Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2011
OR
o 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
(Exact name of registrant as specified in its charter)
INDIANA
35-1068133
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
100 North Michigan Street
South Bend, IN
46614
(Address of principle 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. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o (Do not check if a smaller reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No
Number of shares of common stock outstanding as of July 15, 2011 — 24,213,142 shares
TABLE OF CONTENTS
Page
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements (Unaudited)
Consolidated statements of financial condition — June 30, 2011 and December 31, 2010
3
Consolidated statements of income — three and six months ended June 30, 2011 and 2010
4
Consolidated statements of shareholders’ equity — six months ended June 30, 2011 and 2010
5
Consolidated statements of cash flows — six months ended June 30, 2011 and 2010
6
Notes to the Consolidated Financial Statements
7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
29
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
39
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
40
Defaults Upon Senior Securities
(Removed and reserved)
Item 5.
Other Information
Item 6.
Exhibits
SIGNATURES
41
CERTIFICATIONS
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2
2
1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited - Dollars in thousands)
June 30,
December 31,
2011
2010
ASSETS
Cash and due from banks
$
59,249
62,313
Federal funds sold and interest bearing deposits with other banks
100
34,559
Investment securities available-for-sale (amortized cost of $878,401 and $952,101 at June 30, 2011 and December 31, 2010, respectively)
902,742
969,018
Other investments
18,974
21,343
Trading account securities
143
138
Mortgages held for sale
7,805
32,599
Loans and leases - net of unearned discount
Commercial and agricultural loans
551,820
530,228
Auto, light truck and environmental equipment
473,925
396,500
Medium and heavy duty truck
155,423
162,824
Aircraft financing
607,567
614,357
Construction equipment financing
274,968
285,634
Commercial real estate
568,226
594,729
Residential real estate
390,389
390,951
Consumer loans
95,839
95,400
Total loans and leases
3,118,157
3,070,623
Reserve for loan and lease losses
(85,010
)
(86,874
Net loans and leases
3,033,147
2,983,749
Equipment owned under operating leases, net
77,102
78,138
Net premises and equipment
36,885
33,881
Goodwill and intangible assets
88,325
88,955
Accrued income and other assets
130,479
140,588
Total assets
4,354,951
4,445,281
LIABILITIES
Deposits:
Noninterest bearing
516,189
524,564
Interest bearing
3,007,127
3,098,181
Total deposits
3,523,316
3,622,745
Short-term borrowings:
Federal funds purchased and securities sold under agreements to repurchase
108,799
136,028
Other short-term borrowings
21,324
19,961
Total short-term borrowings
130,123
155,989
Long-term debt and mandatorily redeemable securities
36,785
24,816
Subordinated notes
89,692
Accrued expenses and other liabilities
69,441
65,656
Total liabilities
3,849,357
3,958,898
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 25,643,506 at June 30, 2011 and December 31, 2010
346,535
350,282
Retained earnings
175,374
157,875
Cost of common stock in treasury (1,431,804 shares at June 30, 2011 and 1,470,696 shares at December 31, 2010)
(31,437
(32,284
Accumulated other comprehensive income
15,122
10,510
Total shareholders’ equity
505,594
486,383
Total liabilities and shareholders’ equity
The accompanying notes are a part of the consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited - Dollars in thousands, except per share amounts)
Three Months Ended June 30,
Six Months Ended June 30,
Interest income:
Loans and leases
41,710
43,099
83,009
85,369
Investment securities, taxable
4,912
5,279
9,394
10,680
Investment securities, tax-exempt
1,004
1,422
2,190
2,889
Other
247
250
490
524
Total interest income
47,873
50,050
95,083
99,462
Interest expense:
Deposits
8,162
11,573
16,517
23,978
Short-term borrowings
74
206
163
394
1,648
1,647
3,295
3,294
405
375
664
645
Total interest expense
10,289
13,801
20,639
28,311
Net interest income
37,584
36,249
74,444
71,151
Provision for loan and lease losses
67
5,798
2,265
10,186
Net interest income after provision for loan and lease losses
37,517
30,451
72,179
60,965
Noninterest income:
Trust fees
4,411
4,062
8,403
7,807
Service charges on deposit accounts
4,638
5,275
8,874
9,895
Mortgage banking income
835
425
1,279
1,202
Insurance commissions
1,062
1,061
2,204
2,526
Equipment rental income
6,009
6,672
12,047
13,417
Other income
3,327
3,012
6,298
5,701
Investment securities and other investment gains
1,142
95
1,272
976
Total noninterest income
21,424
20,602
40,377
41,524
Noninterest expense:
Salaries and employee benefits
19,135
18,848
37,773
37,658
Net occupancy expense
2,051
1,939
4,371
4,426
Furniture and equipment expense
3,561
3,196
6,910
5,996
Depreciation - leased equipment
4,795
5,304
9,600
10,668
Professional fees
1,080
1,418
2,176
2,932
Supplies and communication
1,316
1,338
2,710
2,707
FDIC and other insurance
958
1,667
2,634
3,341
Business development and marketing expense
864
880
1,486
1,447
Loan and lease collection and repossession expense
1,500
3,267
2,824
4,373
Other expense
683
1,792
3,935
3,211
Total noninterest expense
35,943
39,649
74,419
76,759
Income before income taxes
22,998
11,404
38,137
25,730
Income tax expense
8,133
3,609
12,664
8,256
Net income
14,865
7,795
25,473
17,474
Preferred stock dividends and discount accretion
(1,717
(3,428
Net income available to common shareholders
6,078
14,046
Per common share
Basic net income per common share
0.61
0.25
1.04
0.57
Diluted net income per common share
Dividends
0.16
0.15
0.32
0.30
Basic weighted average common shares outstanding
24,254,334
24,284,519
24,262,803
24,247,586
Diluted weighted average common shares outstanding
24,263,596
24,292,491
24,271,527
24,254,098
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Cost of
Accumulated
Common
Preferred
Retained
Stock
Comprehensive
Total
Earnings
in Treasury
Income (Loss), Net
Balance at January 1, 2010
570,320
104,930
350,269
142,407
(32,380
5,094
Comprehensive Income, net of tax:
Net Income
Change in unrealized appreciation of available-for-sale securities, net of tax
9,411
Reclassification adjustment for gains included in net income, net of tax
(174
Total Comprehensive Income
26,711
Issuance of 188,470 common shares under stock based compensation awards, including related tax effects
2,884
628
2,256
Cost of 21,471 shares of common stock acquired for treasury
(362
Preferred stock discount accretion
653
(653
Preferred stock dividend (paid and/or accrued)
(2,775
Common stock dividend ($0.30 per share)
(7,282
Stock based compensation
Balance at June 30, 2010
589,502
105,583
350,275
149,799
(30,486
14,331
Balance at January 1, 2011
5,457
(845
30,085
Issuance of 148,291 common shares under stock based compensation awards, including related tax effects
2,818
(168
2,986
Cost of 109,399 shares of common stock acquired for treasury
(2,139
Repurchase of common stock warrant
(3,750
Common stock dividend ($0.32 per share)
(7,806
Balance at June 30, 2011
CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating activities:
Adjustments to reconcile net income to net cash provided (used) by operating activities:
Depreciation of premises and equipment
1,780
2,156
Depreciation of equipment owned and leased to others
Amortization of investment security premiums and accretion of discounts, net
965
795
Amortization of mortgage servicing rights
1,458
1,461
Mortgage servicing asset impairment
16
970
Deferred income taxes
(755
8,637
(1,272
(976
Originations/purchases of loans held for sale, net of principal collected
(40,963
(138,692
Proceeds from the sales of loans held for sale
66,258
107,651
Net gain on sale of loans held for sale
(500
(1,394
Change in trading account securities
(5
12
Change in interest receivable
918
1,255
Change in interest payable
2,462
3,238
Change in other assets
8,347
(3,482
Change in other liabilities
(734
(6,355
2,620
387
Net change in operating activities
77,933
13,991
Investing activities:
Proceeds from sales of investment securities
126,805
71,917
Proceeds from maturities of investment securities
107,843
215,792
Purchases of investment securities
(160,641
(303,604
Net change in other investments
2,370
2,056
Loans sold or participated to others
11,010
9,886
Net change in loans and leases
(62,674
(58,893
Net change in equipment owned under operating leases
(8,564
(4,952
Purchases of premises and equipment
(5,589
(1,041
Net change in investing activities
10,560
(68,839
Financing activities:
Net change in demand deposits, NOW accounts and savings accounts
(108,064
44,177
Net change in certificates of deposit
8,635
(87,055
Net change in short-term borrowings
(25,866
(8,336
Proceeds from issuance of long-term debt
10,554
10,346
Payments on long-term debt
(256
(289
Net proceeds from issuance of treasury stock
Acquisition of treasury stock
Cash dividends paid on preferred stock
Cash dividends paid on common stock
(7,948
(7,408
Net change in financing activities
(126,016
(48,818
Net change in cash and cash equivalents
(37,523
(103,666
Cash and cash equivalents, beginning of year
96,872
210,102
Cash and cash equivalents, end of period
59,349
106,436
Non-cash transactions:
Loans transferred to other real estate and repossessed assets
6,721
10,939
Common stock matching contribution to KSOP plan
2,420
2,545
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) which 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 (GAAP) have been omitted. The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation’s Annual Report on Form 10-K (2010 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, 2010 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.
