c identifi cation method. 40 2006 ANNUAL REPORT FHLB Stock As a member of the FHLB System, First Federal is required to own stock of the FHLB of Cincinnati in an amount principally equal to 0.15% of total assets plus an amount of at least 2% but no more than 4% of its non-grandfathered mission asset activity (as defi ned in the FHLB’s regulations). First Federal is permitted to own stock in excess of the minimum requirement. FHLB stock is a restricted equity security that does not have a readily determinable fair value and is carried at cost. It is evaluated for impairment based upon the ultimate recovery of par value. Both cash and stock dividends are reported as income. Loans Receivable Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal amount outstanding, net of deferred loan fees and costs and the allowance for loan losses. Deferred fees net of deferred incremental loan origination costs, are amortized to interest income generally over the contractual life of the loan using the interest method. Mortgage loans originated and intended for sale in the secondary market are classifi ed as loans held for sale and are carried at the lower of aggregate cost or market, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Interest receivable is accrued on loans and credited to income as earned. The accrual of interest on loans 90 days delinquent or impaired is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. The accrual of interest on these loans is generally resumed after a pattern of repayment has been established and the collection of principal and interest is reasonably assured. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans, actual loss experience, current economic events in specifi c industries and geographical areas, and other pertinent factors including general economic conditions. Determination of the allowance is inherently subjective as it requires signifi cant estimates, including the amounts and timing of expected future cash fl ows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience and consideration of economic trends, all of which may be susceptible to signifi cant change. Allocations of the allowance may be made for specifi c loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off . Loan losses are charged off against the allowance when in management’s estimation it is unlikely that the loan will be collected, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors in order to maintain the allowance for loan losses at the level deemed adequate by management. The determination of whether a loan is considered past due or delinquent is based on the contractual payment terms. A loan is impaired when full payment under the loan terms is not expected. Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash fl ows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identifi ed for impairment disclosures. Acquired Loans Valuation allowances for all acquired loans subject to SOP 03-3 refl ect only those losses incurred after acquisition—that is, the present value of cash fl ows expected at acquisition that are not expected to be collected. FIRST DEFIANCE FINANCIAL CORP. 41 The Company acquires loans individually and in groups or portfolios. At acquisition, the Company reviews each loan to determine whether there is evidence of deterioration of credit quality since origination and if it is probable that it will be unable to collect all amounts due according to the loan’s contractual terms. If both conditions exist, the Company determines whether each such loan is to be accounted for individually or whether such loans will be assembled into pools of loans based on common risk characteristics (credit score, loan type, and date of origination). The Company considers expected prepayments, and estimates the amount and timing of undiscounted expected principal, interest, and other cash fl ows (expected at acquisition) for each loan and subsequently aggregated pool of loans. The Company determines the excess of the loan’s or pool’s scheduled contractual principal and contractual interest payments over all cash fl ows expected at acquisition as an amount that should not be accreted (nonaccretable diff erence). The remaining amount— representing the excess of the loan’s cash fl ows expected to be collected over the amount paid—is accreted into interest income over the remaining life of the loan or pool (accretable yield). Over the life of the loan or pool, the Company continues to estimate cash fl ows expected to be collected, and evaluates whether the present value of its loans determined using the eff ective interest rates has decreased and if so, recognizes a loss. The present value of any subsequent increase in the loan’s or pool’s actual cash fl ows or cash fl ows expected to be collected is used fi rst to reverse any existing valuation allowance for that loan or pool. For any remaining increases in cash fl ows expected to be collected, the Company adjusts the amount of accretable yield recognized on a prospective basis over the loan’s or pool’s remaining life. Loan Commitments and Related Financial Instruments Financial instruments include off balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer fi nancing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such fi nancial instruments are recorded when they are funded. Marketing Costs Marketing costs are expensed as incurred. Loss Contingencies Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material eff ect on the fi nancial statements. Dividend Restriction Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company. These restrictions pose no practical limit on the ability of the bank or holding company to pay dividends at historical levels. See Note 20. Mortgage Servicing Rights The total cost of loans originated or purchased is allocated between loans and servicing rights based on the relative fair values of each at the time of sale. The servicing rights capitalized are amortized in proportion to and over the period of estimated servicing income. Mortgage servicing rights are periodically evaluated for impairment. For purposes of measuring impairment, mortgage servicing rights are stratifi ed based on predominant risk characteristics of the underlying serviced loans. These risk characteristics include loan type (fi xed or adjustable rate) and interest rate. Impairment represents the excess of amortized cost of an individual mortgage servicing rights stratum over its fair value, and is recognized through a valuation allowance. Fair values for individual stratum are based on the present value of estimated future cash fl ows using a discount rate commensurate with the risks involved. Estimates of fair value include assumptions about prepayment, default and interest rates, and other factors which are subject to change over time. Changes in these underlying assumptions could cause the fair value of mortgage servicing rights, and the related valuation allowance, to change signifi cantly in the future. 42 2006 ANNUAL REPORT Servicing fee income is recorded for fees earned for serviced loans. The fees are based on a contractual percentage of the outstanding principal and are recorded as income when earned. The amortization of mortgage servicing rights is netted with loan servicing fee income and along with mortgage loans gain on sale are reported collectively as mortgage banking income on the consolidated statements of income. Real Estate and Other Assets Held for Sale Other assets held for sale are comprised of properties acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. These properties are carried at the lower of cost or fair value, less estimated costs to dispose, at the time of foreclosure or insubstance foreclosure. Losses arising from the acquisition of such property are charged against the allowance for loan losses at the time of acquisition. If fair value declines subsequent to foreclosure, the property is written down against expense. Costs after acquisition are expensed. Premises and Equipment and Long Lived Assets Premises and equipment are carried at cost less accumulated depreciation and amortization computed principally by the straight-line method over the following estimated useful lives: Buildings and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 to 50 years Furniture, fi xtures and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 to 15 years Long-lived assets to be held and those to be disposed of and certain intangibles are evaluated for impairment using the guidance provided by Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for Long-Lived Assets to be Disposed of, relative to accounting for long-lived assets and accounting for long-lived assets to be disposed of either through sale, abandonment, exchange or a distribution to owners. Income Taxes Deferred income taxes refl ect the temporary tax consequences on future years of diff erences between the tax basis and fi nancial statement amounts of assets and liabilities at each year-end. Deferred tax assets and liabilities are refl ected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. An eff ective tax rate of 35% is used to determine after-tax components of other comprehensive income (loss) included in the statements of stockholders’ equity. Business Combinations Business combinations, which have been accounted for under the purchase method of accounting, include the results of operations of the acquired business from the date of acquisition. Net assets of companies acquired are recorded at their estimated fair value as of the date of acquisition. Goodwill and Other Intangibles Core deposit intangibles are a measure of the value of checking and savings deposits acquired in business combinations accounted for under the purchase method. Core deposit intangibles are amortized on an accelerated basis over the estimated lives of the existing deposit relationships acquired, but not exceeding 10 years. Customer Relationship Intangibles