UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2006 ------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________________ to ________________ Commission file number 0-6233 1st SOURCE CORPORATION (Exact name of registrant as specified in its charter) INDIANA 35-1068133 ------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 North Michigan Street South Bend, Indiana 46601 --------------------------------------------------- (Address of principal executive offices) (Zip Code) (574) 235-2000 -------------- (Registrant's telephone number, including area code) Not Applicable -------------- (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No______ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ___ Accelerated filer [X] Non-accelerated filer ____ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ______ No [X] Number of shares of common stock outstanding as of July 24, 2006 - 20,448,581 shares
TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Page Item 1. Financial Statements (Unaudited) Consolidated statements of financial condition -- June 30, 2006, and December 31, 2005 3 Consolidated statements of income -- three months and six months ended June 30, 2006 and 2005 4 Consolidated statements of changes in shareholders' equity six months ended June 30, 2006 and 2005 5 Consolidated statements of cash flows -- six months ended June 30, 2006 and 2005 6 Notes to the Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 Item 3. Quantitative and Qualitative Disclosures About Market Risk 22 Item 4. Controls and Procedures 22 PART II. OTHER INFORMATION Item 1. Legal Proceedings 22 Item 1A. Risk Factors 22 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 23 Item 3. Defaults Upon Senior Securities 23 Item 4. Submission of Matters to a Vote of Security Holders 23 Item 5. Other Information 24 Item 6. Exhibits 24 SIGNATURES 25 2
<TABLE> <CAPTION> 1st SOURCE CORPORATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited - Dollars in thousands) June 30, December 31, 2006 2005 ---------------------------------------- <S> <C> <C> ASSETS Cash and due from banks $ 118,884 $ 124,817 Federal funds sold and interest bearing deposits with other banks 2,320 68,578 Investment securities available-for-sale (amortized cost of $635,176 and $637,878 at June 30, 2006 and December 31, 2005, respectively) 628,366 632,625 Trading account securities 300 - Mortgages held for sale 82,018 67,224 Loans and leases - net of unearned discount: Commercial and agricultural loans 491,334 453,197 Auto, light truck and environmental equipment 337,497 310,786 Medium and heavy duty truck 319,845 302,137 Aircraft financing 453,470 459,645 Construction equipment financing 273,621 224,230 Loans secured by real estate 618,204 601,077 Consumer loans 121,181 112,359 ---------------------------------------- Total loans and leases 2,615,152 2,463,431 Reserve for loan and lease losses (59,197) (58,697) ---------------------------------------- Net loans and leases 2,555,955 2,404,734 Equipment owned under operating leases, net 67,647 58,250 Net premises and equipment 37,414 37,710 Accrued income and other assets 115,622 117,339 ---------------------------------------- Total assets $ 3,608,526 $ 3,511,277 ======================================== LIABILITIES Deposits: Noninterest bearing $ 379,230 $ 393,494 Interest bearing 2,435,379 2,352,093 ---------------------------------------- Total deposits 2,814,609 2,745,587 Federal funds purchased and securities sold under agreements to repurchase 217,923 230,756 Other short-term borrowings 67,799 46,713 Long-term debt and mandatorily redeemable securities 33,554 23,237 Subordinated notes 59,022 59,022 Accrued expenses and other liabilities 63,307 60,386 ---------------------------------------- Total liabilities 3,256,214 3,165,701 SHAREHOLDERS' EQUITY Preferred stock; no par value - - Authorized 10,000,000 shares; none issued or outstanding Common stock; no par value Authorized 40,000,000 shares; issued 23,781,901 at June 30, 2006 and 23,778,780 at December 31, 2005, less unearned shares (263,369 at June 30, 2006 and 260,248 at December 31, 2005)* 7,578 7,578 Capital surplus 214,001 214,001 Retained earnings 154,339 139,601 Cost of common stock in treasury (1,030,812 shares at June 30, 2006, and 782,428 shares at December 31, 2005)* (19,405) (12,364) Accumulated other comprehensive loss (4,201) (3,240) ---------------------------------------- Total shareholders' equity 352,312 345,576 ---------------------------------------- Total liabilities and shareholders' equity $ 3,608,526 $ 3,511,277 ======================================== *Per share data gives retroactive recognition to a 10% stock dividend declared on July 27, 2006. The accompanying notes are a part of the consolidated financial statements. </TABLE> 3
<TABLE> <CAPTION> 1st SOURCE CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited - Dollars in thousands, except per share amounts) Three Months Ended Six Months Ended June 30, June 30, --------------------------- ---------------------------- 2006 2005 2006 2005 --------------------------- ---------------------------- <S> <C> <C> <C> <C> Interest income: Loans and leases $ 44,421 $ 35,465 $ 85,309 $ 69,102 Investment securities, taxable 4,797 3,915 8,722 7,733 Investment securities, tax-exempt 1,292 1,336 2,559 2,600 Other 271 127 587 204 --------------------------- ---------------------------- Total interest income 50,781 40,843 97,177 79,639 Interest expense: Deposits 19,283 13,330 36,316 25,646 Short-term borrowings 2,822 2,006 5,582 3,708 Subordinated notes 1,080 1,000 2,130 1,964 Long-term debt and mandatorily redeemable securities 451 305 905 515 --------------------------- ---------------------------- Total interest expense 23,636 16,641 44,933 31,833 --------------------------- ---------------------------- Net interest income 27,145 24,202 52,244 47,806 Recovery of provision for loan and lease losses (1,671) (3,411) (1,971) (3,832) --------------------------- ---------------------------- Net interest income after recovery of provision for loan and lease losses 28,816 27,613 54,215 51,638 Noninterest income: Trust fees 3,658 3,285 7,049 6,531 Service charges on deposit accounts 4,917 4,251 9,303 8,214 Mortgage banking income 3,105 1,551 4,862 4,318 Insurance commissions 932 833 2,614 1,997 Equipment rental income 4,658 3,927 8,878 7,942 Other income 1,647 1,546 3,133 3,182 Investment securities and other investment gains 150 5 2,233 909 --------------------------- ---------------------------- Total noninterest income 19,067 15,398 38,072 33,093 --------------------------- ---------------------------- Noninterest expense: Salaries and employee benefits 16,873 17,090 32,387 35,634 Net occupancy expense 1,860 1,732 3,727 3,834 Furniture and equipment expense 2,959 2,844 6,093 5,486 Depreciation - leased equipment 3,547 3,194 6,929 6,517 Supplies and communication 1,307 1,321 2,670 2,664 Other expense 5,840 4,445 9,986 8,165 --------------------------- ---------------------------- Total noninterest expense 32,386 30,626 61,792 62,300 --------------------------- ---------------------------- Income before income taxes 15,497 12,385 