1st Source - 10-Q quarterly report FY

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 2007 (2007 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, 2007, 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.

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, and reserves for pooled homogeneous loans and leases.  Management’s evaluation is based upon a continuing review of these portfolios, estimates of customer performance, collateral values and dispositions and assessments of economic and geopolitical events, all of which are subject to judgment and will change.

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.

1st Source Bank, a subsidiary of 1st Source Corporation, grants 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 September 30, 2008 and December 31, 2007, 1st Source Bank had commitments outstanding to originate and purchase mortgage loans aggregating $38.86 million and $29.53 million, respectively. Outstanding commitments to sell mortgage loans aggregated $58.00 million at September 30, 2008, and $45.53 million at December 31, 2007.  Standby letters of credit totaled $79.55 million and $61.79 million at September 30, 2008, and December 31, 2007, respectively.  Standby letters of credit have terms ranging from six months to one year.

Stock-based compensation expense for all stock-based compensation awards granted 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.

The stock-based compensation expense recognized in the condensed consolidated statement of operations for the nine months ended September 30, 2008 and 2007 was 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 third quarter of 2008 (September 30, 2008) 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 September 30, 2008.  This amount changes based on the fair market value of 1st Source’s stock.  Total fair value of options vested and expensed was $12 thousand and $57 thousand, net of tax, for the nine months ended September 30, 2008 and 2007, respectively.

 

As of January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” and SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” including an amendment of SFAS No. 115.  SFAS No. 157 does not change existing guidance as to whether or not an asset or liability is carried at fair value.  It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.  SFAS No. 159 generally permits the measurement of selected eligible financial instruments at fair value at specified election dates, subject to the conditions set forth in the standard.

We also adopted the provisions of FASB Staff Position (FSP) No. 157-2, which defers until January 1, 2009, the application of SFAS 157 to nonfinancial assets and nonfinancial liabilities not recognized or disclosed at least annually at fair value.  Items affected by this deferral include goodwill, repossessions and other real estate, all for which any necessary impairment analyses are performed using fair value measurements.  We do not expect the adoption of FSP No. 157-2 will have a material impact on our financial condition, results of operations, or liquidity.

We elected to adopt SFAS No. 159 for mortgages held for sale (MHFS) at fair value prospectively for new MHFS originations starting on January 1, 2008.  We believe the election for MHFS (which are now hedged with free-standing derivatives (economic hedges)) will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets.  There was no transition adjustment required upon adoption of SFAS No. 159 for MHFS because we continued to account for MHFS originated prior to January 1, 2008 at the lower of cost or fair value.  At September 30, 2008, MHFS carried at fair value totaled $38.70 million.  At September 30, 2008, there were no MHFS that were originated prior to January 1, 2008.

In accordance with SFAS No. 157, we group our financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are:

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

Certain assets and liabilities are measured at fair value on a recurring basis.  The following is a discussion of these assets and liabilities and valuation techniques applied to each for fair value measurement:

The table below presents the balance of assets and liabilities at September 30, 2008 measured at fair value on a recurring basis:

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:

We may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP.   These other financial assets include loans measured for impairment under SFAS 114, venture capital partnership investments and mortgage servicing rights.  Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral.  Collateral values are estimated using customized discounting criteria, appraisals and dealer and trade magazine quotes which are used in a market valuation approach.  Venture capital partnership investments and the adjustments to fair value primarily result from application of lower-of-cost-or-fair value accounting.  The partnership investments are priced using financial statements provided by the partnerships.  Mortgage servicing rights (MSRs) and related adjustments to fair value result from application of lower-of-cost-or-fair value accounting.  Fair value measurements for mortgage servicing rights are derived based on a variety of inputs including prepayment speeds, discount rates, scheduled servicing cash flows, delinquency rates and other assumptions.  MSRs do not trade in an active, open market with readily observable prices and though sales of MSRs do occur, precise terms and conditions typically are not readily available.  For assets measured at fair value on a nonrecurring basis the following represents impairment charges (recoveries) recognized on these assets during the quarter ended September 30, 2008:  impaired loans $0.04 million; venture capital partnership investments $(0.11) million; mortgage servicing rights $( 0.13) million.  For assets measured at fair value on a nonrecurring basis on hand at September 30, 2008, the following table provides the level of valuation assumptions used to determine each valuation and the fair value measurement of the related assets:

The following table reflects the differences between fair value carrying amount of mortgages held for sale measured at fair value under SFAS No. 159 and the aggregate unpaid principal amount we are contractually entitled to receive at maturity on September 30, 2008:

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 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 2007, 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 September 30, 2008, as compared to December 31, 2007, and the results of operations for the three and nine month periods ended September 30, 2008 and 2007. 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 2007 Annual Report.