are a measure of the value of customer relationships accounted for under the purchase method. The Customer Relationship Intangible is amortized over the estimated contractual life of the existing relationship and is limited to 10 years. Goodwill is the excess of the purchase price over the fair value of the assets and liabilities and identifi able intangible assets of companies acquired through business combinations accounted for under the purchase method. Goodwill is evaluated at the business unit level, which for First Defi ance are First Federal Bank and First Insurance. At both December 31, 2006 and December 31, 2005, goodwill at First Federal totaled $31.3 million. At December 31, 2006 and 2005, core deposit intangibles had a gross carrying value of $4.5 million and accumulated amorization of $1.5 million and $873,000 respectively. At December 31, 2006 and 2005, customer relationship intangibles had a gross carrying value of $574,000 and accumulated amoization of $154,000 and $62,000 respectively. At both December 31, 2006 and 2005 goodwill totaled $3.8 million at First Insurance. FIRST DEFIANCE FINANCIAL CORP. 43 Core deposit intangibles are amortized over the life of the related deposits, not to exceed ten years. Amortization expense for core deposit intangibles was $627,000, $693,000 and $110,000 in 2006, 2005 and 2004 respectively. Customer relationship intangibles are amortized over the estimated life of the customer relationship, not to exceed 10 years. Amortization expense for customer relationship intangibles was $92,000 and $62,000 in 2006 and 2005. Amortization of intangibles is expected to total, $573,000, $469,000, $410,000, $402,000 and $402,000 in 2007, 2008, 2009, 2010 and 2011 respectively. Goodwill is not subject to amortization but its value is assessed annually to determine if there is any impairment of value. Settlement of Contingent Liability First Defi ance sold its former Leader Mortgage subsidiary in 2002. During 2004, the Purchaser of that unit asserted certain claims against First Defi ance under the Purchase and Sale Agreement. First Defi ance settled all matters related to the sale of Leader Mortgage in the 2004 third quarter and it recognized a pre-tax charge of $1.9 million, which is included in the 2004 Consolidated Statement of Income. Stock Compensation Plans Eff ective January 1, 2006, First Defi ance adopted Statement of Financial Accounting Standard (SFAS) No. 123(R), Share- based Payment, which requires recognition of compensation cost for all stock-based awards to be based on the grant-date fair value over the service period of stock-based awards, which is usually the same as the vesting period. The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with the Company’s valuation methodology previously utilized for options in footnote disclosures required under SFAS No. 123. The exercise price of stock grants has been and will continue to be based on the market value of the stock at the date of grant. The Company has adopted SFAS No. 123(R) using the modifi ed prospective method, which provides for no retroactive application to prior periods and no cumulative eff ect adjustment to equity accounts. It also provides for expense recognition, for both new and existing stock-based awards, as the required services are rendered. SFAS No. 123(R) also amends SFAS No. 95, Statement of Cash Flows and requires tax benefi ts relating to excess stock-based compensation deductions to be presented in the statement of cash fl ows as fi nancing cash infl ows. In accordance with Staff Accounting Bulletin No. 107 (SAB 107) issued by the Securities and Exchange Commission, stock-based compensation has been classifi ed in the same expense category as cash compensation and has been included in the Compensation and Benefi ts line of the Consolidated Statements of Income for 2006. Prior to January 1, 2006, the Company accounted for stock-based compensation expense using the intrinsic method as required by Accounting Principles Board (ABP) Opinion No. 25, Accounting for Stock Issued to Employees as permitted by SFAS No. 123 Accounting for Stock-Based Compensation. No compensation cost for stock options was refl ected in net income for the years ended December 31, 2005 and 2004, as all options granted had an exercise price equal to the market price of the underlying common stock at the date of grant. The adoption of SFAS No. 123(R) had the following impact on reported amounts compared with amounts that would have been reported using the intrinsic value method under previous accounting. Income before income taxes Income taxes Net income Basic earnings per share Diluted earnings per share Cash fl ow from operating activities Cash fl ow from fi nancing activities Using Previous Accounting 2006 SFAS 123(R) Adjustments As Reported (In Thousands, Except Per Share Amounts) $23,322 7,454 $15,868 $2.26 $2.22 $22,219 $47,025 $(271) (3) (268) $(.04) $(.04) $(481) $481 $23,051 7,451 $15,600 $2.22 $2.18 $21,738 $47,506 44 2006 ANNUAL REPORT The following tables illustrate the eff ect on net income and earnings per share if expense had been measured using the fair value recognition provisions of SFAS 123(R) for the years ended December 31, 2005 and 2004: 2005 2004 (In Thousands, Except Per Share Amounts) As Reported Pro Forma Adjustments Income before income taxes Income taxes Net income Basic earnings per share Diluted earnings per share $17,823 5,853 $11,970 $1.75 $1.69 $(272) (4) $(268) $(.04) $(.04) Pro Forma as if Under SFAS 123(R) $17,551 5,848 $11,703 $1.71 $1.65 As Reported Pro Forma Adjustments $15,598 4,802 $10,796 $1.77 $1.69 $(221) (5) $(216) $(.03) $(.03) Pro Forma as if Under SFAS 123(R) $15,377 4,797 $10,580 $1.74 $1.66 The fair value of stock options granted during 2006, 2005 and 2004 was determined at the date of grant using the Black- Scholes option-pricing model and utilized the following assumptions: Risk free interest rate Weighted average expected life Volatility factors of expected market price of stock Dividend yield 2006 5.16% 6.5 years 22.4% 3.62% December 31, 2005 4.40% 10 years 22.4% 3.39% 2004 4.73% 10 years 22.9% 2.96% The expected average risk-free rate is based on the U.S. Treasury yield curve in eff ect at the time of grant for periods corresponding with the expected life of the option. The expected average life represents the period of time that options granted are expected to be outstanding giving consideration to vesting schedules, historical exercise and forfeiture patterns. Expected volatility is based on historical price fl uctuations of the Company’s common stock. The expected dividend yield is based on historical dividend payments and stock prices. Bank Owned Life Insurance The Company has purchased life insurance policies on certain executives and senior managers. Company owned life insurance is recorded at its cash surrender value, or the amount that can be realized. Postretirement Benefi ts The Company sponsors a defi ned benefi t postretirement plan that provides medical benefi ts to eligible retirees. Postretirement benefi t expense is accrued based on the expected future cost of providing benefi ts during the years service is rendered by the employee. Fair Value of Financial Instruments Fair values of fi nancial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of signifi cant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could signifi cantly aff ect the estimates. Operating Segments While the chief decision-makers monitor the revenue streams of the various products and services, there is one identifi able segment and the remaining identifi able segments are not material and operations are managed and fi nancial performance is evaluated on a Company-wide basis. Accordingly, all of the fi nancial service operations are considered by management to be aggregated in one reportable segment. Reclassifi cations Some items in the prior year fi nancial statements were reclassifi ed to conform to the current presentation. FIRST DEFIANCE FINANCIAL CORP. 45 Adoption of New Accounting Standards Accounting for Defi ned Benefi t Pension and Other Postretirement Plans In September 2006, the FASB issued SFAS No. 158, Employer’s Accounting for Defi ned Benefi t Pension and Other Postretirement Plans, an amendment of SFAS Nos. 87, 88, 106, and 132(R) (“Statement 158”). Statement 158 requires plan sponsors of defi ned benefi t pension and other postretirement benefi t plans (collectively, “postretirement benefi t plans”) to recognize the funded status of their postretirement benefi t plans in the statement of fi nancial position, measure the fair value of plan assets and benefi t obligations as of the date of the fi scal year-end statement of fi nancial position, and provide additional disclosures. On December 31, 2006, the Company adopted the recognition and disclosure provisions of Statement 158. The eff ect of adopting Statement 158 on the Company’s fi nancial condition at December 31, 2006 has been included in the accompanying consolidated fi nancial statements. Statement 158 did not have an eff ect on the Company’s consolidated fi nancial condition at December 31, 2005 and 2004. Statement 158’s provisions regarding the change in the measurement date of postretirement benefi t plans are not applicable as the Company already uses a measurement date of December 31 for its postretirement medical plan. See Note 15 for further discussion of the eff ect of adopting Statement 158 on the Company’s consolidated fi nancial statements. Eff ect of Newly Issued but Not Yet Eff ective Accounting Standards In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140. This Statement provides: 1) revised guidance on when a servicing asset and servicing liability should be recognized; 2) requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable; 3) permits an entity to elect to measure servicing assets and servicing liabilities at exercise price each reporting date and report