Cash Flow — For purposes of the consolidated statements of cash flow, we consider cash and due from banks, federal funds sold and interest bearing deposits with other banks with original maturities of three months or less as cash and cash equivalents.
Note 2. Recent Accounting Pronouncements
Comprehensive Income: In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-05 “Comprehensive Income (Topic 220) — Presentation of Comprehensive Income.” ASU 2011-05 requires that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 is effective retrospectively for fiscal years, and interim periods within those years, beginning after December 15, 2011. We are assessing the impact of ASU 2011-05 on our comprehensive income presentation.
Fair Value Measurements: In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” ASU 2011-04 changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. Consequently, the amendments in this update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs (International Financial Reporting Standards). ASU 2011-04 is effective prospectively during interim and annual periods beginning on or after December 15, 2011. Early application by public entities is not permitted. We are assessing the impact of ASU 2011-04 on our fair value disclosures.
Transfers and Servicing: In April 2011, the FASB issued ASU No. 2011-03 “Transfers and Servicing (Topic 860) - Reconsideration of Effective Control for Repurchase Agreement.” ASU 2011-03 removes from the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should
be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. We are assessing the impact of ASU 2011-03 on our financial condition, results of operations, and disclosures.
Receivables: In April 2011, the FASB issued ASU No. 2011-02 “Receivables (Topic 310) — A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” ASU 2011-02 clarifies whether loan modifications constitute troubled debt restructuring. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. ASU 2011-02 is effective for the first interim and annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. We are assessing the impact of ASU 2011-02 on our financial condition, results of operations, and disclosures.
Business Combinations: In December 2010, the FASB issued ASU No. 2010-29 “Business Combinations (Topic 805) - Disclosure of Supplementary Pro Forma Information for Business Combinations.” If a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 also expands the supplementary pro forma disclosures. ASU 2010-29 was effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. ASU 2010-29 will only affect us if there are future business combinations.
Intangibles - Goodwill and Other: In December 2010, the FASB issued ASU No. 2010-28 “Intangibles - Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” ASU 2010-28 affects all entities that have recognized goodwill and have one or more reporting units whose carrying amount for purposes of performing Step 1 of the goodwill impairment test is zero or negative. ASU 2010-28 was effective for fiscal years and interim periods within those years, beginning after December 15, 2010. ASU 2010-28 did not have an impact on our financial condition, results of operations, or disclosures.
8
Note 3. Investment Securities
Investment securities available-for-sale were as follows:
Amortized
Gross
(Dollars in thousands)
Cost
Unrealized Gains
Unrealized Losses
Fair Value
June 30, 2011
U.S. Treasury and Federal agencies securities
376,304
6,998
(127
383,175
U.S. States and political subdivisions securities
112,900
5,310
(786
117,424
Mortgage-backed securities — Federal agencies
339,583
9,898
(225
349,256
Corporate debt securities
40,563
181
(70
40,674
Foreign government and other securities
6,705
44
(54
6,695
Total debt securities
876,055
22,431
(1,262
897,224
Marketable equity securities
2,346
3,176
(4
5,518
Total investment securities available-for-sale
878,401
25,607
(1,266
December 31, 2010
442,612
5,546
(849
447,309
147,679
4,381
(1,753
150,307
309,046
7,854
(232
316,668
45,778
182
(345
45,615
5,732
18
(34
5,716
950,847
17,981
(3,213
965,615
1,254
2,152
(3
3,403
952,101
20,133
(3,216
At June 30, 2011 and December 31, 2010, the residential mortgage-backed securities we held consisted primarily of GNMA, FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government (or Government Sponsored Enterprise, GSEs).
The contractual maturities of debt securities available-for-sale at June 30, 2011 are shown below. Expected maturities will differ from contractual maturities, because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized Cost
Due in one year or less
45,160
45,550
Due after one year through five years
337,681
344,378
Due after five years through ten years
146,453
151,643
Due after ten years
7,178
6,397
Mortgage-backed securities
Total debt securities available-for-sale
The following table shows the gross realized gains and losses on sale of securities from the securities available-for-sale portfolio, including marketable equity securities. Realized gains and losses on the sales of all securities are computed using the specific identification cost basis. The gross gains and losses in the first six months of 2011 primarily reflect the sale of municipal, Farmer Mac, FHLB and FFCB debt securities. The sale of municipal securities was to reduce credit risk exposure in certain states. The action to sell agency securities was to improve future yield. There was no impact to other than temporary impairment (OTTI) as a result of the 2011 sales. The gross gains and losses in the first six months of 2010 reflect the disposition of FNMA and FHLMC debt securities. There were no OTTI write-downs in 2011 or 2010.
9
Three Months Ended
Six Months Ended
Gross realized gains
1,153
1,598
292
Gross realized losses
(238
(12
Net realized gains (losses)
1,360
280
There were net gains of $5 thousand for the six months ended June 30, 2011 and net losses of $11 thousand recorded for the six months ended June 30, 2010 on $0.14 million in trading securities outstanding at June 30, 2011 and at December 31, 2010.
The following tables summarize our gross unrealized losses and fair value by investment category and age:
Less than 12 Months
12 months or Longer
Fair
Unrealized
Value
Losses
39,869
1,582
6,426
(752
8,008
Mortgage-backed securities - Federal agencies
50,235
(201
4,215
(24
54,450
17,090
940
109,716
(486
10,641
(776
120,357
1
109,717
10,645
(780
120,362
158,497
9,226
(246
9,055
(1,507
18,281
23,351
(213
4,887
(19
28,238
26,407
3,015
220,496
(1,687
13,942
(1,526
234,438
13,947
(1,529
234,443
The initial indication of OTTI for both debt and equity securities is a decline in fair value below amortized cost. Quarterly, the impaired securities are analyzed on a qualitative and quantitative basis in determining OTTI. Declines in the fair value of available-for-sale debt securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of impairment related to other factors is recognized in other comprehensive income. In estimating OTTI impairment losses, we consider among other things, (i) the length of time and the extent to which fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) whether it is more likely than not that we will not have to sell any such securities before a recovery of cost.
At June 30, 2011, we do not have the intent to sell any of the available-for-sale securities in the table above and believe that it is more likely than not that we will not have to sell any such securities before an anticipated recovery of cost. The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased and market illiquidity on auction rate securities which are reflected in U.S. States and Political subdivisions securities. The fair value is expected to recover on all debt securities as they approach their maturity date or repricing date or if market yields for such investments decline. We do not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of June 30, 2011, we believe the impairments detailed in the table above are temporary and no impairment loss has been
10
realized in our consolidated statements of income.
At June 30, 2011 and December 31, 2010, investment securities with carrying values of $255.75 million and $299.88 million, respectively, were pledged as collateral to secure government deposits, security repurchase agreements, and for other purposes.
Note 4. Loan and Lease Financings
We evaluate loans and leases for credit quality at least annually but more frequently if certain circumstances occur (such as material new information which becomes available and indicates a potential change in credit risk). We use two methods to assess credit risk: loan or lease credit quality grades and credit risk classifications. The purpose of the loan or lease credit quality grade is to document the degree of risk associated with individual credits as well as inform management of the degree of risk in the portfolio taken as a whole. Credit risk classifications are used to categorize loans by degree of risk and to designate committee approval authorities for higher risk credits at the time of origination. Credit risk classifications include categories for: Acceptable, Marginal, Special Attention, Special Risk, Restricted by Policy, Regulated and Prohibited by Law.
