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 September 30, 2013
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
46601
(Address of principal executive offices)
(Zip Code)
(574) 235-2000
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 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 October 11, 2013 — 24,322,527 shares
TABLE OF CONTENTS
Page
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements (Unaudited)
Consolidated Statements of Financial Condition — September 30, 2013 and December 31, 2012
3
Consolidated Statements of Income — three and nine months ended September 30, 2013 and 2012
4
Consolidated Statements of Comprehensive Income — three and nine months ended September 30, 2013 and 2012
5
Consolidated Statements of Shareholders’ Equity — nine months ended September 30, 2013 and 2012
Consolidated Statements of Cash Flows — nine months ended September 30, 2013 and 2012
6
Notes to the Consolidated Financial Statements
7
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
33
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
42
Item 4.
Controls and Procedures
43
PART II. OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
44
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
SIGNATURES
45
CERTIFICATIONS
Exhibit 31.1
46
Exhibit 31.2
47
Exhibit 32.1
48
Exhibit 32.2
49
2
1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited - Dollars in thousands)
September 30,
December 31,
2013
2012
ASSETS
Cash and due from banks
$
90,090
83,232
Federal funds sold and interest bearing deposits with other banks
1,676
702
Investment securities available-for-sale (amortized cost of $819,918 and $849,139 at September 30, 2013 and December 31, 2012, respectively)
834,348
880,764
Other investments
22,409
22,609
Trading account securities
177
146
Mortgages held for sale
7,157
10,879
Loans and leases - net of unearned discount
Commercial and agricultural loans
652,180
639,069
Auto, light truck and environmental equipment
452,405
438,147
Medium and heavy duty truck
192,974
172,002
Aircraft financing
704,072
696,479
Construction equipment financing
315,346
278,974
Commercial real estate
574,279
554,968
Residential real estate
455,327
438,641
Consumer loans
121,535
109,273
Total loans and leases
3,468,118
3,327,553
Reserve for loan and lease losses
(84,507
)
(83,311
Net loans and leases
3,383,611
3,244,242
Equipment owned under operating leases, net
61,160
52,173
Net premises and equipment
45,466
45,016
Goodwill and intangible assets
86,629
87,502
Accrued income and other assets
117,238
123,428
Total assets
4,649,961
4,550,693
LIABILITIES
Deposits:
Noninterest bearing
725,263
646,380
Interest bearing
2,954,153
2,977,967
Total deposits
3,679,416
3,624,347
Short-term borrowings:
Federal funds purchased and securities sold under agreements to repurchase
147,991
158,680
Other short-term borrowings
73,451
10,508
Total short-term borrowings
221,442
169,188
Long-term debt and mandatorily redeemable securities
58,440
71,021
Subordinated notes
58,764
Accrued expenses and other liabilities
53,670
68,718
Total liabilities
4,071,732
3,992,038
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 25,641,887 at September 30, 2013 and December 31, 2012
346,535
Retained earnings
252,043
223,715
Cost of common stock in treasury (1,319,336 shares at September 30, 2013 and 1,399,261 shares at December 31, 2012)
(29,362
(31,134
Accumulated other comprehensive income
9,013
19,539
Total shareholders’ equity
578,229
558,655
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
Nine Months Ended
Interest income:
Loans and leases
42,392
40,610
121,674
120,824
Investment securities, taxable
3,581
3,913
10,774
12,574
Investment securities, tax-exempt
764
826
2,295
2,526
Other
229
231
712
688
Total interest income
46,966
45,580
135,455
136,612
Interest expense:
Deposits
4,089
5,419
13,043
16,868
Short-term borrowings
72
36
149
136
1,055
1,647
3,165
4,942
592
571
1,315
1,399
Total interest expense
5,808
7,673
17,672
23,345
Net interest income
41,158
37,907
117,783
113,267
(Recovery of) provision for loan and lease losses
(419
650
1,631
4,959
Net interest income after provision for loan and lease losses
41,577
37,257
116,152
108,308
Noninterest income:
Trust fees
5,260
4,055
13,800
12,407
Service charges on deposit accounts
2,364
2,688
6,928
7,747
Debit card income
2,343
2,020
6,752
6,281
Mortgage banking income
1,103
4,667
5,464
Insurance commissions
1,292
1,483
4,131
4,051
Equipment rental income
4,000
4,604
12,098
14,620
Investment securities and other investment gains
258
89
469
492
Other income
3,538
3,346
10,382
9,556
Total noninterest income
20,158
20,305
59,227
60,618
Noninterest expense:
Salaries and employee benefits
20,441
20,982
59,553
61,668
Net occupancy expense
2,126
1,652
6,480
5,660
Furniture and equipment expense
4,477
3,817
12,285
11,155
Depreciation - leased equipment
3,246
3,795
9,745
11,909
Professional fees
1,178
1,385
3,843
4,232
Supplies and communication
1,330
1,387
4,365
4,165
FDIC and other insurance
874
913
2,679
2,716
Business development and marketing expense
1,306
1,008
3,011
2,925
Loan and lease collection and repossession expense
1,530
1,866
3,382
4,346
Other expense
1,922
388
5,381
3,043
Total noninterest expense
38,430
37,193
110,724
111,819
Income before income taxes
23,305
20,369
64,655
57,107
Income tax expense
8,409
7,364
23,413
19,820
Net income
14,896
13,005
41,242
37,287
Per common share:
Basic net income per common share
0.60
0.53
1.67
1.52
Diluted net income per common share
1.51
Dividends
0.17
0.51
0.49
Basic weighted average common shares outstanding
24,366,220
24,279,178
24,352,073
24,267,535
Diluted weighted average common shares outstanding
24,367,109
24,289,495
24,352,854
24,278,160
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income (loss):
Change in unrealized appreciation (depreciation) of available-for-sale securities
1,853
3,979
(16,881
5,673
Reclassification adjustment for realized losses (gains) included in net income
28
(275
Income tax effect
(706
(1,522
6,327
(2,063
Other comprehensive income (loss), net of tax
1,175
2,459
(10,526
3,335
Comprehensive income
16,071
15,464
30,716
40,622
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Cost of
Accumulated
Common
Preferred
Retained
Stock
Comprehensive
Total
Earnings
in Treasury
Income (Loss), Net
Balance at January 1, 2012
523,918
190,261
(31,389
18,511
Other comprehensive income
Issuance of 169,720 common shares under stock based compensation awards, including related tax effects
3,743
97
3,646
Cost of 104,471 shares of common stock acquired for treasury
(2,617
Common stock dividend ($0.49 per share)
(11,998
Balance at September 30, 2012
553,668
215,647
(30,360
21,846
Balance at January 1, 2013
Other comprehensive loss
Issuance of 169,792 common shares under stock based compensation awards, including related tax effects
3,650
(390
4,040
Cost of 89,867 shares of common stock acquired for treasury
(2,268
Common stock dividend ($0.51 per share)
(12,524
Balance at September 30, 2013
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30,
Operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan and lease losses
Depreciation of premises and equipment
3,515
3,151
Depreciation of equipment owned and leased to others
Amortization of investment security premiums and accretion of discounts, net
2,745
3,140
Amortization of mortgage servicing rights
1,265
2,267
Mortgage servicing asset (recoveries) impairments
230
Deferred income taxes
(3,265
(4,817
(469
(492
Originations of loans held for sale, net of principal collected
(85,010
(165,577
Proceeds from the sales of loans held for sale
91,395
160,301
Net gain on sale of loans held for sale
(2,663
(4,933
Change in trading account securities
(31
(13
Change in interest receivable
(215
(634
Change in interest payable
(1,506
(529
Change in other assets
13,085
10,993
Change in other liabilities
(3,636
404
825
990
Net change in operating activities
68,653
58,636
Investing activities:
Proceeds from sales of investment securities
47,028
40,736
Proceeds from maturities of investment securities
152,706
203,436
Purchases of investment securities
(172,789
(226,567
Net change in other investments
200
(3,390
Loans sold or participated to others
25,054
22,968
Net change in loans and leases
(171,771
(206,261
Net change in equipment owned under operating leases
(18,732
(854
Purchases of premises and equipment
(4,040
(6,521
Net change in investing activities
(142,344
(176,453
Financing activities:
Net change in demand deposits, NOW accounts and savings accounts
79,907
119,128
Net change in certificates of deposit
(24,838
(70,601
Net change in short-term borrowings
52,254
11,401
Proceeds from issuance of long-term debt
5,951
26,873
Payments on long-term debt
(20,313
(360
Net proceeds from issuance of treasury stock
Acquisition of treasury stock
Cash dividends paid on common stock
(12,820
(12,263
Net change in financing activities
81,523
75,304
Net change in cash and cash equivalents
7,832
(42,513
Cash and cash equivalents, beginning of year
83,934
114,327
Cash and cash equivalents, end of period
91,766
71,814
Supplemental Information:
Non-cash transactions:
Loans transferred to other real estate and repossessed assets
5,717
2,319
Common stock matching contribution to Employee Stock Ownership and Profit Sharing Plan
2,801
2,643
1ST SOURCE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
1st Source Corporation is a bank holding company headquartered in South Bend, Indiana that provides, through its subsidiaries (collectively referred to as “1st Source” or “the Company”), a broad array of financial products and services. 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 comprehensive income, 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 (2012 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The Consolidated Statement of Financial Condition at December 31, 2012 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 to the current year presentation.