changes in fair value in earnings in the period in which the changes occur; 4) upon initial adoption, permits a onetime reclassifi cation of available-for-sale securities to trading securities for securities which are identifi ed as off setting the entity’s exposure to changes in the fair value of servicing assets or liabilities that a servicer elects to subsequently measure at fair value; and 5) requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of fi nancial position and additional footnote disclosures. This standard is eff ective as of the beginning of an entity’s fi rst fi scal year that begins after September 15, 2006 with the eff ects of initial adoption being reported as a cumulative-eff ect adjustment to retained earnings. The adoption of this statement will not have a material impact on consolidated fi nancial position or results of operation. Fair Value Measurements In September 2006, FASB issued Statement No. 157, Fair Value Measurements. This Statement defi nes fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifi es assumptions about risk and the eff ect of a restriction on the sale or use of an asset. The standard is eff ective for fi scal years beginning after November 15, 2007. The Company has not yet completed its evaluation of the impact of the adoption of this standard. Accounting for Uncertainty in Income Taxes In July 2006, FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No, 109 (“FIN 48”), which prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classifi cation, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is eff ective for fi scal years beginning after December 15, 2006. The Company has adopted FIN 48 eff ective January 1, 2007. The eff ect of adoption of FIN 48 was not material. 46 2006 ANNUAL REPORT Accounting for Deferred Compensation and Postretirement Benefi t Aspects of Endorsement Split-Dollar Life Insurance Arrangements In September 2006, the FASB Emerging Issues Task Force (“EITF”) fi nalized Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefi t Aspects of Endorsement Split-Dollar Life Insurance Arrangements. This issue requires that a liability be recorded during the service period when a spilt-dollar life insurance agreement continues after participants’ employment or retirement. The required accrued liability will be based on either the post-employment benefi t cost for the continuing life insurance or based on the future death benefi t depending on the contractual terms of the underlying agreement. This issue is eff ective for fi scal years beginning after December 15, 2007. The Company does not have any split-dollar life insurance agreements that continue after participants’ employment. Accounting for Purchases of Life Insurance In September 2006, the FASB EITF fi nalized Issue No. 06-5, Accounting for Purchases of Life Insurance – Determining the Amount That Could be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance). This issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract. It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis. Lastly, the issue discusses whether the cash surrender value should be discounted when the policyholder is contractually limited in its ability to surrender a policy. This issue is eff ective for fi scal years beginning after December 15, 2006. The adoption of this issue will not have a material impact on the fi nancial statements. 3. ACQUISITIONS On April 8, 2005, The Company acquired the Genoa Savings and Loan Company (“Genoa”), a savings and loan headquartered in Genoa, Ohio for a total purchase price of $11.2 million including direct acquisition costs of $220,000. Genoa shareholders received cash of $11.0 million in the all-cash transaction. On January 21, 2005, First Defi ance acquired ComBanc, Inc. (“ComBanc”), a bank-holding company and its wholly- owned subsidiary, the Commercial Bank by acquiring all of the outstanding capital stock of ComBanc for an aggregate purchase price of $38.3 million, including direct acquisition costs of $542,000. ComBanc shareholders received 733,775 shares of First Defi ance stock and cash of $18.7 million. The acquisitions enhanced First Defi ance’s community bank operations by giving them a larger presence in the Toledo, Ohio market area following the Genoa acquisition and allowing them to expand into the Allen County, Ohio area, which was adjacent to existing markets, following the ComBanc acquisition. The value of the common stock issued for the ComBanc acquisition was determined based on an average of the closing price for two days before and after the date the fi nal exchange terms were determined. The following table presents the allocation of the purchase price, including direct acquisition costs, for the Genoa and ComBanc acquisitions to assets acquired and liabilities assumed, based on their fair values: Cash and cash equivalents Investment securities Loans, net of allowances for loan losses Premises and equipment Goodwill and other intangibles Other assets Total assets acquired Deposits Borrowings Other liabilities Total liabilities acquired Net assets acquired Genoa ComBanc (In Thousands) $10,600 15 66,905 2,345 5,501 2,711 88,077 76,786 - 79 76,865 $11,212 $71,915 502 117,494 4,106 15,522 4,388 213,927 163,668 9,863 2,057 175,588 $38,339 FIRST DEFIANCE FINANCIAL CORP. 47 The following (unaudited) pro forma consolidated results of operations for 2005 have been prepared as if the acquisitions of ComBanc and Genoa occurred as of the beginning of that year. Net interest income Net income Net income per share – basic Net income per share – Diluted Year Ended December 31, 2005 2004 (In Thousands, Except Per Share Amounts) $44,085 $10,057 $1.47 $1.42 $48,542 $13,775 $2.00 $1.93 The pro forma results include amortization of fair value adjustments on loans, deposits and FHLB advances, amortization of newly created intangibles, and post-merger acquisition related charges. The pro forma average common shares outstanding used to compute the pro forma basic and diluted income per share includes adjustments for shares issued for the ComBanc acquisition. The pro forma results presented do not include $3.5 million of acquisition related costs included in First Defi ance’s 2005 income statement, nor do they refl ect cost savings or revenue enhancements anticipated from the acquisitions. These pro forma results are not necessarily indicative of what actually would have occurred if the acquisitions had been completed as of the beginning of each period presented, nor are they necessarily indicative of future results. On February 28, 2007 The Company completed the acquisition of Huber, Harger, Welt & Smith Insurance Agency, Inc., a property and casualty insurance agency located in Bowling Green, OH for approximately 77,000 shares of First Defi ance Financial Corp. common stock. Disclosure of pro forma results of this aquisition is immaterial to the Company’s consolidated fi nancial statements. 4. EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share: Numerator for basic and diluted earnings per share net income Denominator: Denominator for basic earnings per share weighted-average shares Eff ect of dilutive securities: Employee stock options Unvested Management Recognition Plan stock Dilutive potential common shares Denominator for diluted earnings per share adjusted weighted-average shares Basic earnings per share Diluted earnings per share 2006 2005 2004 (In Thousands, Except Per Share Amounts) $15,600 $11,970 $10,796 7,028 135 - 135 7,163 $2.22 $2.18 6,843 252 1 253 7,096 $1.75 $1.69 6,094 275 2 277 6,371 $1.77 $1.69 Shares under option of 149,053 in 2006, 3,000 in 2005 and 3,000 in 2004 were excluded from the diluted earnings per share calculation as they were anti-dilutive. 48 2006 ANNUAL REPORT 5. INVESTMENT SECURITIES The following fair value of available for sale securities and the related unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows: At December 31, 2006 Obligations of U.S. government corporations and agencies Mortgage-backed securities REMICs Collateralized mortgage obligations Trust preferred stock Obligations of state and political subdivisions Totals At December 31, 2005 Obligations of U.S. government corporations and agencies Mortgage-backed securities REMICs Collateralized mortgage obligations Trust preferred stock Obligations of state and political subdivisions Totals Amortized Cost $36,108 18,595 3,071 20,099 8,116 24,840 $110,829 $41,173 19,959 998 20,002 7,725 23,257 $113,114 Gross Unrealized Gains Gross Unrealized Losses (In Thousands) $106 23 – 52 82 418 $681 $217 35 – 1 76 574 $903 $(171) (276) (11) (346) (20) (4) $(828) $(325) (263) (7) (330) – (13) $(938) The amortized cost, unrecognized gains and losses, and fair value of securities held to maturity were as follows: At December 31, 2006 FHLMC certifi cates FNMA certifi cates GNMA certifi cates Obligations of states and political subdivisions Totals At December 31, 2005 FHLMC certifi cates FNMA certifi cates GNMA certifi cates Obligations of states and political subdivisions Totals Amortized Cost Gross Unrecognized Gains Gross Unrecognized Losses (In Thousands) $272 614 195 360 $1,441 $333 756 241 445 $1,775 $8 5 1 41 $55 $11 4 – 59 $74 $ – (4) – – $(4) $ – (3) (1) – $(4) Fair Value $36,043 18,342 3,060 19,805 8,178 25,254 $110,682 $41,065 19,731 991 19,673 7,801 23,818 $113,079 Fair Value $280 615 196 401 $1,492 $344 757 240 504 $1,845 FIRST DEFIANCE FINANCIAL CORP. 49 The amortized cost and fair value of securities at December 31, 2006 by contractual maturity are shown below. Expected maturities will diff er 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, which are not due at a single maturity date, have been allocated over maturity groupings based on the weighted-average contractual maturities of the underlying collateral. The mortgage-backed securities may mature earlier than their weighted-average contractual maturities because of principal prepayments. Due in