1st Source - 10-Q quarterly report FY

Note 1.  Basis of Presentation

    The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) that are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in shareholders’ equity, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U. S. generally accepted accounting principles have been omitted. The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K for 2006 (2006 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The balance sheet at December 31, 2006, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements.  Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation.

Note 2.  Acquisition Activity

    On May 31, 2007, we acquired FINA Bancorp (FINA), the parent company of First National Bank, Valparaiso (FNBV), for $134.19 million.  FNBV is a full service bank with 26 banking facilities located in Porter, LaPorte and Starke Counties of Indiana.  Pursuant to the definitive agreement, FINA shareholders were able to choose whether to receive 1st Source common stock and/or cash pursuant to the election procedures described in the definitive agreement.   Under the terms of the transaction, FINA was acquired in exchange for 2,124,974 shares of 1st Source common stock valued at $53.68 million and $80.51 million in cash.  The value of the common stock was $25.26 per share and was calculated as stipulated in the definitive agreement.  We believe that the purchase of FINA is a natural extension of our service area and is consistent with our growth and market expansion initiatives.  We expect to merge FNBV and 1st Source Bank in 2008.

    The acquisition was accounted for under the purchase method of accounting, and accordingly, the purchase price has been allocated to the tangible and identified intangible assets purchased and the liabilities assumed based upon the estimated fair values at the date of acquisition.  There are refinements in the process of allocating the purchase price that have not been entirely completed.  Identified intangible assets and purchase accounting fair value adjustments are being amortized under various methods over the expected lives of the corresponding assets and liabilities.  Goodwill will not be amortized, but will be reviewed for impairment on an annual basis.   Currently, identified intangible assets from the acquisition subject to amortization are $8.86 million and total goodwill from the acquisition is $63.07 million.

    On the date of acquisition, unaudited financial statements of FINA reflected assets of $619.31 million, which included $240.13 million of loans and $184.47 million of investment securities, $523.04 million of deposits and year-to-date net income of $3.85 million.  In conjunction with the $240.13 million of loans, FINA’s allowance for loan losses at the acquisition date was $2.42 million.  We applied the guidance required under the American Institute of Certified Public Accountants Statement of Position 03-3,Accounting for Certain Loans or Debt Securities Acquired in a Transfer(SOP 03-3) and determined that certain loans acquired in the FINA acquisition had evidence of deterioration of credit quality since origination and probable that all contractual required payments wound not be collected on these loans.  We determined that two loans with book value totaling approximately $0.28 million and a fair value of $0.07 were within the guidelines set forth under SOP 03-3.  We recorded these at their fair value and reduced the allowance for loan losses by $0.21 million.  Accordingly, we recorded $2.21 million of allowance for loan losses on loans not subject to SOP 03-3.  During the quarter ended June 30, 2007, we did not increase the allowance for loan losses for loans subject to SOP 03-3.

 

   In February 2007, the Financial Accounting Standards Board (FASB) issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB No. 115” (SFAS No. 159).  This standard permits an entity to choose to measure many financial instruments and certain other items at fair value.  The fair value option permits companies to choose to measure eligible items at fair value at specified election dates.  Companies will report unrealized gains and losses on items for which the fair value option has been elected in earnings after adoption.  SFAS No. 159 requires additional disclosures related to the fair value measurements included in the companies financial statements.  This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007.  Early adoption is permitted; however, we will adopt SFAS No. 159 on January 1, 2008.  We are evaluating the impact of SFAS No. 159 on the consolidated financial statements.

    In July 2006, the FASB issued FASB Interpretation No. 48 (FIN No. 48), “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” which clarifies the accounting for uncertainty in tax positions. FIN No. 48 requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN No. 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings.  We adopted the provisions FIN No. 48 on January 1, 2007.  Details related to the adoption of FIN No. 48 and the impact on our financial statements are more fully discussed in Note 7 – Uncertainty in Income Taxes.