Note 2. Recent Accounting Pronouncements
Investment Companies: In June 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2013-08 “Financial Services-Investment Companies (Topic 946) — Amendments to the Scope, Measurement and Disclosure Requirements.” ASU 2013-08 changes the approach to the investment company assessment in Topic 946, clarifies the characteristics of an investment company and provides comprehensive guidance for assessing whether an entity is an investment company. ASU 2013-08 is effective for interim and annual reporting periods in fiscal years that begin after December 15, 2013. Early application is prohibited. The Company is assessing the impact of ASU 2013-08 on its disclosures.
Comprehensive Income: In February 2013, the FASB issued ASU No. 2013-02 “Comprehensive Income (Topic 220) — Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU 2013-02 requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. ASU 2013-02 is effective prospectively during interim and annual periods beginning after December 15, 2012. The effect of applying this standard is reflected in Note 11 — Accumulated Other Comprehensive Income.
Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities: In January 2013, the FASB issued ASU No. 2013-01 “Balance Sheet (Topic 210) — Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” ASU 2013-01 clarifies that ordinary trade receivables and receivables are not in the scope of ASU 2011-11. ASU 2011-11 applies only to derivatives, repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria in the Accounting Standards Codification or subject to a master netting arrangement or similar agreement.
ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Retrospective disclosure is required for all comparative periods presented. The effect of applying this standard is reflected in Note 8 — Derivative Financial Instruments.
Offsetting Assets and Liabilities: In December 2011, the FASB issued ASU No. 2011-11 “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities.” ASU 2011-11 requires an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Retrospective disclosure is required for all comparative periods presented. The effect of applying this standard is reflected in Note 8 — Derivative Financial Instruments.
Note 3. Investment Securities
Investment securities available-for-sale were as follows:
Amortized
Gross
(Dollars in thousands)
Cost
Unrealized Gains
Unrealized Losses
Fair Value
September 30, 2013
U.S. Treasury and Federal agencies securities
394,063
5,698
(3,468
396,293
U.S. States and political subdivisions securities
111,843
3,821
(984
114,680
Mortgage-backed securities — Federal agencies
280,255
6,277
(2,172
284,360
Corporate debt securities
30,890
242
(9
31,123
Foreign government and other securities
700
707
Total debt securities
817,751
16,045
(6,633
827,163
Marketable equity securities
2,167
5,021
(3
7,185
Total investment securities available-for-sale
819,918
21,066
(6,636
December 31, 2012
410,983
11,353
(83
422,253
100,055
5,864
(482
105,437
301,136
11,296
(25
312,407
30,897
445
(94
31,248
3,700
26
3,726
846,771
28,984
(684
875,071
2,368
3,329
(4
5,693
849,139
32,313
(688
At September 30, 2013 and December 31, 2012, the residential mortgage-backed securities held by the Company consisted primarily of GNMA, FNMA and FHLMC pass-through certificates which are guaranteed by those respective agencies of the United States government (Government Sponsored Enterprise, GSEs).
The contractual maturities of investments in debt securities available-for-sale at September 30, 2013 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
128,276
127,885
Due after one year through five years
346,667
352,734
Due after five years through ten years
61,903
61,568
Due after ten years
616
Mortgage-backed securities
Total debt securities available-for-sale
8
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 for the three and nine months ended September 30, 2013 primarily reflect the sale of federal agency securities. The trades were done for the purpose of balance sheet realignment and managing reinvestment risk by adjusting the timing of future cash flows. There were no other-than-temporary-impairment (OTTI) write-downs in 2013 or 2012.
Gross realized gains
903
275
Gross realized losses
(931
Net realized (losses) gains
(28
The following table summarizes gross unrealized losses and fair value by investment category and age.
Less than 12 Months
12 months or Longer
Fair
Unrealized
Value
Losses
139,539
(3,337
15,094
(131
154,633
30,490
(671
2,691
(313
33,181
Mortgage-backed securities - Federal agencies
94,174
(2,171
(1
94,223
7,900
993
(6
8,893
100
272,203
(6,182
18,827
(451
291,030
18,831
(454
291,034
37,316
7,730
(46
3,364
(436
11,094
6,264
(24
60
6,324
4,431
51,410
(153
7,855
(531
59,265
7,860
(535
59,270
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, the Company considers 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 the Company will not have to sell any such securities before a recovery of cost.
At September 30, 2013, the Company does not have the intent to sell any of the available-for-sale securities in the table above and believes that it is more likely than not, that it will not have to sell any such securities before an anticipated recovery of cost. Primarily the unrealized losses on debt securities are due to increases in market 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. The fair value is expected to recover on all debt securities as they approach their maturity date or re-pricing date or if market yields for such investments decline. The Company does not believe any of the securities are impaired due to reasons of credit quality.
9
At September 30, 2013 and December 31, 2012, investment securities with carrying values of $236.58 million and $216.34 million, respectively, were pledged as collateral to secure government deposits, security repurchase agreements, and for other purposes.
Note 4. Loan and Lease Financings
The Company evaluates 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). The Company uses 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 individual or 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 the Company’s 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 appropriateness 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 the 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).
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
623,884
28,296
442,616
9,789
190,921
2,053
662,126
41,946
299,938
15,408
546,426
27,853
2,765,911
125,345
2,891,256
612,567
26,502
428,582
9,565
170,116
1,886
648,316
48,163
262,980
15,994
507,219
47,749
2,629,780
149,859
2,779,639
10
For residential real estate and consumer loans, credit quality is based on the aging status of the loan and by payment activity. The table below presents the recorded investment in residential real estate and consumer loans by performing or nonperforming status. Nonperforming loans are those loans which are on nonaccrual status or are 90 days or more past due.