one year or less Due after one year through fi ve years Due after fi ve years through ten years Due after ten years Available-for-Sale Held-to-Maturity Amortized Cost $17,968 51,804 18,270 22,787 $110,829 Fair Value Amortized Cost (In Thousands) $17,791 51,571 18,288 23,032 $110,682 $382 809 226 24 $1,441 Fair Value $388 842 238 24 $1,492 Investment securities with carrying amounts of $85.0 million and $82.3 million at December 31, 2006 and 2005, respectively, were pledged as collateral on public deposits, securities sold under repurchase agreements and FHLB advances and for other purposes required or permitted by law. The following table summarizes First Defi ance’s securities that were in an unrealized loss position at December 31, 2006 and December 31, 2005: Duration of Unrealized Loss Position Less than 12 Months 12 Month or Longer Total Fair Value Gross Unrealized Loss Fair Value Gross Unrealized Loss (In Thousands) Fair Value Unrealized Loses At December 31, 2006 Available-for-sale securities: $2,484 Obligations of U.S. govt. corps. and agencies 1,936 Mortgage-backed securities Collateralized mortgage obligations and REMICs 3,545 1,630 Obligations of state and political subdivisions 1,906 Trust Preferred stock Held to maturity securities: Mortgage-backed securities 157 $(7) (12) (12) (4) (20) (3) $15,403 11,471 16,320 39 − $ (164) (264) (345) − − $17,887 13,407 19,865 1,669 1,906 207 (1) 364 Total temporarily impaired securities $11,658 $(58) $43,440 $(774) $55,098 At December 31, 2005 Available-for-sale securities: $16,873 Obligations of U.S. govt. corps. and agencies Mortgage-backed securities 9,488 Collateralized mortgage obligations and REMICs 5,780 Obligations of state and political subdivisions 1,368 Held to maturity securities: Mortgage-backed securities 320 $(173) (151) (62) (13) $8,845 4,352 11,687 20 $ (152) (112) (275) − $25,718 13,840 17,467 1,388 (1) 177 (3) 497 Total temporarily impaired securities $33,829 $(400) $25,081 $(542) $58,910 $(171) (276) (357) (4) (20) (4) $(832) $(325) (263) (337) (13) (4) $(942) The above securities all have fi xed interest rates and defi ned maturities. Their fair value is sensitive to movements in market interest rates. First Defi ance has the ability and intent to hold these investments for a time necessary to recover the amortized cost without impacting its liquidity position. Realized gains from the sale of investment securities totaled $73,000, $1.2 million and $1.4 million ($47,000, $798,000 and $927,000 after tax) in 2006, 2005 and 2004 respectively. Realized losses from securities transactions were $5,000 ($3,000 after tax) in 2005. There were no realized losses during 2006 and 2004. Management deemed that the value of certain investments in trust preferred stock was impaired in 2006 and wrote the investment down by $75,000 ($49,000 after tax). 50 2006 ANNUAL REPORT 6. COMMITMENTS AND CONTINGENT LIABILITIES Loan Commitments Loan commitments are made to accommodate the fi nancial needs of First Federal’s customers; however, there are no long-term, fi xed-rate loan commitments that result in market risk. Standby letters of credit commit the Company to make payments on behalf of customers when certain specifi ed future events occur. They primarily are issued to facilitate customers’ trade transactions. 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 on December 31 was as follows (in thousands): Loan commitments Standby letters of credit Total 2006 $260,349 16,869 $277,218 2005 $275,982 8,785 $284,767 Lease Agreements The Company has entered into lease agreements covering First Insurance’s main offi ce, one banking center location and the land on which one banking center was constructed and numerous stand-alone Automated Teller Machine sites with varying terms and options to renew. Future minimum commitments under non-cancelable operating leases are as follows (in thousands): 2007 2008 2009 2010 2011 Thereafter Total $312 217 224 196 150 3,114 $4,213 Rentals under operating respectively. leases amounted to $353,000, $329,000, and $237,000, in 2006, 2005, and 2004, 7. LOANS RECEIVABLE Loans receivable consist of the following at December 31: Real estate loans: Secured by single family residential Secured by multi-family residential Secured by non-residential real estate Construction Other loans: Automobile Commercial Home equity and improvement Other Total loans Deduct: Undisbursed loan funds Net deferred loan origination fees and costs Allowance for loan losses Totals FIRST DEFIANCE FINANCIAL CORP. 51 December 31, 2006 2005 (In Thousands) $250,808 57,263 522,597 17,339 848,007 33,093 232,914 122,789 10,677 399,473 $275,497 50,040 501,943 21,173 848,653 37,584 171,289 113,000 17,713 339,586 1,247,480 1,188,239 (6,409) (1,182) (13,579) (8,782) (1,303) (13,673) $1,226,310 $1,164,481 Changes in the allowance for loan losses were as follows: Allowance at beginning of year Provision for credit losses Acquired in acquisitions Charge-off s Recoveries Net charge-off s Ending allowance Years Ended December 31, 2006 2005 2004 $13,673 1,756 − 2,276 426 1,850 $13,579 (In Thousands) $9,956 1,442 3,027 1,054 302 752 $13,673 $8,844 1,548 − 685 249 436 $9,956 Unpaid balances of loans with contractual payments delinquent 90 days or more totaled $7.3 million at December 31, 2006 and $5.0 million at December 31, 2005. 52 2006 ANNUAL REPORT Impaired loans having recorded investments of $4.2 million at December 31, 2006 and $822,000 at December 31, 2005, have been recognized in conformity with FASB Statement No. 114, as amended by FASB Statement No. 118. The average recorded investment in impaired loans during 2006, 2005 and 2004 was $4.4 million, 1.1 million, and $732,000 respectively. The total allowance for loan losses related to these loans was $969,000 and $380,000 at December 31, 2006 and 2005. There was $111,000, $61,000 and $36,000 of interest received and recorded in income during 2006, 2005 and 2004 respectively on impaired loans during the impairment period. Loans having carrying values of $4.2 million and $605,000 were transferred to real estate and other assets held for sale in 2006 and 2005, respectively. At December 31, 2006 and December 31, 2005, non-performing loans were $7.3 million and $5.0 million respectively. There was no accrued interest recorded on impaired or non-performing loans at December 31, 2006 or 2005. Also there was $562,000 of loans deemed impaired for which there was no allowance for loan loss allocation at December 31, 2006. There were no loans impaired for which there was no allowance for loan loss allocation at December 31, 2005. First Defi ance is not committed to lend additional funds to debtors whose loans have been modifi ed. Certain loans acquired in the ComBanc and Genoa acquisitions had evidence that the credit quality of the loan had deteriorated since its origination and in management’s assessment at the acquisition date it was probable that First Defi ance would be unable to collect all contractually required payments due. In accordance with American Institute of Certifi ed Public Accountants Statement of Position 03-3 – Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3), these loans have been recorded based on management’s estimate of the fair value of the loans. Detail of these loans are as follows: Amounts recorded in 2005 acquisitions: Genoa ComBanc Total acquired Principal payments received Loans charged off Loan accretion recorded Balance at December 31, 2005 Principal payments received Loans charged off Additional provision for loan loss Loan accretion recorded Balance at December 31, 2006 Contractual Amount Receivable Impairment Discount (In Thousands) Recorded Loan Receivable $1,547 3,387 4,934 (139) (169) − $4,626 (129) (198) (189) − $4,110 $826 1,362 2,188 − (169) − $2,019 − (198) − (138) $1,683 $721 2,025 2,746 (139) − − $2,607 (129) − (189) 138 $2,427 FIRST DEFIANCE FINANCIAL CORP. 53 Interest income on loans is as follows: Commercial and non-residential real-estate loans Mortgage loans Other loans Totals Years Ended December 31, 2006 2005 2004 $63,140 10,526 12,547 $86,213 (In Thousands) $49,869 9,549 10,290 $69,708 $34,506 6,272 6,567 $47,345 There are no industry concentrations (exceeding 10% of gross loans) in First Federal’s non-residential real estate and commercial loan portfolios. The Company’s loans receivable are primarily to borrowers in the Northwest Ohio, Northeast Indiana or Southeast Michigan areas. Loans to executive offi cers and directors and their affi liates during 2006 were as follows (in thousands): Beginning balance New loans Eff ect of change in composition of related parties Repayments Ending balance All such loans are paying as agreed. $3,213 5,204 (2) (4,077) $4,338 54 2006 ANNUAL REPORT 8. MORTGAGE BANKING Net revenues from the sales and servicing of mortgage loans consisted of the following: Gain from sale of mortgage loans Mortgage loan servicing revenue (expense): Mortgage loan servicing revenue Amortization of mortgage servicing rights Mortgage servicing rights valuation adjustments Net revenue from sale and servicing of mortgage loans Years Ended December 31, 2005 2006 2004 $2,424 1,575 (612) 2 966 $3,389 (In Thousands) $2,291 1,421 (784) 417 1,054 $3,345 $2,350 1,126 (704) (1) 421 $2,771 The unpaid principal balance of residential mortgage loans serviced for third parties was $665.4 million at December 31, 2006 compared to $602.5 million at December 31, 2005. Activity for capitalized mortgage servicing rights and the related valuation allowance follows: Mortgage servicing assets: Balance at beginning of period Loans sold, servicing retained NBV of servicing assets acquired Impairment deemed permanent Amortization Carrying value before valuation allowance at end of period Valuation allowance: Balance at beginning of period Impairment recovery (charges) Impairment deemed permanent Balance at end of period Net carrying value of MSRs at end of period Fair value of MSRs at