All loans and leases, except residential real estate loans and consumer loans, are assigned credit quality grades on a scale from 1 to 12 with grade 1 representing superior credit quality. The criteria used to assign grades to extensions of credit that exhibit potential problems or well-defined weaknesses are primarily based upon the degree of risk and the likelihood of orderly repayment, and their effect on our safety and soundness. Loans or leases graded 7 or weaker are considered “special attention” credits and, as such, relationships in excess of $100,000 are reviewed quarterly as part of management’s evaluation of the adequacy of the reserve for loan and lease losses. Grade 7 credits are defined as “watch” and contain greater than average credit risk and are monitored to limit our exposure to increased risk; grade 8 credits are “special mention” and, following regulatory guidelines, are defined as having potential weaknesses that deserve management’s close attention. Credits that exhibit well-defined weaknesses and a distinct possibility of loss are considered ‘‘classified’’ and are graded 9 through 12 corresponding to the regulatory definitions of “substandard” (grades 9 and 10) and the more severe ‘‘doubtful’’ (grade 11) and ‘‘loss’’ (grade 12).
11
The table below presents the credit quality grades of the recorded investment in loans and leases, segregated by class.
Credit Quality Grades
1-6
7-12
504,680
47,140
468,911
5,014
140,418
15,005
560,855
46,712
249,834
25,134
508,983
59,243
2,433,681
198,248
2,631,929
483,603
46,625
389,774
6,726
143,431
19,393
555,106
59,251
246,644
38,990
532,581
62,148
2,351,139
233,133
2,584,272
The table below presents the recorded investment in residential real estate and consumer loans by performing or non-performing status. Non-performing loans are those loans which are on nonaccrual status or are 90 days or more past due.
Performing
Nonperforming
385,901
4,488
Consumer
95,427
412
481,328
4,900
486,228
385,729
5,222
94,973
427
480,702
5,649
486,351
The table below presents the recorded investment of loans and leases, segregated by class, with delinquency aging and nonaccrual status.
90 Days
or More
30-59 Days
60-89 Days
Past Due
Total Financing
Current
and Accruing
Accruing Loans
Nonaccrual
Receivables
545,602
792
160
546,554
5,266
470,680
468
240
471,388
2,537
151,076
151,217
4,206
586,772
3,640
124
590,536
17,031
267,846
1,364
1,482
270,692
4,276
538,707
1,682
796
541,185
27,041
382,960
2,222
719
272
386,173
4,216
94,220
935
65
95,492
347
3,037,863
11,241
3,796
337
3,053,237
64,920
521,363
760
22
522,145
8,083
391,925
528
715
393,168
3,332
157,723
33
157,756
5,068
580,174
16,097
188
596,459
17,898
275,204
601
277,059
8,575
567,254
759
94
568,107
26,622
381,368
3,781
580
264
385,993
4,958
93,290
1,152
531
98
95,071
329
2,968,301
24,364
2,731
362
2,995,758
74,865
A loan or lease is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan or lease agreement. The table below presents impaired loans and leases, segregated by class, and the corresponding reserve for impaired loan and lease losses.
13
Unpaid
Recorded
Principal
Related
Investment
Balance
Allowance
With no related allowance recorded:
2,771
1,387
3,244
13,938
3,670
22,080
22,084
Total with no related allowance recorded
47,090
47,094
With an allowance recorded:
7,477
3,051
446
105
989
172
3,008
817
562
20
6,717
6,716
639
Total with an allowance recorded
19,199
19,198
4,804
Total impaired loans
66,289
66,292
4,930
1,596
1,597
1,748
4,509
5,534
5,535
21,071
39,388
39,390
8,282
8,281
4,190
1,136
377
3,347
1,049
13,913
2,050
3,374
3,379
648
8,625
8,630
893
38,677
38,686
9,207
78,065
78,076
Average recorded investment and interest income recognized on impaired loans and leases, segregated by class, is shown in the table below.
Average Recorded Investment
Interest Income
11,342
114
12,156
230
1,774
2,005
4,350
4,580
17,070
103
16,673
15
6,289
81
7,300
169
30,448
49
30,156
71,273
178
72,870
379
525
14
As of June 30, 2011 and December 31, 2010, we had $6.61 million and $7.31 million, respectively of performing loans classified as troubled debt restructuring.
Note 5. Reserve for Loan and Lease Losses
The reserve for loan and lease loss methodology has been consistently applied for several years, with enhancements instituted periodically. Reserve ratios are reviewed quarterly and revised periodically to reflect recent loss history and to incorporate current risks and trends which may not be recognized in historical data. As we update our historical charge-off analysis, we review the look-back periods for each business loan portfolio. Furthermore, we perform a thorough analysis of charge-offs, non-performing asset levels, special attention outstandings and delinquency in order to review portfolio trends and other factors, including specific industry risks and economic conditions, which may have an impact on the reserves and reserve ratios applied to various portfolios. We adjust the calculated historical based ratio as a result of our analysis of environmental factors, principally economic risk and concentration risk. Key economic factors affecting our portfolios are growth in gross domestic product, unemployment rates, housing market trends, commodity prices, inflation, national and international economic volatility, global debt and capital markets and political stability or lack thereof. Concentration risk is impacted primarily by geographic concentration in Northern Indiana and Southwestern Lower Michigan in our business banking and commercial real estate portfolios and by collateral concentration in our specialty finance portfolios and exposure to foreign markets by geographic risk.
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. For purposes of determining the reserve, we have segmented our loans and leases into classes based on the associated risks within these segments. We have determined that eight classes exist within our loan and lease portfolio. The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for impaired loans, percentage allocations for special attention loans and leases (classified loans and leases and internal watch list credits) without specific reserves, formula reserves (calculated by applying loss factors based upon a review of historical loss experience and qualitative factors) 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.
Changes in the reserve for loan and lease losses, segregated by class, for the three months ended June 30, 2011 and 2010 are shown below.
Auto, light truck
Construction
Commercial and
and environmental
Medium and
Aircraft
equipment
Commercial
Residential
agricultural loans
heavy duty truck
financing
real estate
loans
Balance, beginning of period
16,305
7,924
5,065
30,903
6,798
15,535
2,542
1,088
86,160
Charge-offs
535
257
530
268
1,234
120
3,201
Recoveries
1,492
25
90
63
31
102
1,984
Net charge-offs (recoveries)
(957
232
440
205
1,053
89
155
1,217
Provision (recovery of provision)
(448
1,349
(481
(1,902
209
204
218
Balance, end of period
16,814
9,041
4,584
28,561
6,802
15,400
2,657
1,151
85,010
Ending balance: individually evaluated for impairment
Ending balance: collectively evaluated for impairment
13,763
8,936
4,412
27,744
6,782
14,761
80,206
Financing receivables:
Ending balance
10,248
1,833
4,233
16,946
4,232
28,797
541,572
472,092
151,190
590,621
270,736
539,429
3,051,868
June 30, 2010
21,116
9,164
7,369
21,697
9,390
14,762
2,550
1,779
87,827
542
332
1,278
208
1,139
2,200
195
432
6,326
319
91
23
148
223
323
117
1,037
2,177
284
5,611
(1,213
499
1,592
3,356
825
165
1,968
19,680
9,340
7,683
24,936
9,178
12,750
984
3,463
88,014
3,336
328
2,104
3,049
1,375
2,395
12,587
16,344
9,012
5,579
21,887
7,803
10,355
75,427
539,003
416,152
185,954
596,138
308,602
581,392
401,662
102,846
3,131,749
20,872
3,568
7,301
11,935
10,127
28,397
82,200
518,131
412,584
178,653
584,203
298,475
552,995
3,049,549
Changes in the reserve for loan and lease losses, segregated by class, for the six months ended June 30, 2011 and 2010 are shown below.