30,495 22,431 Income tax expense 5,220 4,158 10,285 7,260 --------------------------- ---------------------------- Net income $ 10,277 $ 8,227 $ 20,210 $ 15,171 =========================== ============================ Other comprehensive (loss) income, net of tax: Change in unrealized (depreciation) appreciation of available-for-sale securities (1,151) 2,305 (961) (1,639) --------------------------- ---------------------------- Total comprehensive income $ 9,126 $ 10,532 $ 19,249 $ 13,532 =========================== ============================ Per common share*: Basic net income per common share $ 0.46 $ 0.36 $ 0.90 $ 0.67 =========================== ============================ Diluted net income per common share $ 0.45 $ 0.36 $ 0.88 $ 0.66 =========================== ============================ Dividends $ 0.127 $ 0.109 $ 0.255 $ 0.218 =========================== ============================ Basic weighted average common shares outstanding* 22,505,875 22,754,331 22,576,338 22,772,502 =========================== ============================ Diluted weighted average common shares outstanding* 22,810,923 23,047,293 22,876,839 23,069,981 =========================== ============================ * The computation of per share data and shares outstanding gives retroactive recognition to a 10% stock dividend declared on July 27, 2006. The accompanying notes are a part of the consolidated financial statements. </TABLE> 4
<TABLE> <CAPTION> 1st SOURCE CORPORATION STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited - Dollars in thousands) - ----------------------------------------------------------------------------------------------------------------------------- Net Unrealized Appreciation Cost of (Depreciation) Common of Securities Common Capital Retained Stock Available- Total Stock Surplus Earnings in Treasury For-Sale - ----------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Balance at January 1, 2005 $326,600 $7,578 $214,001 $115,830 ($10,512) ($ 297) - ----------------------------------------------------------------------------------------------------------------------------- Comprehensive Income, net of tax: Net Income 15,171 - - 15,171 - - Change in unrealized appreciation of available-for-sale securities, net of tax (1,639) - - - - (1,639) ------ Total Comprehensive Income 13,532 - - - - - Issuance of 40,237 common shares under stock based compensation plans, including related tax effects 499 - - 154 345 - Cost of 99,256 shares of common stock acquired for treasury (2,046) - - - (2,046) - Cash dividend ($0.218 per share)* (4,972) - - (4,972) - - - ----------------------------------------------------------------------------------------------------------------------------- Balance at June 30, 2005 $333,613 $7,578 $214,001 $126,183 ($12,213) ($1,936) ============================================================================================================================= Balance at January 1, 2006 $345,576 $7,578 $214,001 $139,601 ($12,364) ($3,240) - ----------------------------------------------------------------------------------------------------------------------------- Comprehensive Income, net of tax: Net Income 20,210 - - 20,210 - - Change in unrealized appreciation of available-for-sale securities, net of tax (961) - - - - (961) ------ Total Comprehensive Income 19,249 - - - - - Issuance of 66,296 common shares under stock based compensation plans, including related tax effects 636 - - 292 344 - Cost of 292,099 shares of common stock acquired for treasury (7,385) - - - (7,385) - Cash dividend ($0.255 per share)* (5,764) - - (5,764) - - - ----------------------------------------------------------------------------------------------------------------------------- Balance at June 30, 2006 $352,312 $7,578 $214,001 $154,339 ($19,405) ($4,201) ============================================================================================================================= *Per share data gives retroactive recognition to a 10% stock dividend declared on July 27, 2006. The accompanying notes are a part of the consolidated financial statements. </TABLE> 5
<TABLE> <CAPTION> 1st SOURCE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited - Dollars in thousands) Six Months Ended June 30, ---------------------------- 2006 2005 ------------ ------------- <S> <C> <C> Operating activities: Net income $ 20,210 $ 15,171 Adjustments to reconcile net income to net cash (used in)/from by operating activities: Provision for loan and lease recoveries (1,971) (3,832) Depreciation of premises and equipment 2,527 2,548 Depreciation of equipment owned and leased to others 6,929 6,517 Amortization of investment security premiums and accretion of discounts, net 392 2,513 Amortization of mortgage servicing rights 2,972 3,588 Mortgage servicing asset impairment recoveries (30) (613) Change in deferred income taxes (3,917) 4,292 Realized investment securities gains (2,233) (909) Change in mortgages held for sale (14,794) (48,826) Change in trading account securities (300) - Change in interest receivable 309 (313) Change in interest payable 1,918 74 Change in other assets (1,534) (2,286) Change in other liabilities 5,517 2,797 Other (152) 136 ------------ ------------ Net change in operating activities 15,843 (19,143) Investing activities: Proceeds from sales of investment securities 61,650 24,573 Proceeds from maturities of investment securities 138,658 153,226 Purchases of investment securities (195,764) (99,631) Net change in short-term investments 66,258 201,009 Loans sold or participated to others - (18) Net change in loans and leases (149,251) (100,720) Net change in equipment owned under operating leases (16,326) (6,492) Purchases of premises and equipment (2,312) (3,529) ------------ ------------ Net change in investing activities (97,087) 168,418 Financing activities: Net change in demand deposits, NOW accounts and savings accounts (210,773) (100,686) Net change in certificates of deposit 279,795 31,013 Net change in short-term borrowings 8,253 (56,223) Proceeds from issuance of long-term debt 10,859 355 Payments on long-term debt (206) (163) Net proceeds from issuance of treasury stock 635 498 Acquisition of treasury stock (7,385) (2,046) Cash dividends (5,867) (5,063) ------------ ------------ Net change in financing activities 75,311 (132,315) Net change in cash and cash equivalents (5,933) 16,960 Cash and cash equivalents, beginning of year 124,817 78,255 ------------ ------------ Cash and cash equivalents, end of period $ 118,884 $ 95,215 ============ ============ The accompanying notes are a part of the consolidated financial statements. </TABLE> 6