Note 4.  Reserve for Loan and Lease Losses

    The reserve for loan and lease losses is maintained at a level believed to be adequate by management to absorb probable losses inherent in the loan and lease portfolio.  The determination of the reserve requires significant judgment reflecting management’s best estimate of probable loan and lease losses related to specifically identified loans and leases as well as probable losses in the remainder of the various loan and lease portfolios.  The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for identified special attention loans and leases (classified loans and leases and internal watch list credits), percentage allocations for special attention loans and leases without specific reserves, formula reserves for each business lending division portfolio, including a higher percentage reserve allocation for special attention loans and leases without a specific reserve, and reserves for pooled homogeneous loans and leases.  Management’s evaluation is based upon a continuing review of these portfolios, estimates of future customer performance, collateral values and dispositions and forecasts of future economic and geopolitical events, all of which are subject to judgment and will change.

Note 5.  Financial Instruments with Off-Balance-Sheet Risk

    To meet the financing needs of our customers, 1st Source Corporation and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate, purchase and sell loans and standby letters of credit.  The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition.  Our exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. We use the same credit policies and collateral requirements in making commitments and conditional obligations as we do for on-balance-sheet instruments.

The following disclosure is not determined in accordance with generally accepted accounting principles (GAAP) and is considered a non-GAAP disclosure.  Management believes that this presentation, while not in accordance with GAAP, provides useful insight as to the impact of the acquisition of First National Bank, Valparaiso on the financial condition from the date of acquisition to June 30, 2007.

We acquired First National Bank, Valparaiso (FNBV) on May 31, 2007 (See Note 2 of the Notes to Consolidated Financial Statements for information concerning this acquisition).  The following table shows (for selected balance sheet items at June 30, 2007) the consolidated balance sheet item, the total for the balance sheet item for FNBV, and the total for the balance sheet item without FNBV.

Our total assets at June 30, 2007, were $4.50 billion, up $697.34 million or 18.32% from December 31, 2006.  The increase in assets was due to the acquisition of FNBV which had assets, including goodwill, of $718.29 million at June 30, 2007.

Total loans and leases were $3.13 billion at June 30, 2007, an increase of $431.63 million or 15.97% from December 31, 2006.  The acquisition of FNBV contributed $238.98 million toward the increase in total loans and leases at June 30, 2007.

Total deposits at June 30, 2007, were $3.59 billion, up $537.16 million or 17.62% over the comparable figures at the end of 2006.  The increase in deposits was due to the acquisition of FNBV which had total deposits of $562.47 million at June 30, 2007.

 

 

Other assets were as follows:

    Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as the operating cash needs of 1st Source Corporation, are met.  Funds are available from a number of sources, including the securities portfolio, the core deposit base, Federal Home Loan Bank borrowings, and the capability to package loans for sale.   Our loan to asset ratio was 69.58% at June 30, 2007 compared to 70.98% at December 31, 2006 and 72.47% at June 30, 2006.  Cash and cash equivalents totaled $97.69 million at June 30, 2007 compared to $118.13 million at December 31, 2006 and $118.88 million at June 30, 2006.  At June 30, 2007, the consolidated statement of financial condition was rate sensitive by $656.00 million more liabilities than assets scheduled to reprice within one year, or approximately 0.80%.  Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.

    During the second quarter of 2007, we completed the private placement issuance of $40 million of trust preferred securities through a newly formed subsidiary trust organized under Delaware law.  The trust preferred securities were issued at $1,000.00 per share and bear a 7.2175 percent per annum fixed rate of interest, payable quarterly.  The securities are redeemable after five years and are due in 2037.  The net proceeds of the issuance were used to fund a portion of the purchase price for FINA.

    During the second quarter of 2007, we obtained commitments for two additional fundings of trust preferred securities that may occur over the next five months.  The trust preferred securities are intended to qualify as tier 1 capital.  The two additional fundings of trust preferred securities may occur as follows:  $17 million to be funded on or before August 1, 2007, at a rate to be determined, and $33 million to be funded on or before October 31, 2007, at a rate to be determined.  These subsequent fundings are expected to be utilized primarily for debt restructuring.