20,544
7,542
5,768
29,811
8,439
11,177
2,518
1,075
86,874
957
325
1,628
853
2,465
154
852
7,234
1,616
70
764
286
34
236
3,105
(659
255
(1
755
2,179
616
4,129
(4,389
1,754
(1,185
(386
(882
6,402
259
692
24,017
9,630
6,186
24,807
8,875
10,453
3,388
88,236
890
804
1,879
2,775
2,540
360
809
11,705
564
43
144
24
297
1,297
326
761
1,840
2,612
1,504
2,517
336
512
10,408
(4,011
471
3,337
2,741
1,807
4,814
587
17
Note 6. Mortgage Servicing Assets
We recognize the rights to service residential mortgage loans for others as separate assets, whether the servicing rights are acquired through a separate purchase or through the sale of originated loans with servicing rights retained. We allocate a portion of the total proceeds of a mortgage loan to servicing rights based on the fair value. The unpaid principal balance of residential mortgage loans serviced for third parties was $1.07 billion and $1.08 billion at June 30, 2011 and December 31, 2010, respectively.
Mortgage servicing assets are evaluated for impairment. For purposes of impairment measurement, mortgage servicing assets are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type and interest rate. If temporary impairment exists within a tranche, a valuation allowance is established through a charge to income equal to the amount by which the carrying value exceeds the fair value. If it is later determined all or a portion of the temporary impairment no longer exists for a particular tranche, the valuation allowance is reduced through a recovery of income.
Changes in the carrying value of mortgage servicing assets and the associated valuation allowance follow:
Mortgage servicing assets:
Balance at beginning of period
6,968
8,116
7,556
8,749
Additions
175
321
1,541
Amortization
(724
(700
(1,458
(1,461
Sales
(218
(661
Carrying value before valuation allowance at end of period
6,419
8,168
Valuation allowance:
Impairment (charges) recoveries
(11
(971
(16
(970
Balance at end of period
Net carrying value of mortgage servicing assets at end of period
6,403
7,197
Fair value of mortgage servicing assets at end of period
10,241
7,489
During the six months ended June 30, 2011 and 2010, management determined that it was not necessary to permanently write-down any previously established valuation allowance. At June 30, 2011 and 2010, the fair value of mortgage servicing assets exceeded the carrying value reported in the consolidated statement of financial condition by $3.84 million and $0.29 million, respectively. This difference represents increases in the fair value of certain mortgage servicing assets that could not be recorded above cost basis.
The key economic assumptions used to estimate the fair value of the mortgage servicing rights follow:
Expected weighted-average life (in years)
3.48
3.56
Weighted-average constant prepayment rate (CPR)
16.74
%
29.46
Weighted-average discount rate
9.30
8.99
Mortgage loan contractual servicing fees, including late fees and ancillary income, were $1.03 million and $0.96 million for the three months ended June 30, 2011 and 2010, respectively. Mortgage loan contractual
servicing fees, including late fees and ancillary income, were $2.05 million and $1.98 million for the six months ended June 30, 2011 and 2010, respectively. Mortgage loan contractual servicing fees are included in mortgage banking income in the consolidated statements of income.
Note 7. Financial Instruments with Off-Balance-Sheet Risk, Commitments and Derivative Transactions
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 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.
We have certain interest rate derivative positions that are not designated as hedging instruments. These derivative positions relate to transactions in which we enter into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each transaction, we agree to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate. At the same time, we agree to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows our client to effectively convert a variable rate loan to a fixed rate. Because the terms of the swaps with our customers and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.
1st Source Bank (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. Commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments.
On December 28, 2010, 1st Source entered into an agreement with the City of South Bend for the sale of the South Bend headquarters building parking garage for $1.95 million. Although the City of South Bend took possession of the parking garage on that date, the proceeds were placed in an escrow account. Under the terms of the agreement, receipt of the proceeds from the escrow is contingent upon 1st Source investing $5.40 million into its properties within the City of South Bend by December 31, 2013. 1st Source intends to fulfill that commitment and expects to receive the proceeds from escrow within the next twelve months. As of June 30, 2011, the parking garage asset has been classified as held for sale and included in accrued income and other assets on the Statement of Financial Condition.
19
At June 30, 2011 and December 31, 2010, the amounts of non-hedging derivative financial instruments are shown in the chart below:
Asset derivatives
Liability derivatives
Notional or
Statement of
contractual
Financial Condition
amount
location
value
Interest rate swap contracts
423,296
Other assets
13,651
Other liabilities
14,055
Loan commitments
24,820
79
N/A
Forward contracts
15,000
463,116
13,730
14,063
446,224
14,959
15,384
28,666
30
40,320
451
515,210
15,440
For the three and six months ended June 30, 2011 and 2010, the amounts included in the consolidated statements of income for non-hedging derivative financial instruments are shown in the chart below:
Gain (loss)
Income location
(185
(143
(183
(178
142
118
289
396
(2,028
(459
(2,353
(1,841
(424
(2,017
We issue letters of credit which 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. Standby letters of credit totaled $16.52 million and $17.84 million at June 30, 2011 and December 31, 2010, respectively. Standby letters of credit generally have terms ranging from six months to one year.
Note 8. Earnings Per Share
Earnings per common share is computed using the two-class method. Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the applicable period, excluding outstanding participating securities. Participating securities include non-vested restricted stock awards. Non-vested restricted stock awards are considered participating securities to the extent the holders of these securities receive non-forfeitable dividends at the same rate as holders of common stock. Diluted earnings per common share is computed using the weighted-average number of shares determined for the basic earnings per common share computation plus the dilutive effect of stock compensation using the treasury stock method. Stock options, where the exercise price was greater than the average market price of the common shares, were excluded from the computation of diluted earnings per common share because the result would have been antidilutive. Stock options of 27,500 and 40,508 were considered antidilutive as of June 30, 2011 and 2010, respectively. A stock warrant of
837,947 shares was considered antidilutive as of June 30, 2010. No stock warrants were outstanding as of June 30, 2011.
The following table presents a reconciliation of the number of shares used in the calculation of basic and diluted earnings per common share for the three and six months ended June 30, 2011 and 2010.
(Dollars in thousands - except per share amounts)
Distributed earnings allocated to common stock
3,888
3,643
7,776
7,259
Undistributed earnings allocated to common stock
10,807
2,380
17,419
6,658
Net earnings allocated to common stock
14,695
6,023
25,195
13,917
Net earnings allocated to participating securities
170
55
278
129
Net income allocated to common stock and participating securities
Weighted average shares outstanding for basic earnings per common share
Dilutive effect of stock compensation
9,262
7,972
8,724
6,512
Weighted average shares outstanding for diluted earnings per common share
Basic earnings per common share
Diluted earnings per common share
Note 9. Stock-Based Compensation
As of June 30, 2011, we had four active stock-based employee compensation plans, which are more fully described in Note 16 of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2010. These plans include the 2001 Stock Option Plan, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan. The 2011 Stock Option Plan was approved by the shareholders on April 21, 2011 but we had not made any grants through June 30, 2011.
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 income for the six months ended June 30, 2011 and 2010 was based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures. GAAP 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 2011 (June 30, 2011) 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, 2011. This amount changes based on
21
the fair market value of 1st Source’s stock. Total fair value of options vested and expensed was $4 thousand and $6 thousand, net of tax, for the six months ended June 30, 2011 and 2010, respectively.
Average
Weighted
Remaining
Contractual
Intrinsic
Number of
Exercise
Term
Shares
Price
(in years)
(in 000’s)
Options outstanding, beginning of year
62,508
17.18
Granted
Exercised
Forfeited
(7,508
17.31
Options outstanding, June 30, 2011
55,000
17.16
0.76
200
Vested and expected to vest at June 30, 2011
Exercisable at June 30, 2011
No options were granted during the six months ended June 30, 2011.
As of June 30, 2011, there was $4.82 million 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 3.66 years.
The following table summarizes information about stock options outstanding at June 30, 2011:
Options Outstanding
Options Exercisable
Range of
Number
of shares
Prices
Outstanding
Life
Exercisable
$12.04 to $17.99
22,000
1.81
12.04
$18.00 to $26.99
33,000
0.06
20.58
The fair value of each stock option was estimated on the date of grant using the Black-Scholes option-pricing model.