end of period Years Ended December 31, 2006 2005 2004 (In Thousands) $5,145 1,076 - - (612) 5,609 (82) 2 - (80) $5,529 $6,684 $4,205 906 926 (108) (784) 5,145 (607) 417 108 (82) $5,063 $6,471 $4,037 872 − − (704) 4,205 (606) (1) − (607) $3,598 $3,743 Amortization of mortgage servicing rights is computed based on payments and payoff s of the related mortgage loans serviced. Estimates of future amortization expense are not easily estimable. FIRST DEFIANCE FINANCIAL CORP. 55 The Company’s servicing portfolio is comprised of the following: Investor Fannie Mae Freddie Mac Other Totals December 31, 2006 2005 Number of Loans Principal Outstanding Number of Loans Principal Outstanding (Dollars In Thousands) 724 7,345 28 8,097 $52,807 612,024 608 $665,439 601 6,858 52 7,511 $39,094 562,199 1,218 $602,511 Signifi cant assumptions at December 31, 2006 used in determining the value of MSRs include a weighted average prepayment rate of 230 PSA and a weighted average discount rate of 8.90%. A sensitivity analysis of the current fair value to immediate 10% and 20% adverse changes in those assumptions as of December 31, 2006 is presented below. These sensitivities are hypothetical. Changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, the eff ect of a variation in a particular assumption on the fair value of the MSR is calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, changes in mortgage interest rates, which drive changes in prepayment rate estimates, could result in changes in the discount rates), which might magnify or counteract the sensitivities. Assumption: Decline in fair value from increase in prepayment rate Declines in fair value from increase in discount rate 10% Adverse Change 20% Adverse Change (In Thousands) $287 190 $551 370 56 2006 ANNUAL REPORT 9. PREMISES AND EQUIPMENT Premises and equipment are summarized as follows: Cost: Land Buildings Leasehold improvements Furniture, fi xtures and equipment Construction in process Less allowances for depreciation and amortization December 31, 2006 2005 (In Thousands) $5,337 28,663 416 17,313 896 52,625 17,726 $34,899 $5,071 25,764 416 15,649 1,020 47,920 15,491 $32,429 Depreciation expense was $2.7 million, $2.4 million and $1.8 million for the years ended December 31, 2006, 2005 and 2004 respectively. The Company has entered into commitments to construct an operations center with a total estimated cost of $8.5 million. At December 31, 2006, $510,000 of costs were incurred and included in the construction in process and $282,000 of costs were incurred for the acquisition of land associated with this project. FIRST DEFIANCE FINANCIAL CORP. 57 10. DEPOSITS The following schedule sets forth interest expense by type of savings deposit: Years Ended December 31, 2005 2006 Checking and money market accounts Savings accounts Certifi cates of deposit Less interest capitalized Totals $7,052 276 25,974 33,302 (29) $33,273 (In Thousands) $3,264 239 17,119 20,622 (7) $20,615 2004 $1,722 134 11,100 12,956 (6) $12,950 At December 31, 2006, accrued interest payable on deposit accounts amounted to $1,867,000, which was comprised of $1,651,000 and $216,000 for certifi cates of deposit and checking and money market accounts respectively. A summary of deposit balances is as follows: Non-interest bearing checking accounts Interest bearing checking and money market accounts Savings deposits Retail certifi cates of deposit less than $100,000 Retail certifi cates of deposit greater than $100,000 Brokered or national certifi cates of deposit December 31, 2006 2005 (In Thousands) $106,328 306,003 74,491 493,594 140,392 17,637 $103,498 276,558 82,766 408,384 161,305 36,990 $1,138,445 $1,069,501 Scheduled maturities of certifi cates of deposit at December 31, 2006 are as follows (in thousands): 2007 2008 2009 2010 2011 2012 and thereafter Total $571,964 70,242 5,513 2,258 1,189 457 $651,623 At December 31, 2006 and 2005, deposits of $274.1 million and $303.3 million, respectively, were in excess of the $100,000 Federal Deposit Insurance Corporation insurance limit. At December 31, 2006 and 2005, $39.1 million and $42.4 million, respectively, in investment securities were pledged as collateral against public deposits for certifi cates in excess of $100,000 and an additional $39.7 million and $38.7 million of securities were pledged at December 31, 2006 and December 31, 2005, respectively as collateral against deposits from private entities in excess of $100,000. Also, First Federal holds $10.8 million in depository bonds at December 31, 2006 with governmental entities, which can be pledged as collateral against public deposits in excess of $100,000. 58 2006 ANNUAL REPORT 11. ADVANCES FROM FEDERAL HOME LOAN BANK First Federal has the ability to borrow funds from the FHLB. First Federal pledges its single-family residential mortgage loan portfolio, certain investment securities and certain multi-family or non-residential real estate loans as security for these advances. Advances secured by investment securities must have collateral of at least 105% of the borrowing. Advances secured by residential mortgages must have collateral of at least 125% of the borrowings. Advances secured by multi- family or non-residential real estate loans securities must have 300% collateral coverage. The total level of borrowing is also limited to 50% of total assets and at least 50% of the borrowings must be secured by either one-to-four family residential mortgages or investment securities. Total loans pledged to the FHLB at December 31, 2006 and December 31, 2005 were $472.2 million and $465.9 million respectively. First Federal has a maximum potential to acquire advances of approximately $212.9 million from the FHLB at December 31, 2006. At year-end, advances from the FHLB were as follows: Principal Terms Advance Amount (In Thousands) Range of Maturities Weighted Average Interest Rate December 31, 2006 Short-term borrowings Single maturity fi xed rate advances Single maturity LIBOR based advances Putable advances Strike-rate advances Amortizable mortgage advances December 31, 2005 Short-term borrowings Single maturity fi xed rate advances Putable advances Strike-rate advances Amortizable mortgage advances $33,100 Overnight 10,000 45,000 45,000 27,000 2,128 $162,228 $28,500 10,000 111,000 27,000 4,460 $180,960 December 2008 March 2011 to November 2011 September 2010 to November 2013 March 2011 to February 2013 March 2008 to December 2015 Overnight December 2008 December 2008 to November 2013 March 2011 to February 2013 March 2008 to December 2015 4.10% 4.94% 5.36% 5.25% 4.18% 3.28% 4.12% 4.94% 4.77% 4.18% 3.94% Putable advances are callable at the option of the FHLB on a quarterly basis. Strike rate advances are callable at the option of the FHLB only when three-month LIBOR rates exceed the agreed upon strike rate in the advance contract. Such strike rates range from 7.5% to 8.0%. When called, First Defi ance has the option of paying off these advances, or converting them to variable rate advances at the three month LIBOR rate. First Defi ance has three advances totaling $45 million outstanding at December 31, 2006 that were converted from callable advances. These advances can be paid in full without penalty at any quarterly repricing date. FIRST DEFIANCE FINANCIAL CORP. 59 Estimated future minimum payments by fi scal year based on maturity date and current interest rates are as follows (in thousands): 2007 2008 2009 2010 2011 Thereafter Total minimum payments Less amounts representing interest Totals $7,420 16,780 6,065 15,869 67,384 45,931 159,449 30,357 $129,092 First Defi ance also utilizes short-term advances from the FHLB to meet cash fl ow needs and for short-term investment purposes. First Defi ance borrows short-term advances under a variety of programs at FHLB. At December 31, 2006, $33.1 million was outstanding under First Defi ance’s REPO Advance line of credit. The total available under the REPO Advance line is $100.0 million. In addition, First Defi ance has $15.0 million available under a Cash Management Advance line of credit and there were no borrowings against that line at December 31, 2006 or 2005. Amounts are generally borrowed under the Cash Management and REPO lines on an overnight basis. Amounts available under the various lines are also subject to the Company’s overall borrowing limitations. Information concerning short-term advances is summarized as follows: Average daily balance during the year Maximum month-end balance during the year Average interest rate during the year Years Ended December 31, 2006 2005 (Dollars In Thousands) $40,104 57,500 5.10% $14,313 45,000 3.79% 12. JUNIOR SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST As of December 31, 2006, the Company sponsored an affi liated trust, First Defi ance Statutory Trust I (the Trust Affi liate), that issued $20 million of Guaranteed Capital Trust Securities (Trust Preferred Securities). In connection with this transaction, the Company issued $20.6 million of Junior Subordinated Deferrable Interest Debentures (Subordinated Debentures) to the Trust Affi liate. The Trust Affi liate 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 the Trust Affi liate are the sole assets of the trust. Distributions on the Trust Preferred Securities issued by the Trust Affi liate 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 the Trust was 6.74% and 5.87% as of December 31, 2006 and 2005 respectively. The Trust Preferred Securities are subject to mandatory redemption, in whole or in part, upon repayment of the Subordinated Debentures. The Company has entered into an agreement that fully and unconditionally guarantees the Trust Preferred Securities subject to the terms of the guarantee. The Trust Preferred Securities and Junior Debentures may be redeemed by the issuer at par after October 28, 2010. The Junior Debentures mature on December 15, 2035. 