Performing
Nonperforming
452,561
2,766
Consumer
121,109
426
573,670
3,192
576,862
435,962
108,814
459
544,776
3,138
547,914
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
643,495
714
750
644,959
7,221
451,659
349
110
452,118
287
192,380
594
688,856
3,725
692,581
11,491
313,532
515
314,047
1,299
566,742
51
566,793
7,486
451,005
956
600
220
452,781
2,546
120,260
517
332
25
121,134
401
3,427,929
3,051
5,568
245
3,436,793
31,325
629,035
807
629,890
9,179
437,087
202
437,289
858
171,950
52
691,187
5,292
272,817
598
274
273,689
5,285
541,811
102
541,913
13,055
434,434
1,019
509
356
436,318
2,323
107,630
816
368
86
108,900
373
3,285,951
3,544
1,199
442
3,291,136
36,417
11
The table below presents impaired loans and leases, segregated by class, and the corresponding reserve for impaired loan and lease losses.
Unpaid
Recorded
Principal
Related
Investment
Balance
Allowance
With no related allowance recorded:
6,470
6,468
2,301
1,214
1,213
15,339
Total with no related allowance recorded
25,918
25,915
With an allowance recorded:
5,189
9,132
1,491
Total with an allowance recorded
14,321
1,540
Total impaired loans
40,239
40,236
2,572
474
3,115
5,109
5,107
19,597
101
30,968
30,966
6,075
6,074
729
2,086
852
1,588
9,749
9,748
1,623
40,717
40,714
12
Average recorded investment and interest income recognized on impaired loans and leases, segregated by class, is shown in the table below.
Three Months Ended September 30,
Average Recorded Investment
Interest Income
11,766
98
9,111
9,645
133
9,441
39
2,578
221
2,474
638
434
1
292
917
10,361
79
6,100
8,832
8,831
1,447
4,512
3,376
4,399
16,531
155
22,757
138
18,507
22,330
302
104
82
40,782
333
45,596
143
40,873
675
48,474
The number of loans and leases classified as troubled debt restructuring (TDR) during the three and nine months ended September 30, 2013 and 2012, segregated by class, are shown in the table below as well as the recorded investment as of September 30. The classification between nonperforming and performing is shown at the time of modification. During 2013 and 2012, modification programs focused on extending maturity dates or modifying payment patterns with most TDRs experiencing a combination of concessions. The modifications did not result in the contractual forgiveness of principal or interest or interest rate reductions below market rates. Consequently, the financial impact of the modifications is immaterial.
Number of
Modifications
Performing TDRs:
7,014
103
Total performing TDR modifications
7,117
Nonperforming TDRs:
299
4,201
1,467
1,163
Total nonperforming TDR modifications
4,500
2,630
Total TDR modifications
5,250
9,747
There were no TDRs which had payment defaults within the twelve months following modification during the three months ended September 30, 2013. There was one commercial and agricultural TDR which had payment defaults within the twelve months following modification during the nine months ended September 30, 2013.
13
This loan was transferred into Other Real Estate during the three months ended June 30, 2013. There were no TDRs which had payment defaults within twelve months following modification during the three and nine months ended September 30, 2012. Default occurs when a loan or lease is 90 days or more past due under the modified terms or transferred to nonaccrual.
The table below presents the recorded investment of loans and leases classified as troubled debt restructurings as of September 30, 2013 and December 31, 2012.
Performing TDRs
9,205
8,839
Nonperforming TDRs
11,845
12,869
Total TDRs
21,050
21,708
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 the historical charge-off analysis is updated, the Company reviews the look-back periods for each business loan portfolio. Furthermore, a thorough analysis of charge-offs, non-performing asset levels, special attention outstandings and delinquency is performed 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. The Company adjusts the calculated historical based ratio as a result of the analysis of environmental factors, principally economic risk and concentration risk. Key economic factors affecting the portfolios are growth in gross domestic product, unemployment rates, housing market trends, commodity prices, inflation and global economic and political issues. Concentration risk is impacted primarily by geographic concentration in Northern Indiana and Southwestern Lower Michigan in the business banking and commercial real estate portfolios and by collateral concentration in the 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 appropriate by the Company to absorb probable losses inherent in the loan and lease portfolio. The determination of the reserve requires significant judgment reflecting the Company’s best estimate of probable loan and lease losses related to specifically identified impaired loans and leases as well as probable losses in the remainder of the various loan and lease portfolios. For purposes of determining the reserve, the Company has segmented loans and leases into classes based on the associated risk within these segments. The Company has determined that eight classes exist within the 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, formula reserves for each business lending division portfolio including percentage allocations for special attention loans and leases not deemed impaired, and reserves for pooled homogeneous loans and leases. The Company’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.
14
Changes in the reserve for loan and lease losses, segregated by class, for the three months ended September 30, 2013 and 2012 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
12,202
11,889
3,178
33,323
6,065
13,529
3,895
1,609
85,690
Charge-offs
50
1,277
76
219
1,671
Recoveries
114
308
64
150
74
907
Net charge-offs (recoveries)
(65
(48
(308
1,179
(64
(150
75
145
Provision (recovery of provision)
(255
(1,588
1,670
448
(801
70
120
Balance, end of period
12,012
10,349
3,403
33,814
6,577
12,878
3,890
1,584
84,507
Ending balance, individually evaluated for impairment
Ending balance, collectively evaluated for impairment
11,963
32,323
82,967
Total reserve for loan and lease losses
Recorded investment in loans
11,659
11,433
640,521
692,639
314,132
558,940
3,427,879
Total recorded investement in loans
September 30, 2012
13,077
10,300
3,618
29,871
6,330
15,172
3,521
1,410
83,299
214
210
461
132
159
311
1,488
125
163
91
90
1,038
154
(146
(125
298
(148
41
450
433
(496
(377
1,427
(585
(99
273
13,356
9,950
3,366
31,000
5,893
15,032
3,440
1,462
83,499
878
500
886
2,313
12,478
9,450
30,114
14,983
81,186
9,148
2,233
322
5,734
4,355
22,524
44,419
575,848
454,432
167,387
680,066
271,915
526,397
436,806
111,143
3,223,994
584,996
456,665
167,709
685,800
276,270
548,921
436,909
3,268,413
15
Changes in the reserve for loan and lease losses, segregated by class, for the nine months ended September 30, 2013 and 2012 are shown below.
12,326
9,584
3,001
34,205
5,390
13,778
3,652
1,375
83,311
463
1,308
88
164
820
3,124
355
236
337
782
560
269
2,689
108
(185
(337
526
(50
(396
218
551
435
(206
580
65
135
1,137
(1,296
456
760
13,091
8,469
3,742
28,626
6,295
16,772
3,362
1,287
81,644
486
3,110
232
1,106
5,928
224
147
484
233
170
38
314
2,824
262
1,896
(147
116
(113
194
792
3,104
527
3,377
(523
2,490
(515
(1,636
272
967
Note 6. Mortgage Servicing Assets
The Company recognizes 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. The Company allocates a portion of the total proceeds of a mortgage loan to servicing rights based on the relative fair value.
16
The unpaid principal balance of residential mortgage loans serviced for third parties was $851.70 million and $921.20 million at September 30, 2013 and December 31, 2012, respectively.
Mortgage servicing assets are evaluated for impairment at each reporting date. For purposes of impairment measurement, mortgage servicing assets are stratified based on the predominant risk characteristics of the underlying servicing, principally by loan type. 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
4,634
4,984
4,645
5,610
Additions
572
1,498
1,411
Amortization
(328
(739
(1,265
(2,267
Sales
Carrying value before valuation allowance at end of period
4,878
4,754
Valuation allowance:
(91
(238
Impairment (charges) recoveries
(230
Balance at end of period
(468
Net carrying value of mortgage servicing assets at end of period
4,286
Fair value of mortgage servicing assets at end of period
7,656
4,478
During the nine months ended September 30, 2013, the Company determined that it was not necessary to permanently write-down any previously established valuation allowance. At September 30, 2013 and 2012, the fair value of mortgage servicing assets exceeded the carrying value reported in the consolidated statement of financial condition by $2.78 million and $0.19 million, respectively. This difference represents increases in the fair value of certain mortgage servicing assets that could not be recorded above cost basis.