Note 10. Income Taxes
The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was $1.08 million at June 30, 2011 and $1.52 million at December 31, 2010. Interest and penalties were recognized through the income tax provision. For the six months ending June 30, 2011 and the twelve months ending December 31, 2010, we recognized approximately $(0.07) million and $0.05 million in interest, net of tax effect, and penalties, respectively. Interest and penalties of approximately $0.53 million and $0.60 million were accrued at June 30, 2011 and December 31, 2010, respectively.
Tax years that remain open and subject to audit include the federal 2007-2010 years and the Indiana 2007-2010 years. Additionally, during the first quarter of 2011 we reached a state tax settlement for the 2008 year and as a result recorded a reduction of unrecognized tax benefits in the amount of $0.84 million that affected the effective tax rate and increased earnings in the amount of $0.47 million. We do not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.
Note 11. Fair Value Measurements
We record certain assets and liabilities at fair value. Fair value is defined 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. Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value. In the absence of quoted market prices, various valuation techniques are utilized to measure fair value. When possible, observable market data for identical or similar financial instruments are used in the valuation. When market data is not available, fair value is determined using valuation models that incorporate management’s estimates of the assumptions a market participant would use in pricing the asset or liability.
Fair value measurements are classified within one of three levels based on the observability of the inputs used to determine fair value, as follows:
· Level 1 — The valuation is based on quoted prices in active markets for identical instruments.
· Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
· Level 3 — The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument. Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.
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.
We elected fair value accounting for mortgages held for sale. We believe the election for mortgages held for sale (which are 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. At June 30, 2011 and December 31, 2010, all mortgages held for sale are carried at fair value.
The following table reflects the differences between fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount we are contractually entitled to receive at maturity on June 30, 2011 and December 31, 2010:
Fair value carrying amount
Aggregate unpaid principal
Excess of fair value carrrying amount over (under) unpaid principal
Mortgages held for sale reported at fair value
7,531
274
(1)
32,285
314
(1) The excess of fair value carrying amount over unpaid principal is included in mortgage banking income and includes changes in fair value at and subsequent to funding, gains and losses on the related loan commitment prior to funding, and premiums on acquired loans.
Financial Instruments on Recurring Basis:
The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:
Investment securities available for sale are valued primarily by a third party pricing agent and both the market and income valuation approaches are implemented using the following types of inputs:
· U.S. treasuries are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
· Government-sponsored agency debt securities and corporate bonds are primarily priced using available market information through processes such as benchmark curves, market valuations of like securities, sector groupings and matrix pricing.
· Other government-sponsored agency securities, mortgage-backed securities and some of the actively traded REMICs and CMOs, are primarily priced using available market information including benchmark yields, prepayment speeds, spreads and volatility of similar securities.
· Other inactive government-sponsored agency securities are primarily priced using consensus pricing and dealer quotes.
· State and political subdivisions are largely grouped by characteristics, i.e., geographical data and source of revenue in trade dissemination systems. Since some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities. Local tax anticipation warrants, with very little market activity, are priced using an appropriate market yield curve.
· Marketable equity (common) securities are primarily priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
Trading account securities are priced using the market approach and utilizing live data feeds from active market exchanges for identical securities.
Mortgages held for sale and the related loan commitments and forward contracts (hedges) are valued using a market value approach and utilizing an appropriate current market yield and a loan commitment closing rate based on historical analysis.
Interest rate swap positions, both assets and liabilities, are valued by a third-party pricing agent using an income approach and utilizing models that use as their basis readily observable market parameters. This valuation process considers various factors including interest rate yield curves, time value and volatility factors. Management believes an adjustment is required to “mid-market” valuations for derivatives tied to its performing loan portfolio to recognize the imprecision and related exposure inherent in the process of estimating credit losses as well as velocity of deterioration evident with systemic risks imbedded in these portfolios.
The table below presents the balance of assets and liabilities at June 30, 2011 and December 31, 2010 measured at fair value on a recurring basis:
Level 1
Level 2
Level 3
Assets:
Investment securities available-for-sale:
20,124
363,051
104,969
12,455
675
41,349
6,020
863,970
13,130
25,642
Accrued income and other assets (Interest rate swap agreements)
25,785
885,426
924,341
Liabilities:
Accrued expenses and other liabilities (Interest rate swap agreements)
20,186
427,123
134,001
16,306
35,623
9,992
5,041
918,456
26,973
23,589
23,727
966,014
1,016,714
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended June 30, 2011 and 2010 are summarized as follows:
Investment securities available- for-sale
Beginning balance April 1, 2011
16,538
17,213
Total gains or losses (realized/unrealized):
Included in earnings
Included in other comprehensive income
317
Purchases
Issuances
Settlements
Maturities
(4,400
(100
(4,500
Transfers into Level 3
Transfers out of Level 3
Ending balance June 30, 2011
Beginning balance April 1, 2010
9,801
10,485
(23
42
(496
Ending balance June 30, 2010
9,324
10,008
There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held at June 30, 2011 or 2010. No transfers between levels occurred during the six months ended June 30, 2011.
Financial Instruments on Non-recurring Basis:
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 adjustments to fair value usually result from application of lower of cost or market accounting or impairment charges of individual assets.
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 reviewed quarterly and estimated using customized discounting criteria, appraisals and dealer and trade magazine quotes which are used in a market valuation approach.
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. For purposes of impairment, MSRs are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type and interest rate. The fair value of each tranche of the servicing portfolio is estimated by calculating the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates,
26
servicing costs, and other economic factors. A fair value analysis is also obtained from an independent third party agent. 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 and the characteristics of our servicing portfolio may differ from those of any servicing portfolios that do trade.
Other real estate is based on the lower of cost or fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach. New appraisals are obtained annually. Repossessions are similarly valued.
For assets measured at fair value on a nonrecurring basis the following represents impairment charges (recoveries) recognized on these assets during the quarter ended June 30, 2011: impaired loans - $1.77 million; partnership investments — $0.03 million; mortgage servicing rights - $0.01 million; repossessions - $0.00 million, and other real estate - $0.05 million.
The table below presents the carrying value of assets at June 30, 2011 and December 31, 2010 measured at fair value on a non-recurring basis:
Loans
Accrued income and other assets (partnership investments)
1,806
Accrued income and other assets (mortgage servicing rights)
Accrued income and other assets (repossessions)
1,302
Accrued income and other assets (other real estate)
9,458
85,261
1,964
5,670
7,592
100,858
GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.
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The fair values of our financial instruments as of June 30, 2011 and December 31, 2010 are summarized in the table below.
Carrying or
Contract Value
Investment securities, available-for-sale
Other investments and trading account securities
19,117
21,481
Loans and leases, net of reserve for loan and lease losses
3,152,053
3,040,895
Cash surrender value of life insurance policies
53,713
54,182
Mortgage servicing rights
8,785
Interest rate swaps
3,551,737
3,654,067
37,214
25,072
87,632
79,811
Off-balance-sheet instruments *
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* Represents estimated cash outflows required to currently settle the obligations at current market rates.
The methodologies for estimating fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The estimated fair value approximates carrying value for cash and due from banks, federal funds sold and interest bearing deposits with other banks, and cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:
Loans and Leases — For variable rate loans and leases that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of other loans and leases are estimated using discounted cash flow analyses which use interest rates currently being offered for loans and leases with similar terms to borrowers of similar credit quality.
Deposits — The fair values for all deposits other than time deposits are equal to the amounts payable on demand (the carrying value). Fair values of variable rate time deposits are equal to their carrying values. Fair values for fixed rate time deposits are estimated using discounted cash flow analyses using interest rates currently being offered for deposits with similar remaining maturities.
Short-Term Borrowings — The carrying values of Federal funds purchased, securities sold under repurchase agreements, and other short-term borrowings, including our liability related to mortgage loans available for repurchase under GNMA optional repurchase programs, approximate their fair values.
Long-Term Debt and Mandatorily Redeemable Securities — The fair values of long-term debt are estimated using discounted cash flow analyses, based on our current estimated incremental borrowing rates for similar types of borrowing arrangements. The carrying values of mandatorily redeemable securities are based on our current estimated cost of redeeming these securities which approximate their fair values.
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Subordinated Notes — Fair values are based on quoted market prices, where available. If quoted market prices are not available, fair values are estimated based on calculated market prices of comparable securities.
Off-Balance-Sheet Instruments — Contract and fair values for certain of our off-balance-sheet financial instruments (guarantees) are estimated based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.