1ST SOURCE CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 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 2005 (2005 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, 2005, 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. Recent Accounting Pronouncements ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES: In July 2006, the Financial Accounting Standards Board (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. This Interpretation 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 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 are currently evaluating the impact of adopting FIN 48 on our financial statements. SHARE-BASED PAYMENT: Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment" (SFAS No.123(R)), using the modified prospective transition method and, therefore, have not restated results for prior periods. Under this transition method, stock-based compensation expense for the first quarter of 2006 included compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS No.123"). Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No.123(R). We recognize these compensation costs on a straight-line basis over the requisite service period of the award. Prior to the January 1, 2006 adoption of SFAS No.123(R), we recognized stock-based compensation expense in accordance with Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees" (APB No. 25). In March 2005, the Securities and Exchange Commission (the SEC) issued Staff Accounting Bulletin No. 107 (SAB No. 107) regarding the SEC's interpretation of SFAS No.123(R) and the valuation of share-based payments for public companies. We have applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R). See Note 5 to the Unaudited Consolidated Financial Statements for a further discussion on stock-based compensation. 7
ACCOUNTING FOR SERVICING OF FINANCIAL ASSETS: In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets- an amendment of FASB Statement No. 140." SFAS No.156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in specific situations. Additionally, the servicing asset or servicing liability shall be initially measured at fair value; however, an entity may elect the "amortization method" or "fair value method" for subsequent balance sheet reporting periods. SFAS No.156 is effective as of an entity's first fiscal year beginning after September 15, 2006. Early adoption is permitted as of the beginning of an entity's fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. We do not expect the adoption of this statement to have a material impact on our financial condition, results of operations or cash flows. ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS: In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140." SFAS No. 155 simplifies accounting for certain hybrid instruments currently governed by SFAS No. 133 , "Accounting for Derivative Instruments and Hedging Activities," by allowing fair value remeasurement of hybrid instruments that contain an embedded derivative that otherwise would require bifurcation. SFAS No. 155 also eliminates the guidance in SFAS No.133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets," which provides such beneficial interests are not subject to SFAS No.133. SFAS No. 155 amends SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a Replacement of FASB Statement No. 125," by eliminating the restriction on passive derivative instruments that a qualifying special-purpose entity may hold. This statement is effective for financial instruments acquired or issued after the beginning of our fiscal year 2007. We do not expect the adoption of this statement to have a material impact on our financial condition, results of operations or cash flows. MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT: In November 2005, the FASB issued Staff Position (FSP) SFAS No. 115-1 and 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The FSP addresses the determination of when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. The FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The FSP amends SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and SFAS No. 124, "Accounting for Certain Investments Held by Not-for-Profit Organizations," and APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock." The FSP nullifies certain requirements of EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments," and supercedes Emerging Issues Task Force (EITF) Abstracts, Topic D-44, "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." The FSP was required to be applied to reporting periods beginning after December 15, 2005. The issuance of this FSP did not have a material impact on the financial condition, the results of operations, or liquidity of 1st Source. ACCOUNTING CHANGES AND ERROR CORRECTIONS: In May 2005, the FASB issued SFAS No. 154, "Accounting for Changes and Error Corrections," which changes the accounting for and reporting of a change in accounting principle. This statement also applies to all voluntary changes in accounting principle and changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impractical to determine either the period - specific or cumulative effects of the change. SFAS No. 154 was 8
effective for accounting changes made in fiscal years beginning after December 15, 2005. The adoption of this standard did not have a material effect on the financial condition, the results of operations or liquidity of 1st Source. Note 3. 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 4. 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. Trustcorp Mortgage Company and 1st Source Bank (Bank), subsidiaries of 1st Source Corporation, grant mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We issue letters of credit that are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. As of June 30, 2006 and December 31, 2005, 1st Source had commitments outstanding to originate and purchase mortgage loans aggregating $219.37 million and $130.73 million, respectively. Outstanding commitments to sell mortgage loans aggregated $126.13 million at June 30, 2006, and $98.39 million at December 31, 2005. Standby letters of credit totaled $80.54 million and $76.43 million at June 30, 2006, and December 31, 2005, respectively. Standby letters of credit have terms ranging from six months to one year. 9
Note 5. Stock-Based Compensation As of June 30, 2006, we had five stock-based employee compensation plans, which are more fully described in Note K of the Consolidated Financial Statements in 1st Source's Annual Report on Form 10-K for the year ended December 31, 2005. These plans include two stock option plans, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan. The Employee Stock Purchase Plan is non-compensatory. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective transition method and, therefore, have not restated results for prior periods. Under this transition method, stock-based compensation expense for the first quarter of 2006 included compensation expense for all stock-based compensation awards granted prior to, but that remained unvested as of, January 1, 2006. Compensation expense was based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123. Prior to January 1, 2006, we accounted for stock-based compensation under the recognition, measurement and pro forma disclosure provisions of APB No. 25, the original provisions of SFAS No. 123, and SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" (SFAS 148). In accordance with APB No. 25, we generally would have recognized compensation expense for stock awards on the grant date and we generally would have recognized compensation expense for stock options only when we granted options with a discounted exercise price or modified the terms of previously issued options, and would have recognized the related compensation expense ratably over the associated service period, which was generally the option vesting term. Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006, is based on the grant-date fair value. For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date. For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model. For all awards we recognize these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term. We estimate forfeiture rates based on historical employee option exercise and employee termination experience. We have identified separate groups of awardees that exhibit similar option exercise behavior and employee termination experience and have considered them as separate groups in the valuation models and expense estimates. As a result of our January 1, 2006, adoption of SFAS No.123(R), the impact to the Consolidated Financial Statements for the three month period ended June 30, 2006 on income before income taxes and on net income were additions of $0.67 million and $0.41 million, respectively; and for the six month period ended June 30, 2006 on income before income taxes and on net income were additions of $1.82 million and $1.12 million, respectively. The cumulative effect of the change in accounting was $0.66 million before income taxes and $0.40 million, after income taxes. The impact on both basic and diluted earnings per share for the three months ended June 30, 2006 was $0.02 per share. The impact on both basic and diluted earnings per share for the six months ended June 30, 2006 was $0.05 per share. In addition, prior to the adoption of SFAS No. 123(R), we presented the tax benefit of stock option exercises as operating cash flows. Upon the adoption of SFAS No. 123(R), tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are classified as financing cash flows. 10
Pro Forma Information under SFAS No. 123 Pro forma information regarding the effect on the net income and basic and diluted income per share for the three and six month periods ended June 30, 2005, had we applied the fair value recognition provisions of SFAS No. 123, are as follows: <TABLE> <CAPTION> ------------------ ------------------ ----------------- THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 ------------------ ------------------ ----------------- 2005 2005 ---- ---- <S> <C> <C> Net income, as reported (000's) $ 8,227 $15,171 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 626 1,542 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (695) (1,632) -------- ---------- Pro forma net income $ 8,158 $15,081 ========= ======== Earnings per share: Basic--as reported $0.36 $0.67 ===== ===== Basic--pro forma $0.36 $0.66 ===== ===== Diluted--as reported $0.36 $0.66 ===== ===== Diluted--pro forma $0.35 $0.65 ===== ===== </TABLE> The stock-based compensation expense recognized in the condensed consolidated statement of operations for the three and six months ended June 30, 2006 is based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based partially on historical experience. The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between 1st Source's closing stock price on the last trading day of the second quarter of 2006 (June 30, 2006) and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2006, this amount changes based on the fair market value of 1st Source's stock. Total intrinsic value of options exercised for the six months ended June 30, 2006 was $637 thousand. Total fair value of options vested and expensed was $12 thousand and $25 thousand, net of tax, for the three and six month periods ended June 30, 2006, respectively. No options were granted during the three and six month periods ended June 30, 2006 or 2005. 11
<TABLE> <CAPTION> June 30, 2006 ---------------------------------- Average Weighted Remaining Total Average Contractual Intrinsic Number of Grant-date Term Value Shares Fair Value (in years) (in 000's) - --------------------------------------------------- ---------------- --------------- ------------------ -------------- <S> <C> <C> <C> <C> Options outstanding, beginning of year 580,848 $24.61 Granted - - Exercised (49,494) 12.14 Forfeited - - ---------------- --------------- Options outstanding, June 30, 2006 531,354 $25.31 2.5 $2,891 ================ =============== Vested and expected to vest at June 30, 2006 531,354 $25.31 2.6 $2,891 ================ Exercisable at June 30, 2006 508,438 $25.75 2.5 $2,543 ================ </TABLE> As of June 30, 2006, there was $301,413 of total unrecognized compensation cost related to nonvested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 5.82 years. The following table summarizes information about stock options outstanding at June 30, 2006: <TABLE> <CAPTION> Weighted Average Weighted Weighted Range of Number Remaining Average Number Average Exercise of shares Contractual Exercise of shares Exercise Prices Outstanding Life Price Exercisable Price - ----------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> $11.31 to $17.99 76,887 4.04 $14.23 63,137 $14.70 $18.00 to $26.99 66,930 4.42 20.82 57,764 20.81 $27.00 to $28.30 387,537 2.06 28.29 387,537 28.29 </TABLE> The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model with the weighed average assumptions included on the table above, under the header "Stock Based Option Valuation and Expense Information under SFAS No.123(R)." ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for historical information contained herein, the matters discussed in this document express "forward-looking statements." Generally, the words "believe," "expect," "intend," "estimate," "anticipate," "project," "will," "should," and similar expressions indicate forward-looking statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or U. S. generally accepted accounting 12
principles; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K for 2005, which filings are available from the SEC. We undertake no obligation to publicly update or revise any forward-looking statements. The following management's discussion and analysis is presented to provide information concerning our financial condition as of June 30, 2006, as compared to December 31, 2005, and the results of operations for the three and six month periods ended June 30, 2006 and 2005. This discussion and analysis should be read in conjunction with our consolidated financial statements and the financial and statistical data appearing elsewhere in this report and our 2005 Annual Report. FINANCIAL CONDITION ------------------- Our total assets at June 30, 2006, were $3.61 billion, up 2.77% from December 31, 2005. Total loans and leases increased 6.16% and total deposits increased 2.51% over the comparable figures at the end of 2005. Nonperforming assets at June 30, 2006, were $15.43 million compared to $22.04 million at December 31, 2005, an improvement of 29.99%. Nonperforming assets decreased across our entire loan and lease portfolios with the exception of loans secured by real estate. The most significant decreases were primarily in the commercial