Mortgage loan contractual servicing fees, including late fees and ancillary income, were $0.79 million and $0.90 million for the three months ended September 30, 2013 and 2012, respectively. Mortgage loan contractual servicing fees, including late fees and ancillary income, were $2.43 million and $2.72 million for the nine months ended September 30, 2013 and 2012, respectively. Mortgage loan contractual servicing fees are included in mortgage banking income in the consolidated statements of income.
Note 7. Commitments and Financial Instruments with Off-Balance-Sheet Risk
1st Source 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. The 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. The Company uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments.
17
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.
The Bank issues letters of credit which are conditional commitments that guarantee the performance of a client 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 clients. Standby letters of credit totaled $16.29 million and $17.29 million at September 30, 2013 and December 31, 2012, respectively. Standby letters of credit generally have terms ranging from six months to one year.
Note 8. Derivative Financial Instruments
Commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are considered derivative instruments. See Note 7 for further information.
The Company has certain interest rate derivative positions that are not designated as hedging instruments. Derivative assets and liabilities are recorded at fair value on the balance sheet and do take into account the effects of master netting agreements. Master netting agreements allow the Company to settle all derivative contracts held with a single counterparty on a net basis, and to offset net derivative positions with related collateral, where applicable. These derivative positions relate to transactions in which the Company enters 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, the Company agrees 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, the Company agrees 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 the client to effectively convert a variable rate loan to a fixed rate. Because the terms of the swaps with the customers and the other financial institutions 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 the Company’s results of operations.
At September 30, 2013 and December 31, 2012, 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
classification
value
Interest rate swap contracts
445,258
Other assets
10,902
Other liabilities
11,110
Loan commitments
8,497
N/A
Forward contracts
12,000
179
465,755
10,984
11,289
446,024
16,126
16,444
33,961
21,500
501,485
16,346
16,477
18
For the three and nine months ended September 30, 2013 and 2012, the amounts included in the consolidated statements of income for non-hedging derivative financial instruments are shown in the chart below:
Gain (loss)
Income classification
(2
21
111
169
567
586
(71
(138
205
(943
(350
(448
(847
68
394
443
At September 30, 2013 and December 31, 2012 the offsetting of financial assets and derivative assets are shown in the chart below:
Gross Amounts
Net Amounts of
Gross amounts not offset in the
Amounts of
Offset in the
Assets Presented in
Statement of Financial Position
Recognized
the Statement of
Financial
Cash Collateral
Assets
Financial Position
Instruments
Received
Net Amount
Interest rate swaps
11,586
684
17,422
1,296
At September 30, 2013 and December 31, 2012 the offsetting of financial liabilities and derivative liabilities are shown in the chart below:
Liabilities Presented in
Liabilities
Pledged
11,794
9,407
1,703
Repurchase agreements
110,491
122,285
121,601
17,740
15,811
633
100,180
117,920
116,624
If a default in performance of any obligation of a repurchase agreement occurs, each party will set-off property held in respect of transactions against obligations owing in respect of any other transactions.
Note 9. 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.
19
There were no stock options outstanding as of September 30, 2013. No stock options were considered antidilutive as of September 30, 2012.
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 nine months ended September 30, 2013 and 2012.
(Dollars in thousands - except per share amounts)
Distributed earnings allocated to common stock
4,146
4,127
12,429
11,899
Undistributed earnings allocated to common stock
10,552
8,706
28,271
24,872
Net earnings allocated to common stock
14,698
12,833
40,700
36,771
Net earnings allocated to participating securities
198
172
542
516
Net income allocated to common stock and participating securities
Weighted average shares outstanding for basic earnings per common share
Dilutive effect of stock compensation
889
10,317
781
10,625
Weighted average shares outstanding for diluted earnings per common share
Basic earnings per common share
Diluted earnings per common share
Note 10. Stock Based Compensation
As of September 30, 2013, the Company had four active stock-based employee compensation plans, which are more fully described in Note 15 of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2012. These plans include three executive stock award plans, namely, the Executive Incentive Plan (EIP), the Restricted Stock Award Plan, and the 1998 Performance Compensation Plan; and the Employee Stock Purchase Plan. The last outstanding grant under the 2001 Stock Option Plan was exercised in March 2013. The 2011 Stock Option Plan was approved by the shareholders on April 21, 2011 but the Company had not made any grants through September 30, 2013.
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 the Company recognizes 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 the Company uses the related vesting term. The Company estimates forfeiture rates based on historical employee option exercise and employee termination experience. The Company has identified separate groups of award recipients 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 consolidated statements of income for the three and nine months ended September 30, 2013 and 2012 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.
20
Total fair value of options vested and expensed was zero for the nine months ended September 30, 2013 and 2012. As of September 30, 2013 there were no outstanding stock options. There were 7,500 stock options exercised at a weighted average price of $12.04 during the nine months ended September 30, 2013. All shares issued in connection with stock option exercises are issued from available treasury stock.
As of September 30, 2013, there was $6.69 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 3.25 years.
Note 11. Accumulated Other Comprehensive Income
The following table presents reclassifications out of accumulated other comprehensive income for the three and nine months ended September 30, 2013.
Amount Reclassified from Accumulated Other Comprehensive Income
Affected Line Item in the
Consolidated Statements of
Income
Unrealized gains and losses on available-for-sale securities
Realized losses included in net income
Tax effect
Net of tax
(17
Note 12. Income Taxes
The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was $2.41 million at September 30, 2013 and $2.02 million at December 31, 2012. Interest and penalties were recognized through the income tax provision. For the nine months ended September 30, 2013 and 2012, the Company recognized approximately $0.11 million and $(0.06) million in interest, net of tax effect, and penalties, respectively. Interest and penalties of approximately $0.66 million and $0.55 million were accrued at September 30, 2013 and December 31, 2012, respectively.
Effective January 1, 2014, the Indiana Financial Institutions tax rate decreases from 8.5% to 8.0% and continues to decrease by 0.5% each of the next three years. As a result of the rate change, the Company decreased the carrying value of certain state deferred tax assets. The impact of this change was not material and was recorded in the financial statements during the second quarter of 2013.
Tax years that remain open and subject to audit include the federal 2010-2012 years and the Indiana 2009-2012 years. The Company does not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.
Note 13. Fair Value Measurements
The Company records 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. The Company uses 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 is 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.
The Company elected fair value accounting for mortgages held for sale. The Company believes the election for mortgages held for sale (which are economically hedged with free standing derivatives) 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 September 30, 2013 and December 31, 2012, all mortgages held for sale were carried at fair value.
22
The following table reflects the differences between the fair value carrying amount of mortgages held for sale measured at fair value and the aggregate unpaid principal amount the Company is contractually entitled to receive at maturity on September 30, 2013 and December 31, 2012:
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
Total Loans
7,106
(1)
10,293
(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.
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. Prices supplied by the independent pricing agent, as well as their pricing methodologies and assumptions, are reviewed by the Company for reasonableness and to ensure such prices are aligned with market levels. In general, the Company’s investment securities do not possess a complex structure that could introduce greater valuation risk. The portfolio mainly consists of traditional investments including U.S. Treasury and Federal agencies securities, federal agency mortgage pass-through securities, and general obligation and revenue municipal bonds. Pricing for such instruments is fairly generic and is easily obtained. On a quarterly basis, prices supplied by the pricing agent are validated by comparison to prices obtained from other third party sources for a material portion of the portfolio.