Limitations — Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. Because no market exists for a significant portion of our financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.
These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market exchange, nor are they intended to represent the fair value of 1st Source as a whole. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet date. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.
Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.
Note 12. Subsequent Events
We have evaluated subsequent events through the date our financial statements were issued. We do not believe any subsequent events have occurred that would require further disclosure or adjustment to our financial statements.
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,” “contemplate,” “seek,” “plan,” “possible,” “assume,” “expect,” “intend,” “targeted,” “continue,” “remain,” “estimate,” “anticipate,” “project,” “will,” “should,” “indicate,” “would,” “may” 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 2010, 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, 2011, as compared to December 31, 2010, and the results of operations for the three and six months ended June 30, 2011 and 2010. 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 2010 Annual Report.
FINANCIAL CONDITION
Our total assets at June 30, 2011, were $4.35 billion, a decrease of $90.33 million or 2.03% from December 31, 2010. Total loans and leases were $3.12 billion, an increase of $47.53 million or 1.55% from December 31, 2010. Fed funds sold and interest bearing deposits with other banks were $0.10 million, a decrease of $34.46 million or 99.71% from December 31, 2010. Total investment securities, available for sale were $902.74 million which represented a decrease of $66.28 million or 6.84% and total deposits were $3.52 billion, a decrease of $99.43 million or 2.74% over the comparable figures at the end of 2010.
Nonperforming assets at June 30, 2011 were $76.49 million, which was a decrease of $12.22 million or 13.78% from the $88.71 million reported at December 31, 2010. At June 30, 2011 and December 31, 2010, nonperforming assets were 2.39% and 2.81 %, respectively of net loans and leases.
Accrued income and other assets were as follows:
Accrued income and other assets:
Bank owned life insurance cash surrender value
Accrued interest receivable
13,300
14,218
Mortgage servicing assets
Other real estate
7,878
6,392
Former bank premises held for sale
1,580
1,200
Repossessions
All other assets
46,303
51,370
Total accrued income and other assets
CAPITAL
As of June 30, 2011, total shareholders’ equity was $505.59 million, up $19.21 million or 3.95% from the $486.38 million at December 31, 2010. In addition to net income of $25.47 million, other significant changes in shareholders’ equity during the first six months of 2011 included $7.81 million of dividends paid and $3.75 million of a common stock warrant repurchased. The accumulated other comprehensive income/(loss) component of shareholders’ equity totaled $15.12 million at June 30, 2011, compared to $10.51 million at December 31, 2010. The increase in accumulated other comprehensive income/(loss) during 2011 was
primarily a result of changes in unrealized gain/(loss) on securities in the available-for-sale portfolio. Our equity-to-assets ratio was 11.61% as of June 30, 2011, compared to 10.94% at December 31, 2010. Book value per common share rose to $20.88 at June 30, 2011, from $20.12 at December 31, 2010.
We declared and paid dividends per common share of $0.16 during the second quarter of 2011. The trailing four quarters dividend payout ratio, representing dividends per common share divided by diluted earnings per common share, was 37.72%. The dividend payout is continually reviewed by management and the Board of Directors subject to the Corporation’s capital and dividend policy.
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 capital amounts and ratios of 1st Source Corporation and 1st Source Bank as of June 30, 2011, are presented in the table below:
To Be Well
Capitalized Under
Minimum Capital
Prompt Corrective
Actual
Adequacy
Action Provisions
Amount
Ratio
Total Capital (to Risk-Weighted Assets):
1st Source Corporation
533,213
15.82
269,571
8.00
336,964
10.00
1st Source Bank
526,345
15.67
168,725
335,906
Tier 1 Capital (to Risk-Weighted Assets):
489,114
14.52
134,786
4.00
202,179
6.00
483,292
14.39
134,362
201,544
Tier 1 Capital (to Average Assets):
11.27
173,578
216,973
5.00
11.17
173,011
216,264
LIQUIDITY AND INTEREST RATE SENSITIVITY
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 (FHLB) borrowings, Federal Reserve Bank (FRB) borrowings, and the capability to package loans for sale.
We have borrowing sources available to supplement deposits and meet our funding needs. 1st Source Bank has established relationships with several banks to provide short term borrowings in the form of federal funds purchased. While at June 30, 2011 there were no amounts outstanding, we could borrow approximately $255.00 million for a short time from these banks on a collective basis. As of June 30, 2011, the Bank had $25.93 million outstanding in FHLB advances and could borrow an additional $169.76 million. We also had $354.88 million available to borrow from the FRB with no amounts outstanding as of June 30, 2011.
Our loan to asset ratio was 71.60% at June 30, 2011 compared to 69.08% at December 31, 2010 and 69.11% at June 30, 2010. Cash and cash equivalents totaled $59.35 million at June 30, 2011 compared to $96.87 million at December 31, 2010 and $106.44 million at June 30, 2010. At June 30, 2011, the consolidated statement of financial condition was rate sensitive by $127.10 million more liabilities than assets scheduled to reprice within one year, or approximately 0.95%. Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.
In addition, the State of Indiana recently changed the law governing the collateralization of public fund deposits. Under the new law, the Indiana Board of Depositories will determine what financial institutions are required to pledge collateral. We have been informed that no collateral is necessary through September 30, 2011 for our Indiana public fund deposits. However, pending legislation could alter this requirement in the future. Our potential liquidity exposure if we must pledge collateral is approximately $567 million.
RESULTS OF OPERATIONS
Net income for the three and six month periods ended June 30, 2011 was $14.87 million and $25.47 million, compared to $7.80 million and $17.47 million for the same periods in 2010. Diluted net income per common share was $0.61 and $1.04 respectively, for the three and six month periods ended June 30, 2011, compared to $0.25 and $0.57 for the same periods in 2010. Return on average common shareholders’ equity was 10.36% for the six months ended June 30, 2011, compared to 5.93% in 2010. The return on total average assets was 1.16% for the six months ended June 30, 2011, compared to 0.78% in 2010.
The increase in net income for the six months ended June 30, 2011, over the first six months of 2010, was primarily the result of decreases in provision for loan and lease losses and noninterest expense and an increase in net interest income. This positive impact to net income was partially offset by a decrease in noninterest income. Details of the changes in the various components of net income are discussed further below.
NET INTEREST INCOME
The taxable equivalent net interest income for the three months ended June 30, 2011 was $38.23 million, an increase of 3.02% over the same period in 2010. The net interest margin on a fully taxable equivalent basis was 3.72% for the three months ended June 30, 2011, compared to 3.57% for the three months ended June 30, 2010. The taxable equivalent net interest income for the six months ended June 30, 2011 was $75.80 million, an increase of 3.99% over 2010, resulting in a net yield of 3.72%, compared to a net yield of 3.53% for the same period in 2010.
During the three and six month periods ended June 30, 2011, average earning assets decreased $57.59 million or 1.38% and $47.33 million or 1.14% respectively, over the comparable periods in 2010. Average interest-bearing liabilities decreased $60.26 million or 1.77% and $54.19 million or 1.59% respectively, for the three and six month periods ended June 30, 2011 over the comparable periods one year ago. The yield on average earning assets decreased 16 basis points to 4.73% for the second quarter of 2011 from 4.89% for the second quarter of 2010. The yield on average earning assets for the six month period ended June 30, 2011 decreased 18 basis points to 4.73% from 4.91% for the six month period ended June 30, 2010. The rate earned on assets decreased due to the reduction in short-term market interest rates from a year ago. Total cost of average interest-bearing liabilities decreased 39 basis points to 1.24% for the second quarter 2011 from 1.63% for the second quarter 2010. Total cost of average interest-bearing liabilities decreased 44 basis points to 1.24% for the six months ended June 30, 2011, from 1.68% for the six months ended June 30, 2010. The result to the net interest margin, or the difference between interest income on earning assets and interest expense on interest-bearing liabilities, was an increase of 15 basis points and 19 basis points respectively, for the three and six month periods ended June 30, 2011 from June 30, 2010.