and agricultural loans, aircraft financing, and construction equipment financing categories. At June 30, 2006, nonperforming assets were 0.57% of net loans and leases compared to 0.87% at December 31, 2005. Accrued income and other assets were as follows: (Dollars in Thousands) June 30, December 31, 2006 2005 -------------- ------------ Accrued income and other assets: Bank owned life insurance cash surrender value $ 35,444 $ 34,772 Accrued interest receivable 14,071 14,381 Mortgage servicing assets 14,281 19,363 Other real estate 819 959 Repossessions 1,083 4,284 Intangible assets 20,056 21,381 All other assets 29,868 22,199 -------------- ------------ Total accrued income and other assets $ 115,622 $ 117,339 ============== ============ CAPITAL ------- As of June 30, 2006, total shareholders' equity was $352.31 million, up 1.95% from the $345.58 million at December 31, 2005. In addition to net income of $20.21 million, other significant changes in shareholders' equity during the first six months of 2006 included $7.39 million in treasury stock purchases, and $5.76 million of dividends paid. The accumulated other comprehensive loss component of shareholders' equity totaled $4.20 million at June 30, 2006, 13
compared to $3.24 million at December 31, 2005. The increase in accumulated other comprehensive loss was a result of changes in unrealized gain or loss on securities in the available-for-sale portfolio. Our equity-to-assets ratio was 9.76% as of June 30, 2006, compared to 9.84% at December 31, 2005. Book value per common share rose to $15.67 at June 30, 2006, up from $15.20 at December 31, 2005 (per share data gives retroactive recognition to a 10% stock dividend declared on July 27, 2006). We declared and paid dividends per common share of $0.127 during the second quarter of 2006. The trailing four quarters dividend payout ratio, representing dividends per share divided by diluted earnings per share, was 28.63% (per share data gives retroactive recognition to a 10% stock dividend declared on July 27, 2006). The dividend payout is continually reviewed by management and the Board of Directors. The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U. S. banking organizations. The actual and required capital amounts and ratios of 1st Source and our largest subsidiary, the Bank, as of June 30, 2006, are presented in the table below: <TABLE> <CAPTION> To Be Well Capitalized Under Minimum Capital Prompt Corrective Actual Adequacy Action Provisions (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - -------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Total Capital (To Risk-Weighted Assets): 1st Source $433,349 14.42 % $240,422 8.00 % $300,527 10.00 % Bank 413,465 14.04 235,549 8.00 294,436 10.00 Tier 1 Capital (to Risk-Weighted Assets): 1st Source 393,707 13.10 120,211 4.00 180,316 6.00 Bank 375,810 12.76 117,774 4.00 176,662 6.00 Tier 1 Capital (to Average Assets): 1st Source 393,707 11.37 138,495 4.00 173,119 5.00 Bank 375,810 11.13 135,094 4.00 168,868 5.00 </TABLE> LIQUIDITY AND INTEREST RATE SENSITIVITY --------------------------------------- The Bank's liquidity is monitored and closely managed by the Asset/Liability Committee (ALCO), which is comprised of the Bank's senior management. Asset and liability management includes the management of interest rate sensitivity and the maintenance of an adequate liquidity position. The purpose of interest rate sensitivity management is to stabilize net interest income during periods of changing interest rates. Liquidity management is the process by which the Bank ensures that adequate liquid funds are available to meet financial commitments on a timely basis. Financial institutions must maintain liquidity to meet day-to-day requirements of depositors and borrowers, take advantage of market opportunities and provide a cushion against unforeseen needs. Liquidity of the Bank is derived primarily from core deposits, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability funded liquidity is deposit growth and retention of the core deposit base. The principal sources of asset funded liquidity are available-for-sale investment securities, cash and due from banks, Federal funds sold, securities purchased under agreements to resell, and loans and interest bearing deposits with other banks maturing within one year. Additionally, liquidity is provided by bank lines of credit, repurchase agreements, and the ability to borrow from the Federal Reserve Bank and Federal Home Loan Bank. 14
The ALCO monitors and manages the relationship of earning assets to interest bearing liabilities and the responsiveness of asset yields, interest expense, and interest margins to changes in market interest rates. At June 30, 2006, the consolidated statement of financial condition was rate sensitive by $320.28 million more liabilities than assets scheduled to reprice within one year, or approximately 0.86%. RESULTS OF OPERATIONS --------------------- Net income for the three and six month periods ended June 30, 2006, was $10.28 million and $20.21 million respectively, compared to $8.23 million and $15.17 million for the same periods in 2005. Diluted net income per common share was $0.45 and $0.88 respectively, for the three and six month periods ended June 30, 2006, compared to $0.36 and $0.66 for the same periods in 2005 (per share data gives retroactive recognition to a 10% stock dividend declared on July 27, 2006). Return on average common shareholders' equity was 11.62% for the six months ended June 30, 2006, compared to 9.33% in 2005. The return on total average assets was 1.18% for the six months ended June 30, 2006, compared to 0.91% in 2005. The increase in net income for the six months ended June 30, 2006, over the first six months of 2005, was primarily the result of a 9.28% improvement in net interest income and a 15.05% improvement in noninterest income. Total interest income increased primarily due to increase in the volume and yields on loans. Total interest expense increased primarily due to increased volumes and higher cost of funds, reflecting the interest rate environment. Details of the changes in the various components of net income are further discussed below. NET INTEREST INCOME ------------------- The taxable equivalent net interest income for the three months ended June 30, 2006, was $27.81 million, an increase of 11.76% over the same period in 2005. The net interest margin on a fully taxable equivalent basis was 3.44% for the three months ended June 30, 2006, compared to 3.18% for the three months ended June 30, 2005. The taxable equivalent net interest income for the six month period ended June 30, 2006, was $53.53 million, an increase of 8.94% over 2005, resulting in a net yield of 3.36%, compared to a net yield of 3.16% for the same period in 2005. Total average earning assets increased 3.31% and 2.42%, respectively, for the three and six month periods ended June 30, 2006, over the comparative periods in 2005. Average loans and leases outstanding increased 9.33% and 8.60% for the three and six month periods, compared to the same periods in 2005; the increase was due primarily to increased loan outstandings