The valuation policy and procedures for Level 3 fair value measurements of available for sale debt securities are decided through collaboration between management of the Corporate Accounting and Funds Management departments. The changes in fair value measurement for Level 3 securities are analyzed on a periodic basis under a collaborative framework with the aforementioned departments. The methodology and variables used for input are derived from the combination of observable and unobservable inputs. The unobservable inputs are determined through internal assumptions that may vary from period to period due to external factors, such as market movement and credit rating adjustments.
23
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 direct placement municipal securities, 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. Validation of third party agent valuations is accomplished by comparing those values to the Company’s swap counterparty valuations. 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 expected credit losses as well as velocity of deterioration evident with systemic risks imbedded in these portfolios.
24
The table below presents the balance of assets and liabilities at September 30, 2013 and December 31, 2012 measured at fair value on a recurring basis:
Level 1
Level 2
Level 3
Assets:
Investment securities available-for-sale:
19,693
376,600
108,163
6,517
800,953
26,878
Accrued income and other assets (Interest rate swap agreements)
27,055
819,012
852,584
Liabilities:
Accrued expenses and other liabilities (Interest rate swap agreements)
20,063
402,190
97,736
7,701
847,307
25,756
25,902
874,312
907,915
The changes in investment securities available-for-sale Level 3 assets measured at fair value on a recurring basis for the quarter ended September 30, 2013 and 2012 are summarized as follows:
Beginning balance July 1, 2013
5,452
Total gains or losses (realized/unrealized):
Included in earnings
Included in other comprehensive income
56
Purchases
1,500
Issuances
Settlements
Maturities
(491
Transfers into Level 3
Transfers out of Level 3
Ending balance September 30, 2013
Beginning balance July 1, 2012
8,143
(474
Ending balance September 30, 2012
7,741
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 September 30, 2013 or 2012. No transfers between levels occurred during the nine months ended September 30, 2013. One transfer between levels occurred during the nine months ended September 30, 2012. No transfers between Level 1 and 2 occurred during the period ended September 30, 2013. A foreign government debt security was transferred from Level 3 to Level 2 as of March 31, 2012 due to the Company’s periodic review of valuation methodologies and inputs. The Company determined that the observable inputs used in determining fair value warranted a transfer to Level 2 as the unobservable inputs were deemed to be insignificant to the overall fair value measurement.
The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a recurring basis at September 30, 2013 and December 31, 2012.
Valuation
Methodology
Unobservable Inputs
Range of Inputs
Investment securities available-for sale
Adjustable rate securities
1,708
Discounted cash flows
Illiquidity adjustment
4.00% - 8.00%
Term assumption (1)
5 yrs
Coupon forecast assumption
0.37%
Direct placement municipal securities
4,809
Credit spread assumption
1.16% - 1.66%
0.50% - 0.88%
4,337
1.22% - 1.95%
(1) Term assumption is influenced by security call history
The sensitivity to changes in the unobservable inputs and their impact on the fair value measurement can be significant. The significant unobservable inputs for adjustable rate securities are illiquidity, term and coupon forecast assumptions. The illiquidity adjustment is negatively correlated to the fair value measure. An increase (decrease) in the determined illiquidity adjustment will lower (increase) the fair value measure. The term assumption is negatively correlated to the fair value measure. An increase (decrease) in the determined term adjustment will decrease (increase) the fair value measure. The coupon forecast is positively correlated to the fair value measure. An increase (decrease) in the determined coupon forecast will increase (decrease) the fair value measure. A permutation that includes a change in the coupon forecast with a change in either or both of the two variables will mitigate the significance of the change to the fair value measure. The significant unobservable input for direct placement municipal securities is the underlying market level used to determine the fair value measure. An increase (decrease) in the estimated yield level of the market will decrease (increase) the fair value measure of the securities.
Financial Instruments on Non-recurring Basis:
The Company may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring 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.
The Credit Policy Committee, a management committee, is responsible for overseeing the valuation processes and procedures for Level 3 measurements of impaired loans, other real estate and repossessions. The Committee reviews these assets on a quarterly basis to determine the accuracy of the observable inputs, generally third party appraisals, auction values, values derived from trade publications and data submitted by
27
the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues. The Committee establishes discounts based on asset type and valuation source; deviations from the standard are documented. The discounts are reviewed periodically, annually at a minimum, to determine they remain appropriate. Consideration is given to current trends in market values for the asset categories and gain and losses on sales of similar assets. The Loan and Funds Management Committee of the Board of Directors is responsible for overseeing the Credit Policy Committee.
Discounts vary depending on the nature of the assets and the source of value. Aircraft are generally valued using quarterly trade publications adjusted for engine time, condition, maintenance programs, discounted by 10%. Likewise, autos are valued using current auction values, discounted by 10%; medium and heavy duty trucks are valued using trade publications and auction values, discounted by 15%. Construction equipment and environmental equipment is generally valued using trade publications and auction values, discounted by 20%. Real estate is valued based on appraisals or evaluations, discounted by 20% at a minimum with higher discounts for property in poor condition or property with characteristics which may make it more difficult to market. Commercial loans subject to borrowing base certificates are generally discounted by 20% for receivables and 40% - 75% for inventory with higher discounts when monthly borrowing base certificates are not required or received.
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. In accordance with fair value measurements, only impaired loans for which a reserve for loan loss has been established based on the fair value collateral require classification in the fair value hierarchy. As a result, only a portion of the Company’s impaired loans are classified in the fair value hierarchy.
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. Quantitative unobservable inputs are not reasonably available for reporting purposes.
The Company has established mortgage servicing rights (MSRs) valuation policies and procedures based on industry standards and to ensure valuation methodologies are consistent and verifiable. 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. 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, servicing costs, and other economic factors. Prepayment rates and discount rates are derived through a third party pricing agent. Changes in the most significant inputs, including prepayment rates and discount rates, are compared to the changes in the fair value measurements and appropriate resolution is made. A fair value analysis is also obtained from an independent third party agent and compared to the internal valuation for reasonableness. 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 the Company’s 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. Fair values are reviewed quarterly and 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 September 30, 2013: impaired loans - $0.00 million; partnership investments - $(0.07) million; mortgage servicing rights - $0.00 million; repossessions - $0.00 million, and other real estate - $0.10 million.
The table below presents the carrying value of assets at September 30, 2013 and December 31, 2012 measured at fair value on a non-recurring basis:
Impaired loans - collateral based
7,608
Accrued income and other assets (partnership investments)
2,017
Accrued income and other assets (mortgage servicing rights)
Accrued income and other assets (repossessions)
2,811
Accrued income and other assets (other real estate)
5,953
23,267
2,027
2,032
63
5,344
14,111
29
The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a non-recurring basis at September 30, 2013 and December 31, 2012.
Carrying Value
Valuation Methodology
Impaired loans
Collateral based measurements including appraisals, trade publications, auction values
Discount for lack of marketability and current conditions
10% - 90%
Mortgage servicing rights
Constant prepayment rate (CPR)
11.1% - 15.7%
Discount rate
9.75% - 12.75%
Repossessions
2,957
Appraisals, trade publications and auction values
Discount for lack of marketability
0% - 3%
Other real estate
7,072
Appraisals
0% - 74%
5,760
14.1% - 23.2%
8.5% - 11.5%
59
0% - 45%
6,550
0% - 68%
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.
30
The fair values of the Company’s financial instruments as of September 30, 2013 and December 31, 2012 are summarized in the table below.