The largest contributor to the decrease in the yield on average earning assets for the six months ended June 30, 2011, compared to the six months ended June 30, 2010, was a reduction in yields on taxable investment securities of 60 basis points. Total average investment securities decreased $5.47 million or 0.60% for the second quarter and increased $29.05 million or 3.21% for the six month period over one year ago. Average mortgages held for sale decreased $30.29 million or 85.67% and $16.93 million or 60.39% respectively, for the three and six month periods ended June 30, 2011, over the comparable periods a year ago due to the elimination
32
of our wholesale broker activity. Average net loans and leases decreased $20.27 million or 0.65% for the second quarter of 2011 from the second quarter of 2010 and $33.13 million or 1.07% for the six months ended June 30, 2011 compared to the same period in 2010. Average other investments, which include federal funds sold, time deposits with other banks, Federal Reserve Bank excess balances, Federal Reserve Bank and Federal Home Loan Bank stock and commercial paper, decreased $1.55 million or 1.54% and $26.33 million or 22.58% respectively, for the three and six month periods ended June 30, 2011, over the comparable periods a year ago.
Average interest-bearing deposits decreased $55.50 million or 1.77% and $48.54 million or 1.55% respectively, for the second quarter of 2011 and first six months of 2011 over the same periods in 2010. The effective rate paid on average interest-bearing deposits decreased 41 basis points to 1.07% for the second quarter 2011 compared to 1.48% for the second quarter 2010. The effective rate paid on average interest-bearing deposits decreased 47 basis points to 1.08% for the first six months of 2011 compared to 1.55% for the first six months of 2010. The decline in the average cost of interest-bearing deposits during the second quarter and first six months of 2011 as compared to the second quarter and first six months of 2010 was primarily the result of interest rate re-pricing on maturing certificates of deposit.
Average short-term borrowings decreased $10.36 million or 6.73% and $11.14 million or 7.08% respectively, for the second quarter of 2011 and the first six months of 2011, compared to the same periods in 2010. The decrease in average short-term borrowings was primarily due to lower repurchase agreements and lower secured borrowings. Interest paid on short-term borrowings decreased 33 basis points for the second quarter of 2011 and 29 basis points for the first six months of 2011 due to the interest rate decrease on adjustable rate borrowings. Average long-term debt increased $5.60 million or 20.55% during the second quarter of 2011 as compared to the second quarter of 2010 and increased $5.48 million or 23.14% during the first six months of 2011 as compared to the first six months of 2010. The increase in long-term borrowings was the result of higher borrowings with the Federal Home Loan Bank offset by lower borrowings on a line of credit. Interest paid on long-term borrowings decreased 57 basis points for the second quarter and 90 basis points for the first six months of 2011 due to lower effective rates on new 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.
DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS’ EQUITY
INTEREST RATES AND INTEREST DIFFERENTIAL
Three months ended June 30,
Six months ended June 30,
Interest
Income/
Yield/
Expense
Rate
ASSETS:
Investment securities:
Taxable
792,298
2.49
743,598
2.85
803,867
2.36
728,296
2.96
Tax exempt
119,380
1,501
5.04
173,553
2,095
4.84
130,132
3,235
5.01
176,650
4,240
Mortgages - held for sale
5,064
60
4.75
35,350
5.12
11,105
239
4.34
28,033
724
5.21
3,100,598
41,802
5.41
3,120,871
42,839
5.51
3,077,434
83,079
5.44
3,110,565
85,033
99,451
1.00
101,004
0.99
90,251
1.09
116,576
0.91
Total Earning Assets
4,116,791
48,521
4.73
4,174,376
50,914
4.89
4,112,789
96,437
4,160,120
101,201
4.91
58,905
60,898
58,808
59,403
(87,594
(88,945
(87,927
(89,083
338,932
371,295
339,948
371,158
4,427,034
4,517,624
4,423,618
4,501,598
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Interest-bearing deposits
3,072,890
1.07
3,128,393
1.48
3,078,801
1.08
3,127,336
1.55
143,548
0.21
153,909
0.54
146,124
0.22
157,262
0.51
7.37
7.41
32,853
4.94
27,251
29,160
4.59
23,681
5.49
Total Interest-Bearing Liabilities
3,338,983
1.24
3,399,245
1.63
3,343,777
3,397,971
1.68
Noninterest-bearing deposits
524,643
464,434
519,966
456,193
64,545
67,110
64,090
64,688
Shareholders’ equity
498,863
586,835
495,785
582,746
Net Interest Income
38,232
37,113
75,798
72,890
Net Yield on Earning Assets on a Taxable Equivalent Basis
3.72
3.57
3.53
PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES
The provision for loan and lease losses for the three and six month periods ended June 30, 2011 was $0.07 million and $2.27 million respectively, compared to a provision for loan and lease losses in the three and six month periods ended June 30, 2010 of $5.80 million and $10.19 million respectively. Net charge-offs of $1.22 million were recorded for the second quarter 2011, compared to $5.61 million for the same quarter a year ago. Year-to-date net charge-offs of $4.13 million have been recorded in 2011, compared to $10.41 million through June 30, 2010.
On June 30, 2011, 30 day and over loan and lease delinquencies were 0.49% as compared to 1.15% on June 30, 2010. The decrease in delinquencies was primarily in aircraft, construction equipment and commercial loans. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.73% as compared to 2.81% one year ago. A summary of loan and lease loss experience during the three and six months ended June 30, 2011 and 2010 is located in Note 5 of the Consolidated Financial Statements.
A loan or lease is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. We evaluate loans and leases exceeding $100,000 for impairment and establish an allowance as a component of the reserve for loan and lease losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan and lease and the recorded investment in the loan or lease exceeds its fair value. A summary of impaired loans as of June 30, 2011 and December 31, 2010 is reflected in Note 4 of the Consolidated Financial Statements.
NONPERFORMING ASSETS
Nonperforming assets were as follows:
Loans and leases past due 90 days or more
361
1,230
Nonaccrual loans and leases
74,853
68,433
6,673
2,363
8,670
Equipment owned under operating leases
474
Total nonperforming assets
76,491
88,712
87,706
Nonperforming assets as a percentage of total loans and leases were 2.39% at June 30, 2011, 2.81% at December 31, 2010, and 2.71% at June 30, 2010. Nonperforming assets totaled $76.49 million at June 30, 2011, a decrease of 13.78% from the $88.71 million reported at December 31, 2010, and a 12.79% decrease from the $87.71 million reported at June 30, 2010. The decrease during the first six months of 2011 compared to the same period in 2010 was primarily related to decreases in nonaccrual loans and leases and repossessions as the economy slowly improves.
The decrease in nonaccrual loans and leases at June 30, 2011 from June 30, 2010 was spread among the various loan portfolios except for increases in aircraft. The largest dollar decrease at June 30, 2011 from December 31, 2010 occurred in the construction equipment portfolio, with notable decreases also occurring in the medium and heavy duty truck and commercial portfolios. A summary of nonaccrual loans and leases and past due aging for the period ended June 30, 2011 and December 31, 2010 is located in Note 4 of the Consolidated Financial Statements.
As of June 30, 2011, the industry with the largest dollar exposure was with borrowers whose primary source of income was derived from commercial real estate. These impaired loans totaled approximately $25.66 million which were comprised of $18.94 million secured by commercial real estate and included in loans secured by real estate and $6.72 million secured by aircraft and included in aircraft financing. We have limited exposure to commercial real estate. However, our borrowers with commercial real estate exposure, whether local real estate developers in our commercial portfolio or customers in our niche portfolios such as aircraft whose underlying business is dependent on developing, marketing and managing real estate properties, have suffered as a result of declining real estate values and minimal sales activity. Furthermore, aircraft values declined during 2009 and 2010, increasing the risk in aircraft secured transactions.
The increase over the past year in other real estate is due to foreclosing on real estate in the local market for which we have a current appraisal and is well secured.
Repossessions consisted mainly of aircraft at June 30, 2011. At the time of repossession, 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, unless the equipment is in the process of immediate sale. Any subsequent write-downs are included in noninterest expense.
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A summary of other real estate and repossessions is shown in the table below:
214
475
655
716
7,557
157
201
125
7,019
5,308
5,697
859
1,084
9,180
12,062
15,343
For financial statement purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets.
Foreign Outstandings — Our foreign loan and lease outstandings, all denominated in U.S. dollars were $206.20 million and $201.03 million as of June 30, 2011 and December 31, 2010, respectively. Foreign loans and leases are in aircraft financing. Loan and lease outstandings to borrowers in Brazil and Mexico were $147.16 million and $36.80 million as of June 30, 2011, respectively, compared to $134.34 million and $34.03 million as of December 31, 2010, respectively. Outstanding balances to borrowers in other countries were insignificant.