60 2006 ANNUAL REPORT 13. NOTES PAYABLE AND OTHER SHORT-TERM BORROWINGS Total short term borrowings, revolving and term debt is summarized as follows: Securities sold under agreement to repurchase Amounts outstanding at year-end Year-end interest rate Average daily balance during year Maximum month-end balance during the year Average interest rate during the year Revolving line of credit facilities to fi nancial institutions Average daily balance during year Maximum month-end balance during the year Average interest rate during the year Years Ended December 31, 2006 2005 (Dollars In Thousands) $30,424 2.98% 20,318 30,424 2.84% $80 − 5.13% $25,748 2.68% 17,718 25,748 2.18% $301 43,799 2.25% As of December 31, 2006, First Defi ance had the following line of credit facilities available for short-term borrowing purposes: A $15 million revolving line of credit facility with a fi nancial institution. The facility is unsecured and has an interest rate of fed funds rate plus 0.45%. There were no amounts outstanding on the line at December 31, 2006 or 2005. The maximum borrowed at any point in time under the line was $0 and $4.0 million in 2006 and 2005, respectively. The average balance outstanding for the year was $0 and $67,000 in 2006 and 2005, respectively. A $20 million fed funds line of credit with a fi nancial institution. The line is unsecured and has an interest rate of the institution’s fed funds rate. There were no amounts outstanding on the line at December 31, 2006 and 2005. The maximum borrowed at any point in time under the line was $20.0 million in both 2006 and 2005, and the average balance outstanding was $80,000 and $554,000 in 2006 and 2005, respectively. A $15 million fed funds line of credit with a fi nancial institution. The line is unsecured and has an interest rate of the institution’s fed funds rate. There were no amounts outstanding on the line at December 31, 2006. This line of credit was established in 2006 and was not used. A $5.0 million revolving line of credit with a fi nancial institution. There was no amount outstanding on the line at December 31, 2006 and 2005. The line is secured by the stock of First Federal Bank and the interest rate is either the lender’s prime rate or LIBOR plus 1.75%, whichever is selected by First Defi ance. The maximum borrowed at any point in time under the line was $0 and $3.0 million in 2006 and 2005, and the average balance outstanding was $0 and $1.3 million in 2006 and 2005, respectively. 14. OTHER NON-INTEREST EXPENSE The following is a summary of other non-interest expense: Legal and other professional fees Marketing State franchise taxes Printing and offi ce supplies Postage Amortization of intangibles Other Total other non-interest expense Years Ended December 31, 2006 2005 $1,732 1,330 1,288 879 781 719 4,166 (In Thousands) $1,366 1,095 1,285 745 645 755 3,231 $10,895 $9,122 2004 $1,343 592 868 577 422 110 2,282 $6,194 FIRST DEFIANCE FINANCIAL CORP. 61 15. POSTRETIREMENT BENEFITS First Defi ance sponsors a defi ned benefi t postretirement plan that is intended to supplement Medicare coverage for certain retirees who meet minimum age requirements. First Federal employees who retired prior to April 1, 1997 who completed 20 years of service after age 40 receive full medical coverage at no cost. Such coverage continues for surviving spouses of those participants for one year, after which coverage may be continued provided the spouse pays 50% of the average cost. First Federal employees retiring after April 1, 1997 are provided medical benefi ts at a cost based on their combined age and years of service at retirement. Surviving spouses are also eligible for continued coverage after the retiree is deceased at a subsidy level that is 10% less than what the retiree is eligible for. First Federal employees retiring before July 1, 1997 receive dental and vision care in addition to medical coverage. First Federal employees who retire after July 1, 1997 are not eligible for dental or vision care, but those retirees and their spouses each receive up to $200 annually in a medical spending account. Funds in that account may be used for payment of uninsured medical expenses. First Federal employees who were born after December 31, 1950 are not eligible for the medical coverage described above at retirement. Rather, a medical spending account of up to $10,000 (based on the participant’s age and years of service) will be established to reimburse medical expenses for those individuals. First Insurance employees who were born before December 31, 1950 can continue coverage until they reach age 65, or in lieu of continuing coverage, can elect the medical spending account option, subject to eligibility requirements. Employees hired or acquired after January 1, 2003 are eligible only for the medical spending account option. Adoption of Statement 158 On December 31, 2006, the Company adopted the recognition and disclosure provisions of FASB Statement No. 158, Employers’ Accounting for Defi ned Benefi t Pension and Other Postretirement Plans, an amendment of FASB Statements No 87, 88, 106 and 132(R) (“Statement 158”). Statement 158 required the Company to recognize the funded status (i.e., the diff erence between the fair value of plan assets and the projected benefi t obligations) of its defi ned benefi t postretirement medical plan in the December 31, 2006 statement of fi nancial position, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adjustment to accumulated other comprehensive income at adoption represents the net unrecognized actuarial losses and unrecognized prior service costs, which were previously netted against the plan’s funded status in the Company’s statement of fi nancial position pursuant to the provisions of Statement 106. These amounts will be subsequently recognized as net periodic pension cost pursuant to the Company’s historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic pension cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic cost on the same basis as the amounts recognized in accumulated other comprehensive income at adoption of Statement 158. The incremental eff ects of adopting the provisions of Statement 158 on the Company’s statement of fi nancial position at December 31, 2006 are presented in the following table. The adoption of Statement 158 had no eff ect on the Company’s consolidated statement of income for the year ended December 31, 2006, or for any prior period presented, and it will not eff ect the Company’s operating results in future periods. Accrued Postretirement Liability Deferred income tax liability Accumulated other comprehensive income (loss) At December 31, 2006 Prior to Adopting Statement 158 Eff ect of Adopting Statement 158 As Reported at December 31, 2006 (In Thousands) $1,232 (1,605) (95) $886 310 (576) $2,118 (1,295) (671) 62 2006 ANNUAL REPORT Included in accumulated other comprehensive income at December 31, 2006 are the following amounts that have not yet been recognized in net periodic pension cost: unrecognized prior service costs of $69,000 ($45,000 net of tax) and unrecognized actuarial losses of $817,000 ($531,000 net of tax). The prior service cost and actuarial loss included in other comprehensive income and expected to be recognized in net postretirement benefi t cost during the fi scal year-ended December 31, 2007 is $8,000 ($5,000 net of tax) and $30,000 ($19,000 net of tax), respectively. Reconciliation of Funded Status and Accumulated Benefi t Obligation The plan is not currently funded. The following table summarizes benefi t obligation and plan asset activity for the plan measured as of December 31 each year: Change in benefi t obligation: Benefi t obligation at beginning of year Service cost Interest cost Participant contribution Plan amendments Actuarial (gains)/losses Benefi ts paid Benefi t obligation at end of year Change in fair value of plan assets: Balance at beginning of year Employer contribution Participant contribution Benefi ts paid Balance at end of year Funded status at end of year December 31, 2006 2005 (In Thousands) $1,581 40 107 38 – 524 (172) 2,118 – 134 38 (172) – $1,630 49 97 34 38 (141) (126) 1,581 – 92 34 (126) – $(2,118) $(1,581) At December 31, 2005, unrecognized prior service cost and net losses totaled $77,000 and $317,000 respectively. Net periodic postretirement benefi t cost includes the following components: Service cost-benefi ts attributable to service during the period Interest cost on accumulated postretirement benefi t obligation Net amortization and deferral Net periodic postretirement benefi t cost Years Ended December 31, 2006 $40 107 32 $179 2005 (In Thousands) $49 97 25 $171 2004 $48 97 23 $168 FIRST DEFIANCE FINANCIAL CORP. 63 The following assumptions were used in determining the components of the postretirement benefi t obligation: Weighted average discount rates: Used to determine benefi t obligations at December 31 Used to determine net periodic postretirement benefi t cost for years ended December 31 Assumed health care cost trend rates at December 31: Health care cost trend rate assumed for next year Rate to which the cost trend rate is assumed to decline (the ultimate trend rate) Year that rate reaches ultimate trend rate 2006 5.75% 5.75% 10.00% 4.00% 2019 2005 5.75% 6.00% 8.00% 4.00% 2014 The following benefi ts are expected to be paid over the next fi ve years and in aggregate for the next fi ve years thereafter. Because the plan is unfunded, the expected net benefi ts to be paid and the estimated Company contributions are the same amount. The Company has elected to opt for the Federal subsidy approach in lieu of coverage under Medicare Part D. These amounts include an estimate of that tax-free Federal subsidy: 2007 2008 2009 2010 2011 2012 through 2016 Before Refl ecting Medicate Part D Subsidy Impact of Medicare Part D Subsidy After Refl ecting Medicare Part D Subsidy $118 130 140 154 165 1,014 (In Thousands) $(22) (25) (29) (31) (34) (257) $96 105 111 123 131 757 Assumed health care cost trend