Carrying or
Contract Value
Investment securities, available-for-sale
Other investments and trading account securities
22,586
Loans and leases, net of reserve for loan and lease losses
3,408,703
Cash surrender value of life insurance policies
58,057
3,686,218
2,636,029
1,050,189
152,714
68,728
57,837
71,707
Off-balance-sheet instruments *
166
22,755
3,287,976
56,572
3,641,280
2,556,122
1,085,158
161,138
8,050
71,557
72,914
188
* Represents estimated cash outflows required to currently settle the obligations at current market rates.
31
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, other investments, 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 the 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 the current estimated incremental borrowing rates for similar types of borrowing arrangements. The carrying values of mandatorily redeemable securities are based on the current estimated cost of redeeming these securities which approximate their fair values.
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 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 the 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 the Company’s 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 the Company 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 the Company 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.
32
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.
ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following management’s discussion and analysis is presented to provide information concerning 1st Source Corporation and its subsidiaries’ (collectively referred to as “the Company”, “we”, and “our”) financial condition as of September 30, 2013, as compared to December 31, 2012, and the results of operations for the three and nine months ended September 30, 2013 and 2012. 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 2012 Annual Report.
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 other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such 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 2012, which filings are available from the SEC. We undertake no obligation to publicly update or revise any forward-looking statements.
FINANCIAL CONDITION
Our total assets at September 30, 2013 were $4.65 billion, an increase of $99.27 million or 2.18% from December 31, 2012. Total loans and leases were $3.47 billion, an increase of $140.57 million or 4.22% from December 31, 2012. Total investment securities, available for sale were $834.35 million which represented a decrease of $46.42 million or 5.27% and total deposits were $3.68 billion, an increase of $55.07 million or 1.52% over the comparable figures at the end of 2012. Short-term borrowings were $221.44 million, an increase of $52.25 million or 30.89% from December 31, 2012.
Nonperforming assets at September 30, 2013 were $40.33 million, which was a decrease of $1.94 million or 4.57% from the $42.27 million reported at December 31, 2012. At September 30, 2013 and December 31, 2012, nonperforming assets were 1.14% and 1.25%, 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
12,913
12,698
Mortgage servicing assets
5,002
4,311
Former bank premises held for sale
951
1,034
All other assets
32,626
44,105
Total accrued income and other assets
CAPITAL
As of September 30, 2013, total shareholders’ equity was $578.23 million, up $19.57 million or 3.50% from the $558.66 million at December 31, 2012. In addition to net income of $41.24 million, other significant changes in shareholders’ equity during the first nine months of 2013 included $12.52 million of dividends paid. The accumulated other comprehensive income/(loss) component of shareholders’ equity totaled $9.01 million at September 30, 2013, compared to $19.54 million at December 31, 2012. The decrease in accumulated other comprehensive income/(loss) during 2013 was the result of changes in unrealized gain/(loss) on securities in the available-for-sale portfolio. Our equity-to-assets ratio was 12.44% as of September 30, 2013, compared to 12.28% at December 31, 2012. Book value per common share rose to $23.77 at September 30, 2013, from $23.04 at December 31, 2012.
We declared and paid dividends per common share of $0.17 during the third quarter of 2013. The trailing four quarters dividend payout ratio, representing dividends per common share divided by diluted earnings per common share, was 31.48%. The dividend payout is continually reviewed by management and the Board of Directors subject to the Company’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 September 30, 2013, are presented in the table below:
Capitalized Under
Minimum Capital
Prompt Corrective
Actual
Adequacy
Action Provisions
Amount
Ratio
Total Capital (to Risk-Weighted Assets):
1st Source Corporation
588,627
15.89
%
296,294
8.00
370,368
10.00
1st Source Bank
558,869
15.12
295,741
369,676
Tier 1 Capital (to Risk-Weighted Assets):
539,572
14.57
148,147
4.00
222,221
6.00
511,491
13.84
147,871
221,806
Tier 1 Capital (to Average Assets):
11.91
181,151
226,439
5.00
11.31
180,875
226,093
34
In July of 2013, the Federal Reserve and other federal banking agencies issued the final Basel III rule to help ensure that banks maintain strong capital positions. Under the final rule, minimum requirements increase for both the quantity and quality of capital held by banking organizations. The rule includes a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5% and a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets that apply to all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4.0% to 6.0% and includes a minimum leverage ratio of 4.0% for all banking organizations. These new standards will become effective for us on January 1, 2015.
LIQUIDITY AND INTEREST RATE SENSITIVITY
Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as our operating cash needs 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. At September 30, 2013 we had $37.50 million outstanding and could borrow approximately $227.50 million for a short time from these banks on a collective basis. As of September 30, 2013, we had $92.65 million outstanding in FHLB advances and could borrow an additional $103.04 million. We also had $344.47 million available to borrow from the FRB with no amounts outstanding as of September 30, 2013.
Our loan to asset ratio was 74.58% at September 30, 2013 compared to 73.12% at December 31, 2012 and 72.82% at September 30, 2012. Cash and cash equivalents totaled $91.77 million at September 30, 2013 compared to $83.93 million at December 31, 2012 and $71.81 million at September 30, 2012. At September 30, 2013, the consolidated statement of financial condition was rate sensitive by $178.35 million more assets than liabilities scheduled to reprice within one year, or approximately 1.09%. Management believes that the present funding sources provide adequate liquidity to meet our cash flow needs.
Under Indiana law governing the collateralization of public fund deposits, the Indiana Board of Depositories determines which financial institutions are required to pledge collateral based on the strength of their financial ratings. We have been informed that no collateral is required for our public fund deposits. However, the Board of Depositories could alter this requirement in the future and adversely impact our liquidity. Our potential liquidity exposure if we must pledge collateral is approximately $613 million.
RESULTS OF OPERATIONS
Net income for the three and nine month periods ended September 30, 2013 was $14.90 million and $41.24 million, compared to $13.01 million and $37.29 million for the same periods in 2012. Diluted net income per common share was $0.60 and $1.67 for the three and nine month periods ended September 30, 2013, compared to $0.53 and $1.51 for the same periods in 2012. Return on average common shareholders’ equity was 9.65% for the nine months ended September 30, 2013, compared to 9.21% in 2012. The return on total average assets was 1.20% for the nine months ended September 30, 2013, compared to 1.12% in 2012.
The increase in net income for the nine months ended September 30, 2013, over the first nine months of 2012, was primarily the result of an increase in net interest income and a decrease in provision for loan and lease losses. Details of the changes in the various components of net income are discussed further below.
35
NET INTEREST INCOME
The taxable equivalent net interest income for the three months ended September 30, 2013 was $41.60 million, an increase of 8.29% over the same period in 2012. The net interest margin on a fully taxable equivalent basis was 3.79% for the three months ended September 30, 2013, compared to 3.63% for the three months ended September 30, 2012. The taxable equivalent net interest income for the nine months ended September 30, 2013 was $119.15 million, an increase of 3.75% over 2012, resulting in a net yield of 3.69% compared to a net yield of 3.70% for the same period in 2012.
During the three and nine month periods ended September 30, 2013, average earning assets increased $144.60 million or 3.44% and $168.24 million or 4.06% respectively, over the comparable periods in 2012. Average interest-bearing liabilities increased $51.72 million or 1.59% and $57.47 million or 1.78% respectively, for the three and nine month periods ended September 30, 2013 over the comparable periods one year ago. The yield on average earning assets decreased 4 basis points to 4.32% for the third quarter of 2013 from 4.36% for the third quarter of 2012. The yield on average earning assets for the nine month period ended September 30, 2013 decreased 21 basis points to 4.24% from 4.45% for the nine month period ended September 30, 2012. The rate earned on assets decreased due to the reduction in loan and investment yields in the current interest rate environment. Total cost of average interest-bearing liabilities decreased 24 basis points to 0.70% for the third quarter 2013 from 0.94% for the third quarter 2012. Total cost of average interest-bearing liabilities decreased 25 basis points to 0.72% for the nine months ended September 30, 2013, from 0.97% for the nine months ended September 30, 2012. The result to the net interest margin, or the ratio of net interest income to average earning assets, was an increase of 16 basis points and a decrease of 1 basis point, respectively for the three and nine month periods ended September 30, 2013 from September 30, 2012.