NONINTEREST INCOME
Noninterest income for the three month period ended June 30, 2011 and 2010 was $21.42 million and $20.60 million, respectively. Noninterest income for the six month period ended June 30, 2011 and 2010 was $40.38 million and $41.52 million, respectively. Details of noninterest income follow:
Noninterest income increased $0.82 million or 3.99% for the second quarter and decreased $1.15 million or 2.76% for year-to-date 2011 as compared to the same periods in 2010.
Trust fees increased $0.35 million or 8.59% and $0.60 million or 7.63% for the three and six month periods ended June 30, 2011 over the three and six month periods ended June 30, 2010, respectively. The increase in trust fees was a result of an increase in market values of investment accounts.
Service charges on deposit accounts decreased $0.64 million or 12.08% and $1.02 million or 10.32% for the three and six months ended June 30, 2011, respectively over the comparable periods one year ago. The decline in service charges on deposit accounts reflects a lower volume of nonsufficient fund transactions.
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Mortgage banking income increased $0.41 million or 96.47% in the second quarter of 2011 as compared to the second quarter of 2010. Mortgage banking income was relatively flat for the six months ended 2011 compared to the six months ended 2010. A mortgage servicing rights fair value impairment charge of $0.97 million was recorded in the second quarter 2010 compared to only $0.01 million charge in second quarter 2011. This positive variance was offset by reduced gains on loan sales due to lower production volumes in 2011 as a result of the elimination of broker business in late 2010.
Insurance commissions were flat in the three months ended June 30, 2011 and decreased $0.32 million or 12.75% in the six months ended June 30, 2011 over the same periods a year ago. The decrease was due to reduced contingent commissions, primarily as a result of a high level of claims activity in our books of business. We also experienced a loss of commercial business premiums in the Fort Wayne market due to declines in business relationships.
Equipment rental income declined $0.66 million or 9.94% in the second quarter of 2011 compared to the second quarter 2010. Equipment rental income declined $1.37 million or 10.21% for year-to-date 2011 compared to the same period in 2010. The average equipment rental portfolio decreased 9.24% in 2011 over the same period in 2010 resulting in lower rental income.
Other income increased $0.32 million or 10.46% and $0.60 million or 10.47% for the three and six month periods ended June 30, 2011, respectively as compared to the same periods in 2010, mainly due to higher earnout fees on the sale of assets of 1st Source Investment Advisors related to the management of the 1st Source Monogram Funds.
The increase in investment securities and other investment gains of $1.05 million in the three months ended June 30, 2011 was due to gains on the sale of agency securities in 2011 versus no sales in 2010. The increase in investment securities and other investment gains of $0.30 million or 30.34% in the six months ended June 30, 2011 was due to gains on the sale of agency securities offset by lower partnership investment gains in 2011 compared to the same period a year earlier.
NONINTEREST EXPENSE
Noninterest expense for the three month period ended June 30, 2011 and 2010 was $35.94 million and $39.65 million, respectively. Noninterest expense for the six month period ended June 30, 2011 and 2010 was $74.42 million and $76.76 million, respectively. Details of noninterest expense follow:
Intangible asset amortization
331
650
662
358
3,285
2,549
37
Noninterest expense decreased $3.71 million or 9.35% for the second quarter and $2.34 million or 3.05% for year-to-date 2011 as compared to the same periods in 2010. Salaries and employee benefits, net occupancy, supplies and communication, business development and marketing, and intangible asset amortization all changed slightly in 2011 over the same periods in 2010.
During the second quarter and first six months of 2011, furniture and equipment expense increased $0.37 million or 11.42% and $0.91 million or 15.24%, respectively compared to the second quarter and first six months of 2010. The higher expense was mainly due to computer processing charges and corporate aircraft maintenance.
Depreciation on leased equipment decreased $0.51 million or 9.60% and $1.07 million or 10.01% in conjunction with the decrease in equipment rental income for the three and six months ended June 30, 2011, respectively as compared to the same periods one year ago.
Professional fees decreased $0.34 million or 23.84% for the three month period ended June 30, 2011 as compared to the three month period ended June 30, 2010 and $0.76 million or 25.78% for the six month period ended June 30, 2011 as compared to the same period a year earlier. The reduction in professional fees in 2011 was the result of lower consulting and legal fees.
Loan and lease collection and repossession expense decreased $1.77 million or 54.09% and $1.55 million or 35.42% for the second quarter and first six months of 2011, respectively as compared to the same periods in 2010 mainly due to negative valuation adjustments on repossessed aircraft in 2010 which were not present in 2011. This positive variance was offset by higher repurchased mortgage loan losses in 2011 compared to 2010.
FDIC and other insurance expense decreased $0.71 million or 42.53% and $0.71 million or 21.16% for the three and six months ended June 30, 2011, respectively compared to the three and six months ended June 30, 2010. The lower premium expense in 2011 was a result of a new assessment base and rates imposed by the FDIC.
Other expenses decreased $1.10 million or 75.50% in the three months ended June 30, 2011 as compared to the three months ended June 30, 2010 primarily due to a gain on the sale of our former corporate aircraft. Other expense increased $0.74 million or 28.87% for the six months ended June 30, 2011 over the same period one year ago due to a charge of $1.68 million for provision on unfunded loan commitments offset by the gain on sale of the corporate aircraft.
INCOME TAXES
The provision for income taxes for the three and six month periods ended June 30, 2011 was $8.13 million and $12.66 million, respectively compared to $3.61 million and $8.26 million for the same periods in 2010. The effective tax rates were 35.36% and 31.65% for the second quarter ended June 30, 2011 and 2010, respectively and 33.21% and 32.09% for the six months ended June 30, 2011 and 2010, respectively. Additionally, during the first quarter of 2011 we reached a state tax settlement for the 2008 year and as a result recorded a reduction of unrecognized tax benefits in the amount of $0.84 million that affected the effective tax rate and increased earnings in the amount of $0.47 million.
38
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, 2010. For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2010.
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-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at June 30, 2011, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by 1st Source in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.
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 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
ITEM 1. Legal Proceedings.
1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of our businesses. Our management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.
We received notice in April 2011 that the United States Department of Justice has initiated an investigation of 1st Source prompted by pricing practices of certain brokers from whom we purchased mortgages in prior years that were originated by them. The investigation is pursuant to the Equal Credit Opportunity Act and Fair Housing Act. As previously disclosed, we ended our relationships with third-party mortgage brokers in 2010. We are cooperating fully with the investigation and, based on our present understanding, do not expect an outcome that would have any material adverse effect on our consolidated financial position or results of operations.
ITEM 1A. Risk Factors.
There have been no material changes in risks faced by 1st Source since December 31, 2010. For information regarding our risk factors, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2010.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
Total number of
Maximum number (or approximate
Total number
shares purchased
dollar value) of shares
price paid per
as part of publicly announced
that may yet be purchased under
Period
purchased
share
plans or programs (1)
the plans or programs
April 01 - 30, 2011
1,229,472
May 01 - 31, 2011
100,000
19.66
1,129,472
June 01 - 30, 2011
19.75
1,128,973
(1) 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on April 26, 2007. Under the terms of the plan, 1st Source may repurchase up to 2,000,000 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 871,027 shares.
ITEM 3. Defaults Upon Senior Securities.
None
ITEM 4. (Removed and reserved).
ITEM 5. Other Information.
ITEM 6. Exhibits
The following exhibits are filed with this report:
31.1
Certification of Chief Executive Officer required by Rule 13a-14(a).
31.2
Certification of Chief Financial Officer required by Rule 13a-14(a).
32.1
Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer.
32.2
Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer.
101.INS
XBRL Instance Document
101.SCH
XBRL Taxonomy Extension Schema Document
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
101.LAB
XBRL Taxonomy Extension Labels Linkbase Document
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
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.
DATE
July 21, 2011
/s/ CHRISTOPHER J. MURPHY III
Christopher J. Murphy III
Chairman of the Board, President and CEO
/s/ LARRY E. LENTYCH
Larry E. Lentych
Treasurer and Chief Financial Officer
Principal Accounting Officer