Our total assets at September 30, 2008, were $4.41 billion, relatively unchanged from December 31, 2007.  Total loans and leases were $3.31 billion at September 30, 2008, an increase of $123.42 million or 3.87% from December 31, 2007.  Total deposits at September 30, 2008, were $3.35 billion, down $119.25 million or 3.44% from the comparable figures at the end of 2007.  Total investment securities, available for sale were $658.91 million at September 30, 2008, a decrease of $121.08 million or 15.52% from December 31, 2007.

Nonperforming assets at September 30, 2008, were $30.00 million compared to $18.48 million at December 31, 2007, an increase of 62.34%.  The majority of the increase was in nonaccrual loans in the medium and heavy duty truck financing portfolio.  At September 30, 2008, nonperforming assets were 0.88% of net loans and leases compared to 0.56% at December 31, 2007.

As of September 30, 2008, total shareholders' equity was $441.01 million, up $10.51 million or 2.44% from the $430.50 million at December 31, 2007.  In addition to net income of $21.07 million, other significant changes in shareholders’ equity during the first nine months of 2008 included $10.15 million of dividends paid.  The accumulated other comprehensive income component of shareholders’ equity totaled $1.62 million at September 30, 2008, compared to $2.52 million at December 31, 2007.  The decrease in accumulated other comprehensive income was a result of changes in unrealized gain or loss on securities in the available-for-sale portfolio.  Our equity-to-assets ratio was 10.00% as of September 30, 2008, compared to 9.68% at December 31, 2007. Book value per common share rose to $18.29 at September 30, 2008, up from $17.87 at December 31, 2007.  Tangible book value per common share was $14.47 at September 30, 2008, up from $13.99 at December 31, 2007.

We declared and paid dividends per common share of $0.14 during the third quarter of 2008.  The trailing four quarters dividend payout ratio, representing dividends per share divided by diluted earnings per share, was 48.31%.  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 Corporation and 1st Source Bank, as of September 30, 2008, are presented in the table below:

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 75.17% at September 30, 2008 compared to 71.76% at December 31, 2007 and 72.55% at September 30, 2007.  Cash and cash equivalents totaled $75.70 million at September 30, 2008 compared to $153.14 million at December 31, 2007 and $117.56 million at September 30, 2007.  At September 30, 2008, the consolidated statement of financial condition was rate sensitive by $516.90 million more liabilities than assets scheduled to reprice within one year, or approximately 0.83%.  Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.

Net income for the three and nine month periods ended September 30, 2008, was $4.47 million and $21.07 million respectively, compared to $6.13 million and $22.71 million for the same periods in 2007.  Diluted net income per common share was $0.18 and $0.86 respectively, for the three and nine month periods ended September 30, 2008, compared to $0.25 and $0.96 for the same periods in 2007.  Return on average common shareholders' equity was 6.35% for the nine months ended September 30, 2008, compared to 7.58% in 2007. The return on total average assets was 0.64% for the nine months ended September 30, 2008, compared to 0.75% in 2007.

The change in net income for the nine months ended September 30, 2008, over the first nine months of 2007, was primarily the result of an increase of $5.32 million to our provision for loan and lease losses, $10.26 million of other than temporary impairment on investment securities, and a $10.93 million increase in noninterest expense, which were offset by a $11.98 million increase in net interest income, a $9.58 million increase in noninterest income and a $3.31 million reduction in income tax expense.  Details of the changes in the various components of net income are further discussed below.

Average short term borrowings increased $130.35 million or 43.81% and $111.50 million or 42.44%, respectively, for the third quarter of 2008 and the first nine months of 2008, compared to the same time periods in 2007.  Interest paid on short-term borrowings decreased due to the interest rate decrease in adjustable rate borrowings.  Average long-term debt decreased $9.38 million or 21.22% during the third quarter of 2008 as compared to the third quarter of 2007 and decreased $9.14 million or 20.88% during the first nine months of 2008 as compared to the first nine months of 2007.  The majority of the decrease in long-term debt was made up of Federal Home Loan Bank borrowings.

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.

The provision for loan and lease losses for the three and nine month periods ended September 30, 2008, was $3.57 million and $9.60 million, respectively, compared to the provision for loan and lease losses of $3.66 million and $4.28 million for the three and nine month periods ended September 30, 2007, respectively.  Net recoveries of $0.34 million were recorded for the third quarter 2008, compared to net charge-offs of $1.84 million for the same quarter a year ago.  Year-to-date net charge-offs of $0.60 million have been recorded in 2008, compared to net charge-offs of $0.80 million through September 2007.

In the third quarter 2008, over 30 day loan and lease delinquencies were 0.­­­83%, as compared to 0.42% for the thirdquarter 2007.  The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.28% as compared to 2.02% for the same period one year ago and 2.09% at December 31, 2007.  A summary of loan and lease loss experienced during the three- and nine- month periods ended September 30, 2008 and 2007 is provided below.