    Additionally, during the second quarter of 2007, we provided notice to the trustee for the 690,000 shares of floating rate trust preferred securities issued by 1st Source Capital Trust II of our plans to redeem these securities on August 1, 2007.  The redemption price will be $25.00 per preferred security plus accrued dividends to the date of redemption.

    

    Net income for the three and six month periods ended June 30, 2007, was $8.06 million and $16.58 million respectively, compared to $10.28 million and $20.21 million for the same periods in 2006.  Diluted net income per common share was $0.34 and $0.72 respectively, for the three and six month periods ended June 30, 2007, compared to $0.45 and $0.88 for the same periods in 2006.  Return on average common shareholders' equity was 8.68% for the six months ended June 30, 2007, compared to 11.62% in 2006. The return on total average assets was 0.87% for the six months ended June 30, 2007, compared to 1.18% in 2006.

    The decrease in net income for the six months ended June 30, 2007, over the first six months of 2006, was primarily the result of an increase of $2.60 million to our provision for loan and lease losses, a $1.52 million decline in noninterest income and a $4.45 million increase in noninterest expense, which were partially offset by a $2.04 million reduction in income tax expense.  Details of the changes in the various components of net income are further discussed below.

    The taxable equivalent net interest income for the three months ended June 30, 2007, was $29.61 million, an increase of 6.49% over the same period in 2006. The net interest margin on a fully taxable equivalent basis was 3.16% for the three months ended June 30, 2007, compared to 3.44% for the three months ended June 30, 2006. The taxable equivalent net interest income for the six month period ended June 30, 2007, was $56.58 million, an increase of 5.69% over 2006, resulting in a net yield of 3.17%, compared to a net yield of 3.36% for the same period in 2006.

    Average earning assets increased $506.53 million or 15.60% and $393.75 million or 12.27%, respectively, for the three and six month periods ended June 30, 2007, over the comparable periods in 2006.  Average interest-bearing liabilities increased $497.03 million or 18.42% and $396.39 million or 14.87%, respectively, for the three and six month periods ended June 30, 2007, over the comparable period one year ago.  The acquisition of FNBV increased our average earning assets by $92.20 million and our average interest-bearing liabilities by $84.63 million.  The yield on average earning assets increased 38 basis points to 6.74% for the second quarter of 2007 from 6.36% for the second quarter of 2006.  The yield on average earning assets for the six month period ended June 30, 2007, increased 51 basis points to 6.70% from 6.19% for the six month period ended June 30, 2006. The rate earned on assets continued to experience positive impacts from the increases in short-term market interest rates from a year ago.  Total cost of average interest-bearing liabilities increased 69 basis points to 4.20% for the second quarter of 2007 from 3.51% for the second quarter of 2006. Total cost of average interest-bearing liabilities increased 76 basis points to 4.16% for the six month period ended June 30, 2007 from 3.40% for the six month period ended June 30, 2006.  The cost of interest-bearing liabilities was also affected by short-term market interest rates.  The result to the net interest margin, or the difference between interest income on earning assets and expense on interest-bearing liabilities, was a decrease of 28 basis points and 19 basis points, respectively, for the three and six month periods ended June 30, 2007 from June 30, 2006.

    The largest contributor to the increase in the yield on average earning assets for the first six months of 2007, on a volume-weighted basis, was the $303.60 million or 12.14% increase in net loans and leases as compared to the first six months of 2006.   Average loans and leases grew by $357.22 million or 14.05% during the second quarter of 2007, compared to the second quarter of 2006.  Average loans and leases outstanding increased across our entire portfolio, most notably in construction equipment financing, commercial loans, aircraft financing, loans secured by real estate, and medium and heavy duty truck financing for both the second quarter and year-to-date 2007 as compared to 2006.   The acquisition of FNBV increased our average loans and leases by $39.58 million.  The majority of loans acquired from FNBV were loans secured by real estate.