rates have a signifi cant eff ect on the amounts reported for the health care plans. A one- percentage-point change in assumed health care cost trend rates would have the following eff ect (in thousands): Eff ect on total of service and interest cost Eff ect on postretirement benefi t obligation One-Percentage-Point Increase One-Percentage-Point Decrease Year Ended December 31 Year Ended December 31 2006 $25 262 (In Thousands) 2005 $19 197 2006 $(21) (221) 2005 $(16) (166) 64 2006 ANNUAL REPORT 16. REGULATORY MATTERS First Federal is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material eff ect on the consolidated fi nancial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, First Federal must meet specifi c capital guidelines that involve quantitative measures of First Federal’s assets, liabilities and certain off -balance-sheet items as calculated under regulatory accounting practices. First Federal’s capital amounts and classifi cation are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require First Federal to maintain minimum amounts and ratios of Tier I and total capital to risk-weighted assets and of Tier I capital to average assets. As of December 31, 2006 and 2005, First Federal meets all capital adequacy requirements to which it is subject and the most recent notifi cation from the Offi ce of Thrift Supervision (OTS) categorized First Federal as well capitalized under the regulatory framework. There are no conditions or events since these notifi cations that management believes have changed any of the well-capitalized categorizations of First Federal. The following schedule presents First Federal’s regulatory capital ratios: Actual Required for Capital Adequacy Purposes Required to be Well Capitalized Amount Ratio Amount Ratio Amount Ratio As of December 31, 2006 Tangible Capital Tier 1 (Core) Capital Tier 1 Capital to risk-weighted assets Risk-Based Capital As of December 31, 2005 Tangible Capital Tier 1 (Core) Capital Tier 1 Capital to risk-weighted assets Risk-Based Capital (Dollars In Thousands) $140,017 140,017 140,017 153,596 $120,072 120,072 120,072 133,679 9.42% 9.42% 10.80% 11.85% 8.47% 8.47% 10.63% 11.84% $22,293 59,448 51,859 103,716 $21,276 56,736 45,161 90,323 1.50% 4.00% 4.00% 8.00% 1.50% 4.00% 4.00% 8.00% N/A $74,311 77,787 129,645 N/A $70,920 67,742 112,904 N/A 5.00% 6.00% 10.00% N/A 5.00% 6.00% 10.00% First Defi ance is a unitary thrift holding company and is regulated by the OTS. The OTS does not have defi ned capital requirements for unitary thrift holding companies. FIRST DEFIANCE FINANCIAL CORP. 65 17. INCOME TAXES The components of income tax expense are as follows: Current: Federal State and local Deferred Years Ended December 31, 2006 2005 2004 $6,579 2 870 $7,451 (In Thousands) $5,367 7 479 $5,853 $4,677 35 90 $4,802 The provision for income taxes diff ers from that computed at the statutory corporate tax rate as follows: Tax expense at statutory rate (35%) Increases (decreases) in taxes from: ESOP adjustments State income tax – net of federal tax benefi t Tax exempt interest income Bank owned life insurance Stock option expense under FAS 123(R) Other Totals Years Ended December 31, 2006 2005 $8,068 163 – (414) (367) 90 (89) (In Thousands) $6,238 193 – (394) (268) – 84 2004 $5,457 83 23 (498) (332) – 69 $7,451 $5,853 $4,802 Deferred federal income taxes refl ect the net tax eff ects of temporary diff erences between the carrying amounts of assets and liabilities for fi nancial reporting purposes and the amounts used for income tax purposes. 66 2006 ANNUAL REPORT Signifi cant components of First Defi ance’s deferred federal income tax assets and liabilities are as follows: Deferred federal income tax assets: Allowance for loan losses Postretirement benefi t costs Deferred compensation Impaired loans Accrued vacation Deferred loan origination fees and costs Employee Stock Ownership Plan Deposit and FHLB advance mark to market Net unrealized losses on available-for-sale securities Other Total deferred federal income tax assets Deferred federal income tax liabilities: FHLB stock dividends Goodwill Mortgage servicing rights Fixed assets Core deposit intangible Loan mark to market Other Total deferred federal income tax liabilities Net deferred federal income tax liability December 31, 2006 2005 (In Thousands) $4,584 741 669 589 291 134 123 59 52 143 7,385 2,949 1,484 1,478 1,321 1,039 315 94 8,680 $(1,295) $4,565 415 547 706 259 51 185 150 13 296 7,187 2,585 1,084 1,207 1,277 1,265 564 – 7,982 $(795) The realization of the Company’s deferred tax assets is dependent upon the Company’s ability to generate taxable income in future periods and the reversal of deferred tax liabilities during the same period. The Company has evaluated the available evidence supporting the realization of its deferred tax assets and determined it is more likely than not that the assets will be realized and thus no valuation allowance was required at December 31, 2006. Retained earnings at December 31, 2006 include approximately $11.0 million for which no tax provision for federal income taxes has been made. This amount represents the tax bad debt reserve at December 31, 1987, which is the end of the Company’s base year for purposes of calculating the bad debt deduction for tax purposes. If this portion of retained earnings is used in the future for any purpose other than to absorb bad debts, the amount used will be added to future taxable income. The unrecorded deferred tax liability on the above amount at December 31, 2006 was approximately $3.85 million. FIRST DEFIANCE FINANCIAL CORP. 67 18. EMPLOYEE BENEFIT PLANS ESOP Plan First Defi ance has an Employee Stock Ownership Plan (ESOP) covering all employees of First Defi ance age 21 or older who have at least one year of credited service. Contributions to the ESOP are made by First Defi ance and are determined by First Defi ance’s Board of Directors at their discretion. The contributions may be made in the form of cash or First Defi ance common stock. The annual contributions may not be greater than the amount deductible for federal income tax purposes and cannot cause First Federal to violate regulatory capital requirements. To fund the plan, the ESOP borrowed funds from First Defi ance for the purpose of purchasing shares of First Defi ance common stock. The ESOP acquired a total of 863,596 shares in 1993 and 1995. The loan outstanding at December 31, 2006 and 2005 was $1,134,000 and $1,722,000 respectively. Principal and interest payments on the loan are due in equal quarterly installments through June of 2008. The loan is collateralized by the shares of First Defi ance’s common stock and is repaid by the ESOP with funds from the Company’s contributions to the ESOP, dividends on unallocated shares and earnings on ESOP assets. As principal and interest payments on the loan are paid, shares are released from collateral and committed for allocation to active employees, based on the proportion of debt service paid in the year. Shares held by the ESOP which have not been released for allocation are reported as stock acquired by the ESOP plan in the statement of fi nancial condition. As shares are released, First Defi ance records compensation expense equal to the average fair value of the shares over the period in which the shares were earned. Also, the shares released for allocation are included in the average shares outstanding for earnings per share computations. Dividends on allocated shares are recorded as a reduction of retained earnings and dividends on unallocated shares are recorded as additional ESOP expense. ESOP compensation expense was $891,000, $976,000, and $956,000, for 2006, 2005 and 2004, respectively. Shares held by the ESOP at December 31 were as follows: Year Ended December 31, 2006 Year Ended December 31, 2005 Beginning Balance Allocation of shares to participants Distribution of shares to former participants Ending Balance 474,200 48,790 (24,741) 498,249 132,408 (48,790) - 606,608 - (24,741) 435,174 48,791 (9,765) 181,199 (48,791) - 83,618 581,867 474,200 132,408 606,608 Allocated Unallocated Total Allocated Unallocated Total 616,373 - (9,765) Of the 83,618 unallocated shares at December 31, 2006, 12,197 were released during the 2006 fourth quarter for allocation in 2007. The 71,421 unreleased shares have a fair value of $2.2 million at December 31, 2006, while the fair value of 120,211 unreleased shares at December 31, 2005 was $3.3 million. A total of $553,000 and $532,000 of dividends in 2006 and 2005, respectively, were used for debt service. 401(k) Plan Employees of First Defi ance are eligible to participate in the First Defi ance Financial Corp. 401(k) Employee Savings Plan (First Defi ance 401(k)) if they meet certain age and service requirements. Under the First Defi ance 401(k), First Defi ance matches 50% of the participants’ contributions, to a maximum of 3% of compensation. The First Defi ance 401(k) also provides for a discretionary First Defi ance contribution in addition to the First Defi ance matching contribution. First Defi ance matching contributions totaled $355,000, $333,000 and $293,000 for the years ended December 31, 2006, 2005 and 2004 respectively. There were no discretionary contributions in any of those years. 