in aircraft financing, commercial and agricultural loans, auto and light truck financings, construction equipment financing, medium and heavy duty truck financings, and loans secured by real estate. These increases were offset slightly by decreases in consumer loans and environmental equipment loans and leases. Total average investment securities decreased 13.25% and 15.95% for the three and six month periods ended June 30, 2006, as compared to one year ago, as availability of excess funds used for investment purposes decreased due to loan growth. These decreases were due primarily to decreases in U. S. Treasury securities and Federal agency securities. For the six month period, average mortgages held for sale decreased 18.98%, due to timing differences in loan sales for the first six months of 2006 as compared to the first six months of 2005. Other investments, which include federal funds sold, time deposits with other banks and trading account securities, decreased for the three and six month periods ended June 30, 2006 over the same periods of 2005. The taxable equivalent yields on total average earning assets were 6.36% and 5.30% for the three month periods ended June 30, 2006 and 2005, respectively, and 6.19% and 5.21% for the six month periods ended June 30, 2006 and 2005, respectively. 15
Average interest bearing deposits increased 5.78% and 3.80% for the three and six month periods ended June 30, 2006, respectively, over the same periods in 2005. The rates on average interest-bearing deposits were 3.31% and 2.42% for the three months ended June 30, 2006 and 2005, and 3.19% and 2.34% for the six month periods ended June 30, 2006 and 2005, respectively. The increase in the average cost of interest-bearing deposits during the first six months of 2006 as compared to the first six months of 2005 was primarily the result of increases in interest rates offered on deposit products due to increases in market interest rates and increased competition for deposits across all markets. These higher cost deposits were pursued due to increased funding needs. The rates on average interest-bearing liabilities were 3.51% and 2.59% for the three month periods ended June 30, 2006 and 2005, respectively, and 3.40% and 2.49% for the six month periods ended June 30, 2006 and 2005, respectively. The following table provides an analysis of net interest income and illustrates the interest earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. Yields/rates are computed on a tax-equivalent basis, using a 35% rate. Nonaccrual loans and leases are included in the average loan and lease balance outstanding. 16
<TABLE> <CAPTION> DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL (Dollars in thousands) Three months ended June 30, ------------------------------ 2006 2005 ---------------------------- ---------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate ---------------------------- ---------------------------- <S> <C> <C> <C> <C> <C> <C> ASSETS: Investment securities: Taxable $ 453,246 $ 4,797 4.25% $ 534,446 $ 3,915 2.94% Tax exempt 174,071 1,855 4.27% 188,716 1,951 4.15% Mortgages - held for sale 54,654 916 6.72% 76,839 1,151 6.01% Net loans and leases 2,542,118 43,604 6.88% 2,325,183 34,379 5.93% Other investments 22,240 271 4.89% 17,064 127 2.98% ---------------------------- ---------------------------- Total Earning Assets 3,246,329 51,443 6.36% 3,142,248 41,523 5.30% Cash and due from banks 80,058 85,701 Reserve for loan and lease losses (59,428) (62,613) Other assets 215,573 194,544 ------------ ------------- Total $ 3,482,532 $ 3,359,880 ============ ============= LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing deposits $ 2,334,683 $19,283 3.31% $ 2,206,994 $13,330 2.42% Short-term borrowings 270,896 2,822 4.18% 296,979 2,006 2.71% Subordinated notes 59,022 1,080 7.34% 59,022 1,000 6.80% Long-term debt and mandatorily redeemable securities 33,496 451 5.40% 18,026 305 6.79% ---------------------------- ---------------------------- Total Interest-Bearing Liabilities 2,698,097 23,636 3.51% 2,581,021 16,641 2.59% Noninterest-bearing deposits 372,024 396,596 Other liabilities 60,262 53,916 Shareholders' equity 352,149 328,347 ------------ ------------- Total $ 3,482,532 $ 3,359,880 ============ ============= ------- ------- Net Interest Income $27,807 $24,882 ======= ======= Net Yield on Earning Assets on a Taxable ----- ----- Equivalent Basis 3.44% 3.18% ===== ===== </TABLE> <TABLE> <CAPTION> DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL (Dollars in thousands) Six months ended June 30, -------------------------- 2006 2005 ----------------------- -------------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate <S> <C> <C> <C> <C> <C> <C> ASSETS: Investment securities: Taxable $ 456,013 $ 8,722 3.86% $ 565,088 $ 7,733 2.76% Tax exempt 174,547 3,682 4.25% 185,114 3,802 4.14% Mortgages - held for sale 53,545 1,743 6.56% 66,086 1,934 5.90% Net loans and leases 2,499,834 83,729 6.75% 2,301,846 67,295 5.90% Other investments 25,380 587 4.66% 15,413 204 2.67% ----------------------- -------------------------------- Total Earning Assets 3,209,319 98,463 6.19% 3,133,547 80,968 5.21% Cash and due from banks 80,001 83,080 Reserve for loan and lease losses (59,067) (63,134) Other assets 213,753 195,839 ------------ ------------ Total $ 3,444,006 $ 3,349,332 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing deposits $ 2,293,114 $36,316 3.19% $ 2,209,069 $25,646 2.34% Short-term borrowings 281,386 5,582 4.00% 294,904 3,708 2.54% Subordinated notes 59,022 2,130 7.28% 59,022 1,964 6.71% Long-term debt and mandatorily redeemable securities 32,250 905 5.66% 17,975 515 5.78% ----------------------- -------------------------------- Total Interest-Bearing Liabilities 2,665,772 44,933 3.40% 2,580,970 31,833 2.49% Noninterest-bearing deposits 367,637 387,312 Other liabilities 59,863 53,107 Shareholders' equity 350,734 327,943 ------------ ------------ Total $ 3,444,006 $ 3,349,332 ============ ============ ------- ------- Net Interest Income $53,530 $49,135 ======= ======= Net Yield on Earning Assets on a Taxable ----- ----- Equivalent Basis 3.36% 3.16% ===== ===== </TABLE> 17
PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES ----------------------------------------------- The recovery of provision for loan and lease losses for the three month periods ended June 30, 2006 and 2005 was $1.67 million and $3.41 million, respectively, and $1.97 million and $3.83 million for the six month periods ended June 30, 2006 and 2005, respectively. Net recoveries of $1.77 million were recorded for the second quarter 2006, compared to net recoveries of $0.31 million for the same quarter a year ago. Year-to-date net recoveries of $2.47 million have been recorded in 2006, compared to net charge-offs of $0.29 million through June 2005. In the second quarter 2006, loan and lease delinquencies were 0.23%, as compared to 0.53% for the second quarter 2005, and 0.38% at the end of 2005. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.26% as compared to 2.50% for the same period one year ago and 2.38% at December 31, 2005. A summary of loan and lease loss experienced during the three and six month periods ended June 30, 2006 and 2005 is provided below. <TABLE> <CAPTION> Summary of Reserve for Loan and Lease Losses ------------------------------------------------------------- (Dollars in Thousands) Three Months Ended Six Months Ended June 30, June 30, ------------------------------------------------------------- 2006 2005 2006 2005 ---------- --------------- ------------- -------------- <S> <C> <C> <C> <C> Reserve for loan and lease losses - beginning balance $ 59,097 $ 62,647 $ 58,697 $ 63,672 Charge-offs (591) (853) (1,371) (3,056) Recoveries 2,362 1,164 3,842 2,763 ---------- --------------- ------------- -------------- Net recoveries/(charge-offs) 1,771 311 2,471 (293) Recovery of provision for loan and lease losses (1,671) (3,411) (1,971) (3,832) ---------- --------------- ------------- -------------- Reserve for loan and lease losses - ending balance $ 59,197 $ 59,547 $ 59,197 $ 59,547 ========== =============== ============= ============== Loans and leases outstanding at end of period $2,615,152 $2,380,614 $2,615,152 $2,380,614 Average loans and leases outstanding during period 2,542,118 2,325,183 2,499,834 2,301,846 Reserve for loan and lease losses as a percentage of loans and leases outstanding at end of period 2.26% 2.50% 2.26% 2.50% Ratio of net (recoveries)/charge-offs during period to average loans and leases outstanding (0.28)% (0.05)% (0.20)% 0.03% </TABLE> 18
NONPERFORMING ASSETS -------------------- Nonperforming assets were as follows: <TABLE> <CAPTION> (Dollars in thousands) June 30, December 31, June 30, 2006 2005 2005 ------------- ------------- ------------- <S> <C> <C> <C> Loans and leases past due 90 days or more $ 278 $ 245 $ 52 Nonaccrual and restructured loans and leases 13,252 16,552 19,447 Other real estate 819 960 1,067 Repossessions 1,082 4,284 411 Equipment owned under operating leases - - 1,088 ------------- ------------- ------------- Total nonperforming assets $ 15,431 $ 22,041 $ 22,065 ============= ============= ============= </TABLE> Nonperforming assets totaled $15.43 million at June 30, 2006, reflecting an improvement of 29.99% from $22.04 million at December 31, 2005 and an improvement of 30.07% from $22.07 million at June 30, 2005. The improvement during the first six months of 2006 was primarily related to a decrease in nonaccrual loans and leases in all areas, with the exception of loans secured by real estate, and a decline in aircraft repossessions. Nonperforming assets as a percentage of total loans and leases improved to 0.57% at June 30, 2006, from 0.87% at December 31, 2005 and 0.91% at June 30, 2005. As of June 30, 2006, the Bank had a $3.32 million standby letter of credit outstanding that supported bond indebtedness of a customer. Due to the current financial condition of the customer, if this standby letter of credit is funded, the Bank likely will foreclose on the real estate securing the customer's reimbursement obligation. This likely will result in an increase in other real estate for approximately the same amount as the funding. As of June 30, 2006, repossessions consisted of aircraft, automobiles, light trucks, and environmental equipment. At the time of repossession, unless the equipment is in the process of immediate sale, the recorded amount of the loan or lease is written down, if necessary, to the estimated value of the equipment or vehicle by a charge to the reserve for loan and lease losses. Any subsequent write-downs are included in noninterest expense. 19
SUPPLEMENTAL LOAN INFORMATION AS OF JUNE 30, 2006 <TABLE> <CAPTION> (Dollars in thousands) Nonaccrual Other real estate Year-to-date Loans and leases and owned and net credit losses/ outstanding restructured loans repossessions (recoveries) ------------------ --------------------- ------------------- ------------------ <S> <C> <C> <C> <C> Commercial and agricultural loans $ 491,334 $ 1,214 $ - $ (391) Auto, light truck and environmental equipment 337,497 712 58 (233) Medium and heavy duty truck 319,845 - - (16) Aircraft financing 453,470 6,143 958 (1,463) Construction equipment financing 273,621 1,385 - (719) Loans secured by real estate 618,204 3,704 819 15 Consumer loans 121,181 94 66 261 ------------------ --------------------- ------------------- ------------------ Total $ 2,615,152 $ 13,252 $ 1,901 $ (2,546) ================== ===================== =================== ================== </TABLE> NONINTEREST INCOME ------------------ Noninterest income for the three month periods ended June 30, 2006 and 2005 was $19.07 million and $15.40 million, respectively, and $38.07 million and $33.09 million for the six month periods ended June 30, 2006 and 2005, respectively. Details of noninterest income follow: <TABLE> <CAPTION> (Dollars in thousands) Three Months Ended Six Months Ended June 30, June 30, ---------------------------- ----------------------------- 2006 2005 2006 2005 <S> <C> <C> <C> <C> Noninterest income: Trust fees $ 3,658 $ 3,285 $ 7,049 $ 6,531 Service charges on deposit accounts 4,917 4,251 9,303 8,214 Mortgage banking income 3,105 1,551 4,862 4,318 Insurance commissions 932 833 2,614 1,997 Equipment rental income 4,658 3,927 8,878 7,942 Other income 1,647 1,546 3,133 3,182 Investment securities and other investment gains 150 5 2,233 909 ---------------- ---------- --------------- ------------ Total noninterest income $19,067 $15,398 $38,072 $33,093 ================ ========== =============== ============ </TABLE> During the second quarter of 2006, mortgage banking income increased primarily due to a gain on a bulk sale of mortgage servicing rights of $1.25 million. Equipment rental income increased during the second quarter of 2006 mainly due to an increase in the operating lease portfolio and rental recoveries. Service charges on deposit accounts, which include overdraft and NSF fees, increased as a result of growth in the number of retail deposit accounts and increased incidence rates. Trust fees and insurance commissions increased in both the three and six month periods ended June 30, 2006, over the same periods in 2005. Trust fees increased due to growth in assets under management and an increase in IRA custodian revenue. Insurance commissions increased due to growth in commercial lines and higher premiums and higher contingent commissions in the first quarter. 20