The largest contributor to the decrease in the yield on average earning assets for the three and nine months ended September 30, 2013, compared to the three and nine months ended September 30, 2012, was a reduction in yields on net loans and leases of 10 basis points and 30 basis points, respectively. The yields on net loans and leases would have seen further decreases of 18 basis points and 6 basis points for the three and nine month periods ended September 30, 2013, respectively, were it not for the positive impact of interest recoveries. Average net loans and leases increased $215.64 million or 6.60% for the third quarter of 2013 from the third quarter of 2012 and $226.23 million or 7.09% for the nine months ended September 30, 2013 compared to the same period in 2012. Total average investment securities decreased $29.52 million or 3.45% for the third quarter and decreased $34.17 million or 3.90% for the nine month period over one year ago. Tax equivalent yield on investment securities decreased 13 basis points for the third quarter 2013. Average mortgages held for sale decreased $14.49 million or 64.49% and $8.69 million or 51.07% respectively, for the three and nine month periods ended September 30, 2013, over the comparable periods a year ago. 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 $27.03 million or 44.15% and $15.13 million or 24.10% respectively, for the three and nine month periods ended September 30, 2013, over the comparable periods a year ago.
Average interest-bearing deposits increased $44.07 million or 1.49% and $66.84 million or 2.27% respectively, for the third quarter of 2013 and the first nine months of 2013 over the same periods in 2012. The effective rate paid on average interest-bearing deposits decreased 19 basis points to 0.54% for the third quarter 2013 compared to 0.73% for the third quarter 2012. The effective rate paid on average interest-bearing deposits decreased 18 basis points to 0.58% for the first nine months of 2013 compared to 0.76% for the first nine months of 2012. The decline in the average cost of interest-bearing deposits during the third quarter of 2013 and the first nine months of 2013 as compared to the third quarter and first nine months of 2012 was primarily the result of interest rate re-pricing on maturing certificates of deposit and a change in deposit mix.
Average short-term borrowings increased $46.11 million or 32.95% and increased $8.33 million or 5.94%, respectively for the third quarter of 2013 and the first nine months of 2013 compared to the same periods in 2012 in order to fund loan growth. Interest paid on short-term borrowings increased 5 basis points for the third quarter and was flat for the first nine months of 2013. Average subordinated notes decreased $30.93 million for the third quarter of 2013 and the first nine months of 2013 while the effective rate paid decreased 19 basis points and 16 basis points, respectively due to the redemption of trust preferred securities in December 2012. Average long-term debt decreased $7.54 million or 11.46% during the third quarter of 2013 as compared to the third quarter of 2012 and increased $13.22 million or 25.87% during the first nine months of 2013 as compared to the first nine months of 2012. The decrease in long-term borrowings during the third quarter of 2013 as compared to the third quarter of 2012 was the result of decreased borrowings with the Federal Home Loan Bank (FHLB). The increase in long-term borrowings for the nine months ended September 30, 2013 compared to the same period a year ago was mainly the result of higher borrowings with the FHLB. Interest paid on long-term borrowings increased 58 basis points for the third quarter of 2013 compared to the third quarter of 2012 due to higher rates on mandatorily redeemable securities, offset by lower effective rates on FHLB borrowings. Interest paid on long-term borrowings decreased 93 basis points for the first nine months of 2013 compared to the first nine months of 2012 due to lower effective rates on FHLB 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
Interest
Average
Income/
Yield/
Expense
Rate
ASSETS:
Investment securities:
Taxable
717,081
1.98
750,003
2.08
736,192
1.96
768,994
2.18
Tax exempt
108,395
1,126
4.12
104,991
1,225
4.64
105,825
3,385
4.28
107,189
3,739
4.66
Mortgages - held for sale
7,979
87
4.33
22,470
193
3.42
8,329
235
3.77
17,022
451
3.54
3,483,942
42,389
4.83
3,268,304
40,531
4.93
3,415,752
121,714
4.76
3,189,526
120,733
5.06
34,186
2.66
61,214
1.50
47,644
2.00
62,769
1.46
Total Earning Assets
4,351,583
47,412
4.32
4,206,982
46,093
4.36
4,313,742
136,820
4.24
4,145,500
138,185
4.45
58,122
58,226
58,648
60,048
(86,570
(84,120
(85,204
(83,221
302,822
318,337
306,846
325,126
4,625,957
4,499,425
4,594,032
4,447,453
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Interest-bearing deposits
2,992,091
0.54
2,948,022
0.73
3,016,570
0.58
2,949,726
0.76
186,064
0.15
139,951
0.10
148,626
0.13
140,294
7.12
89,692
7.31
7.20
7.36
58,244
4.03
65,780
3.45
64,307
2.73
51,090
3.66
Total Interest-Bearing Liabilities
3,295,163
0.70
3,243,445
0.94
3,288,267
0.72
3,230,802
0.97
Noninterest-bearing deposits
705,778
635,152
677,269
603,805
50,427
70,865
56,804
71,806
Shareholders’ equity
574,589
549,963
571,692
541,040
Net Interest Income
41,604
38,420
119,148
114,840
Net Yield on Earning Assets on a Taxable Equivalent Basis
3.79
3.63
3.69
3.70
37
PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES
The provision for loan and lease losses for the three and nine month period ended September 30, 2013 was $(0.42) million and $1.63 million respectively, compared to a provision for loan and lease losses in the three and nine month periods ended September 30, 2012 of $0.65 million and $4.96 million respectively. Net charge-offs of $0.76 million were recorded for the third quarter 2013, compared to net charge-offs of $0.45 million for the same quarter a year ago. Year-to-date net charge-offs of $0.44 million have been recorded in 2013, compared to net charge-offs $3.10 million through September 30, 2012.
On September 30, 2013, 30 day and over loan and lease delinquencies were 0.26% compared to 0.54% on September 30, 2012. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.44% as compared to 2.55% one year ago. A summary of loan and lease loss experience during the three and nine months ended September 30, 2013 and 2012 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 September 30, 2013 and December 31, 2012 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
477
Nonaccrual loans and leases
42,756
4,842
1,101
1,248
Equipment owned under operating leases
Total nonperforming assets
40,334
42,267
50,456
Nonperforming assets as a percentage of total loans and leases were 1.14% at September 30, 2013, 1.25% at December 31, 2012, and 1.51% at September 30, 2012. Nonperforming assets totaled $40.33 million at September 30, 2013, a decrease of 4.57% from the $42.27 million reported at December 31, 2012, and a 20.06% decrease from the $50.46 million reported at September 30, 2012. The decrease during the first nine months of 2013 compared to the same period in 2012 was primarily related to a decrease in nonaccrual loans and leases as the economy slowly improves.
The decrease in nonaccrual loans and leases at September 30, 2013 from December 31, 2012 and the decrease in nonaccrual loans and leases at September 30, 2013 from September 30, 2012 occurred across almost all loan types. A summary of nonaccrual loans and leases and past due aging for the period ended September 30, 2013 and December 31, 2012 is located in Note 4 of the Consolidated Financial Statements.
As of September 30, 2013, 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 $11.66 million which were comprised of $10.69 million secured by commercial real estate and included in loans secured by real estate and $0.97 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 have suffered in this economy. Furthermore, aircraft values for some models declined from 2010 to 2012, increasing the risk in aircraft secured transactions; however, values appear to have stabilized in 2013.