68 2006 ANNUAL REPORT 19. STOCK OPTION PLANS First Defi ance has established incentive stock option plans for its directors and its employees and has reserved 1,727,485 shares of common stock for issuance under the plans. A total of 1,467,204 shares are reserved for employees and 260,281 shares are reserved for directors. As of December 31, 2006, 404,154 options (394,439 for employees and 9,715 for directors) have been granted and remain outstanding at option prices based on the market value of the underlying shares on the date the options were granted. There are 20,836 options granted under the 1993 plan that are currently exercisable, 82,218 options granted under the 1996 plan that vest at 20% per year beginning in 1997 of which 77,776 are fully vested and currently exercisable, 216,300 options granted under the 2001 plan which vest at 20% per year beginning in 2002, of which 157,030 are fully vested and currently exercisable and 84,800 options granted under the 2005 plan which vest at 20% per year beginning in 2006, of which 7,160 are fully vested and 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 fi ve years after the retirement date for the 1993, 2001 and 2005 plans and on the earlier of the scheduled expiration date or twelve months after the retirement date for the 1996 plan. The following table summarizes stock option activity for 2006: Balance at January 1, 2006 Granted Exercised Forfeited Balance at December 31, 2006 Options Weighted Average Option Prices Outstanding 569,099 50,250 (203,595) (11,600) 404,154 $16.00 26.58 11.54 23.26 $19.36 The weighted-average fair value of options granted during the years ended December 31, 2006, 2005 and 2004 were $5.96, $5.67 and $6.85 respectively. Proceeds, related tax benefi ts realized from options exercised and intrinsic value of options exercised were as follows: Proceeds of options exercised Related tax benefi t recognized Intrinsic value of options exercised Year ended December 31, 2006 $2,348 481 3,092 2005 $1,561 261 1,906 As of December 31, 2006 and 2005, 275,400 and 314,050 shares, respectively, were available for grant under the Company’s stock option plans. The aggregate intrinsic value of all options outstanding at December 31, 2006 was $4.40 million. The aggregate intrinsic value of all options that were exercisable at December 31, 2006 was $3.73 million. Information about stock options outstanding is as follows: Outstanding Exercisable Range of Exercise Prices $10.52 - $12.99 $13.00 - $17.99 $18.00 - $23.99 $24.00 - $28.75 Total at December 31, 2006 Weighted Average Exercise Price Shares Weighted Average Remaining Contractual Life (in years) Weighted Average Exercise Price Shares 26,000 174,951 48,150 155,053 404,154 $11.54 14.20 19.41 26.11 $19.36 2.69 3.34 6.16 8.34 5.56 26,000 174,951 28,650 33,201 262,802 $11.54 14.20 19.36 26.61 $16.03 FIRST DEFIANCE FINANCIAL CORP. 69 20. PARENT COMPANY AND REGULATORY RESTRICTIONS Dividends paid by First Federal to First Defi ance are subject to various regulatory restrictions. In accordance with these restrictions, First Federal must submit a request to the Offi ce of Thrift Supervision to initiate dividend payments. Condensed parent company fi nancial statements, which include transactions with subsidiaries, follow: Statements of Financial Condition Assets Cash and cash equivalents Investment securities, available for sale, carried at fair value Investment in subsidiaries Loan receivable from First Defi ance Employee Stock Ownership Plan Other assets Total assets Liabilities and stockholders’ equity: Subordinated debentures Accrued liabilities Stockholders’ equity Total liabilities and stockholders’ equity December 31, 2006 2005 (In Thousands) $1,317 1,916 177,691 1,134 667 $9,406 1,494 160,035 1,722 706 $182,725 $173,363 $20,619 2,281 159,825 $20,619 1,528 151,216 $182,725 $173,363 Statements of Income Dividends from subsidiaries Interest on loan to ESOP Interest expense Other income Noninterest expense Loss before income taxes and equity in earnings of subsidiaries Income tax (credit) Loss before equity in earnings of subsidiaries Undistributed equity in (distributions in excess of) earnings of subsidiaries Net income Years Ended December 31, 2006 2005 2004 $1,000 $119 (1,310) 140 (653) (704) (577) (127) 15,727 $15,600 (In Thousands) $34,415 $169 (275) 102 (637) 33,774 (212) 33,986 (22,016) $11,970 $5,500 $214 (3) 45 (470) 5,286 (56) 5,342 5,454 $10,796 70 2006 ANNUAL REPORT Statements of Cash Flows Operating activities: Net income Adjustments to reconcile net income to net cash (used in) provided by operating activities: Distribution in excess of (undistributed equity in) earnings of subsidiaries Security impairment loss Change in other assets and liabilities Net cash provided by operating activities Investing activities: Investment in unconsolidated trust subsidiary Cash paid for ComBanc, Inc., Cash paid for Genoa Savings and Loan Company Principal payments received on ESOP loan Purchase of available-for-sale securities Maturities of available-for-sale securities Sale of available-for-sale securities Net cash (used in) provided by investing activities Financing activities: Proceeds from issuance of subordinated debt securities Capital contribution to subsidiary Stock options exercised Excess tax benefi t from exercise of stock options Purchase of common stock for treasury Cash dividends paid Net cash used in fi nancing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Years Ended December 31, 2006 2005 2004 (In Thousands) $15,600 $11,970 $10,796 (15,727) 75 695 643 – – – 588 (500) 35 – 123 – (1,000) 1,257 481 (2,852) (6,741) (8,855) (8,089) 9,406 $1,317 22,016 – 232 34,218 (619) (18,693) (10,869) 552 (500) – 70 (30,059) 20,619 (10,000) 1,561 – (1,547) (5,852) 4,781 8,940 466 $9,406 (5,454) – 699 6,041 – – – 505 – – – 505 – – 1,556 – (4,691) (5,011) (8,146) (1,600) 2,066 $466 FIRST DEFIANCE FINANCIAL CORP. 71 21. FAIR VALUE STATEMENT OF CONSOLIDATED FINANCIAL CONDITION The following is a comparative condensed consolidated statement of fi nancial condition based on carrying amount and estimated fair values of fi nancial instruments as of December 31, 2006 and 2005. Statement of Financial Accounting Standards (SFAS) No. 107, Disclosures about Fair Value of Financial Instruments excludes certain fi nancial instruments and all nonfi nancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of First Defi ance Financial Corp. 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 fl ows, risk characteristics and interest rates, all of which are subject to change. With the exception of investment securities, the Company’s fi nancial 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 signifi cantly diff erent. The carrying amount of cash and cash equivalents, warehouse and 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. For investment securities, fair value has been based or current market quotations. If market prices are not available, fair value has been estimated based upon the quoted price of similar instruments. 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 fl ow analysis, using interest rates currently being off ered for loans with similar terms. The allowance for loan losses is considered to be a reasonable adjustment for credit risk. SFAS No. 107 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 SFAS No. 107. The carrying value of Subordinated Debentures and deposits with fi xed maturities is estimated based on interest rates currently being off ered on instruments with similar characteristics and maturities. FHLB advances with maturities greater than 90 days are valued based on discounted cash fl ow 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 December 31, 2006. December 31, 2006 December 31, 2005 Carrying Value Estimated Fair Values Carrying Value Estimated Fair Values (In Thousands) Assets: Cash and cash equivalents Investment securities Loans, net, including loans held for sale Other assets Total assets Liabilities and stockholders’ equity: Deposits Advances from Federal Home Loan Bank Subordinated debentures Short term borrowings and other interest bearing liabilities Advance payments by borrowers for taxes and insurance 135,997 $1,527,879 $1,138,445 162,228 20,619 30,424 667 $50,023 112,123 1,229,736 $50,023 112,174 1,223,886 1,391,882 $1,386,083 $49,256 114,924 1,165,508 $1,329,688 $49,256 114,854 1,169,763 1,333,873 127,209 $1,461,082 $1,137,904 160,403 19,967 30,424 667 $1,069,501 180,960 20,619 25,748 605 $1,067,279 179,435 20,619 25,748 605 Other liabilities Total liabilities Stockholders’ equity Total liabilities and stockholders’ equity 15,671 1,368,054 159,825 $1,527,879 12,433 1,309,866 151,216 $1,461,082 1,352,383 $1,349,365 1,297,433 $1,293,686 72 2006 ANNUAL REPORT 22. QUARTERLY CONSOLIDATED RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the quarterly consolidated results of operations: 2006 Interest income Interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Gain (loss) on sale or write-down of securities Noninterest income Noninterest expense Income before income taxes Income taxes Net income Earnings per share: Basic $0.55 Diluted Average shares outstanding: Basic 7,005 Diluted 2005 Interest income Interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Gain on sale of securities Noninterest income Noninterest expense Income before income taxes Income taxes Net income Earnings per share: Basic $0.43 Diluted Average shares outstanding: Basic 6,668 Diluted Three Months Ended March 31* June 30* September 30 December 31 (In Thousands, Except Per Share Amounts) $21,709 9,400 $22,953 10,694 12,309 383 11,926 - 4,515 10,742 5,699 1,848 $3,851 $0.56 $0.54 7,029 7,182 $16,436 5,826 10,610 347 10,263 621 3,640 10,244 4,280 1,409 12,259 683 11,576 - 5,127 10,795 5,908 1,955 $3,953 $0.54 $0.55 7,032 7,162 $18,669 6,816 11,853 349 11,504 515 3,365 12,518 2,866 838 $24,092 11,883 12,209 373 11,836 - 5,060 11,091 5,805 1,982 $3,823 $0.56 $0.53 7,051 7,146 $19,932 7,715 12,217 368 11,849 86 3,930 10,496 5,369 1,742 $24,311 12,066 12,245 317 11,928 (2) 4,924 11,211 5,639 1,666 $3,973 $0.55 7,168 $21,137 8,535 12,602 378 12,224 - 3,768 10,684 5,308 1,864 $2,871 $2,028 $3,627 $3,444 $0.30 $0.41 6,869 6,945 $0.53 $0.28 6,908 7,119 $0.50 $0.51 6,927 7,159 $0.48 7,161 * - The signifi cant increase in noninterest expense and resulting decline in net income for the quarters ended March 31 and June 30, 2005 was primarily due to $884,000 and $2.5 million in those quarters respectively of acquisition related charges associated with the previously disclosed 2005 acquisitions. 

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