Gains on venture partnership investment totaled $2.07 million for the first six months of 2006 compared to gains of $0.74 million for the first six months of 2005. NONINTEREST EXPENSE ------------------- Noninterest expense for the three month periods ended June 30, 2006 and 2005 was $32.39 million and $30.63 million, respectively, and $61.79 million and $62.30 million for the six month periods ended June 30, 2006 and 2005, respectively. Details of noninterest expense follow: <TABLE> <CAPTION> (Dollars in thousands) Three Months Ended Six Months Ended June 30, June 30, --------------------------- ----------------------------- 2006 2005 2006 2005 <S> <C> <C> <C> <C> Noninterest expense: Salaries and employee benefits $ 16,873 $ 17,090 $ 32,387 $ 35,634 Net occupancy expense 1,860 1,732 3,727 3,834 Furniture and equipment expense 2,959 2,844 6,093 5,486 Depreciation - leased equipment 3,547 3,194 6,929 6,517 Professional fees 1,104 685 1,989 1,484 Supplies and communication 1,307 1,321 2,670 2,664 Business development and marketing expense 1,048 910 1,690 1,520 Intangible asset amortization 659 670 1,325 1,328 Loan and lease collection and repossession expense 185 318 275 184 Other expense 2,844 1,862 4,707 3,649 ---------- ---------- -------- ---------- Total noninterest expense $ 32,386 $ 30,626 $ 61,792 $ 62,300 ========== ========== ======== ========== </TABLE> The overall decrease in noninterest expense was mainly reflected in salaries and employee benefits on a year-over-year basis. This decrease was primarily due to the first quarter 2006 reversal of previously recognized stock-based compensation expense under historical accounting methods related to the estimated forfeiture of stock awards. This one-time expense reversal, combined with the adoption of SFAS No. 123(R) estimated forfeiture accounting requirements, resulted in a reduction in stock-based compensation of $2.07 million, pre-tax. Stock-based compensation is discussed further in Note 5 of the Unaudited Notes to Consolidated Financial Statements. As of June 30, 2006, leased equipment depreciation increased on a year-over-year basis, primarily due to the increase in the operating lease portfolio. Professional fees increased mostly due to higher audit and regulatory examination fees. Other expenses were higher at June 30, 2006, as compared to one year ago as a result of higher legal contingency expenses and losses related to an employee defalcation, which contributed equally to the increase. Furniture and equipment expense increased on a year-over-year basis due to increased software costs, expenses related to the core system conversion project and other processing charges. Loan and lease collection and repossession expense increased slightly on a year-over-year basis as gains on disposition of repossessed assets decreased and valuation adjustments related to repossessed assets increased. Supplies and communication and business development and marketing expense remained comparable to 2005 levels. 21
INCOME TAXES ------------ The provision for income taxes for the three and six month periods ended June 30, 2006, was $5.22 million and $10.29 million, respectively, compared to $4.16 million and $7.26 million, respectively, for the same period in 2005. The effective tax rates were 33.68% for the quarter ended June 30, 2006 and 33.73% for the six month period ended June 30, 2006, compared to 33.57% and 32.37% for the three and six month periods ended June 30, 2005, respectively. The effective tax rate increased due to an increase in pre-tax income. The provision for income taxes for the three and six month periods ended June 30, 2006 and 2005, are at a rate which management believes approximates the effective rate for the year. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in market risks faced by 1st Source since December 31, 2005. For information regarding 1st Source's market risk, refer to 1st Source's Annual Report on Form 10-K for the year ended December 31, 2005. ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report an evaluation was carried out, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at June 30, 2006, our disclosure controls and procedures were effective in accumulating and communicating to management (including such officers) the information relating to 1st Source (including its consolidated subsidiaries) required to be included in our periodic SEC filings. In addition, there were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the second fiscal quarter of 2006 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. PART II. OTHER INFORMATION ITEM 1. Legal Proceedings. 1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of their businesses. Management does not expect that the outcome of any such proceedings will have a material adverse effect on 1st Source's consolidated financial position or results of operations. ITEM 1A. Risk Factors. There have been no material changes in risks faced by 1st Source since the filing of our Annual Report on Form 10-K for the year ended December 31, 2005. For information regarding our risk factors, refer to 1st Source's Annual Report on Form 10-K for the year ended December 31, 2005. 22
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds <TABLE> <CAPTION> ISSUER PURCHASES OF EQUITY SECURITIES (a) (b) (c) (d) Total number of Maximum number(or approximate Total number Average shares purchased dollar value) of shares of shares price paid per as part of publicly announced that may yet be purchased under Period purchased share plans or programs the plans or programs* - -------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> April 01 - 30, 2006 0 0 0 1,025,248 May 01 - 31, 2006 62,710 28.40 62,710 962,538 June 01 - 30, 2006 120 28.30 120 962,418 (1) 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on April 27, (2006.) Under the terms of the plan, 1st Source may repurchase up to 1,025,248* shares of its common stock when favorable conditions exist on the open market or through private transactions at various prices from time to time. Since the inception of the plan, 1st Source has repurchased a total of 62,830* shares. *Unadjusted for 10% stock dividend declared on July 27, 2006. </TABLE> ITEM 3. Defaults Upon Senior Securities. None ITEM 4. Submission of Matters to a Vote of Security Holders. The following actions were taken by the shareholders of 1st Source at the annual shareholders' meeting held April 27, 2006: 1. Election of Directors The directors named below were elected to the board of directors for terms expiring in April 2009, as follows: Nominee Votes For Votes Withheld ------- --------- -------------- Terry L. Gerber 20,156,933 316,799 William P. Johnson 20,163,184 573,549 Craig A. Kapson 20,137,994 295,118 John T. Phair 20,163,184 176,077 Mark D. Schwabero 20,163,184 309,373 In addition, the following directors continued in office after the 2006 annual meeting: Terms Expiring in April 2007: Terms Expiring in April 2008: ----------------------------- ----------------------------- David C. Bowers Lawrence E. Hiler Daniel B. Fitzpatrick Rex Martin Wellington D. Jones III Christopher J. Murphy III Dane A. Miller Timothy K. Ozark Toby S. Wilt 23
ITEM 5. Other Information. None ITEM 6. Exhibits The following exhibits are filed with this report: 1. Exhibit 31.1 Certification of Chief Executive Officer required by Rule 13a-14(a). 2. Exhibit 31.2 Certification of Chief Financial Officer required by Rule 13a-14(a). 3. Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer. 4. Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer. 24
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. 1st Source Corporation DATE July 27, 2006 /s/CHRISTOPHER J. MURPHY III - ---- ------------- ---------------------------- Christopher J. Murphy III Chairman of the Board, President and CEO DATE July 27, 2006 /s/LARRY E. LENTYCH - ---- ------------- ------------------- Larry E. Lentych Treasurer and Chief Financial Officer Principal Accounting Officer 25