Other real estate is the result of foreclosing on real estate in the local market for which we have a current appraisal and are well secured. Other real estate increased slightly over the past year due to current foreclosures outpacing sales of existing properties.
Repossessions consisted mainly of aircraft financing at September 30, 2013. 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.
A summary of other real estate and repossessions is shown in the table below:
162
2,632
1,165
3,589
1,060
545
1,253
370
415
7,813
4,374
6,090
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 $268.74 million and $271.41 million as of September 30, 2013 and December 31, 2012, respectively. Foreign loans and leases are in aircraft financing. Loan and lease outstandings to borrowers in Brazil and Mexico were $153.50 million and $58.46 million as of September 30, 2013, respectively, compared to $169.42 million and $55.12 million as of December 31, 2012, respectively. Outstanding balances to borrowers in other countries were insignificant.
NONINTEREST INCOME
Noninterest income for the three month period ended September 30, 2013 and 2012 was $20.16 million and $20.31 million, respectively. Noninterest income for the nine month period ended September 30, 2013 and 2012 was $59.23 million and $60.62 million, respectively. Details of noninterest income follow:
Noninterest income decreased $0.15 million or 0.72% for the three months ended September 30, 2013 as compared to the same period in 2012. Noninterest income decreased $1.39 million or 2.29% for the nine months ended September 30, 2013 compared to the same period one year ago. Investment securities and other investments gains increased slightly during the third quarter of 2013 over the same period in 2012, while decreasing slightly during the first nine months of 2013 versus the first nine months of 2012.
Trust fees increased $1.21 million or 29.72% and $1.39 million or 11.23% for the three and nine months ended September 30, 2013 over the same periods a year ago. The increase in trust fees was primarily the result of an increase in market values of investments held in the trust accounts of clients.
Service charges on deposit accounts decreased $0.32 million or 12.05% and $0.82 million or 10.57% for the three and nine months ended September 30, 2013, respectively over the comparable periods one year ago. The decrease in service charges on deposit accounts reflects a lower volume of nonsufficient fund transactions.
Debit card income increased $0.32 million or 15.99% and $0.47 million or 7.50% in the three and nine months ended September 30, 2013 over the same periods a year ago. The increase in debit card income was the result of increased transaction fees coupled with an increase in amount of debit card transactions in 2013.
Mortgage banking income decreased $0.92 million or 45.40% in the third quarter of 2013 as compared to the third quarter of 2012. Mortgage banking income decreased $0.80 million or 14.59% during the first nine months of 2013 versus the first nine months of 2012. This variance was caused by decreased gains on loan sales due to lower production volumes offset by lower mortgage servicing rights amortization expense in 2013.
Insurance commissions decreased $0.19 million or 12.88% in the three months ended September 30, 2013 over the same period a year ago. The decrease related to lower premium and agency fees. Insurance commissions remained flat for the nine months ended September 30, 2013 versus the first nine months in 2012.
Equipment rental income declined $0.60 million or 13.12% in the third quarter of 2013 compared to the third quarter 2012. Equipment rental income declined $2.52 million or 17.25% for year-to-date 2013 compared to the same period in 2012. The average equipment rental portfolio decreased 19.37% in 2013 over the same period in 2012 resulting in lower rental income. In addition, new leases are at lower rates due to current market conditions and increased competition.
40
Other income increased $0.19 million or 5.74% and $0.83 million or 8.64% for the three and nine months ended September 30, 2013, respectively as compared to the same periods in 2012 primarily due to higher mutual fund income and dividend income.
NONINTEREST EXPENSE
Noninterest expense for the three month period ended September 30, 2013 and 2012 was $38.43 million and $37.19 million, respectively. Noninterest expense for the nine month period ended September 30, 2013 and 2012 was $110.72 million and $111.82 million, respectively. Details of noninterest expense follow:
Noninterest expense increased $1.24 million or 3.33% for the third quarter and decreased $1.10 million or 0.98% for year-to-date 2013 as compared to the same periods in 2012. FDIC and other insurance expense decreased slightly in 2013 over the same periods in 2012. Supplies and communication expense decreased during the third quarter of 2013 over the same period in 2012 while slightly increasing for year-to-date 2013 as compared to the same period in 2012.
Salaries and employee benefits decreased $0.54 million or 2.58% and $2.12 million or 3.43% in the three and nine months ended September 30, 2013, respectively versus the three and nine months ended September 30, 2012. Lower base salary expense was primarily due to fewer full time equivalent employees offset by annual performance raises. Loan producer commissions were lower due to decreased residential mortgage loan volumes.
Net occupancy expense was higher by $0.47 million or 28.69% for the third quarter of 2013 and $0.82 million or 14.49% for year-to-date 2013 respectively, compared to the same periods one year ago. The increase was primarily a result of higher real estate taxes, depreciation and repairs.
Furniture and equipment expense increased $0.66 million or 17.29% and $1.13 million or 10.13% for the third quarter and year-to-date 2013 compared to the same periods in 2012. Furniture and equipment expense was higher mainly due to increased equipment depreciation, computer processing charges and software maintenance costs.
During the third quarter and first nine months of 2013, depreciation on leased equipment decreased $0.55 million or 14.47% and $2.16 million or 18.17%, respectively in conjunction with the decrease in equipment rental income as compared to the same periods one year ago.
Professional fees decreased $0.21 million or 14.95% and $0.39 million or 9.19% for the three and nine month periods ended September 30, 2013 respectively, as compared to the three and nine month periods ended September 30, 2012. The decrease in professional fees in 2013 was primarily the result of reduced utilization of consulting services.
Business development and marketing expense increased $0.30 million or 29.56% for the three months ended September 30, 2013 versus the three months ended September 30, 2012 and was flat for the nine months ended September 30, 2013 versus the nine months ended September 30, 2012. The third quarter increase was primarily due to higher charitable contributions and institutional marketing.
Loan and lease collection and repossession expense decreased $0.34 million or 18.01% for the three months ended September 30, 2013 compared to the same period in 2012 primarily due to a reduction in average repossessions outstanding and lower repurchased mortgage loan losses in 2013 compared to 2012. Loan and lease collection and repossession expense decreased $0.96 million or 22.18% in the nine month period ended September 30, 2013 compared to the same period a year ago mainly due to a reduction in average repossessions outstanding offset by higher repurchased mortgage loan losses in 2013 compared to 2012.
Other expenses increased $1.53 million or 395.36% and $2.34 million or 76.83% in the three and nine month periods ended September 30, 2013, respectively as compared to the same periods in 2012 primarily related to a gain on the sale of the corporate headquarters’ parking garage that occurred during the third quarter of 2012 in addition to a previously reported trustee matter during 2013.
INCOME TAXES
The provision for income taxes for the three and nine month periods ended September 30, 2013 was $8.41 million and $23.41 million, respectively compared to $7.36 million and $19.82 million for the same periods in 2012. The effective tax rates were 36.08% and 36.15% for the third quarter ended September 30, 2013 and 2012, respectively and 36.21% and 34.71% for the nine months ended September 30, 2013 and 2012, respectively. The effective tax rates are higher in 2013 compared to 2012 due to the impact of state refunds for 2009 received in January of 2012.
Effective January 1, 2014, the Indiana Financial Institutions tax rate decreases from 8.5% to 8.0% and continues to decrease by 0.5% each of the next three years. As a result of the rate change, we decreased the carrying value of certain state deferred tax assets. The impact of this change was not material and was recorded in the financial statements during the second quarter of 2013.
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, 2012. For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2012.
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 September 30, 2013, 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 third fiscal quarter of 2013 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. 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.
ITEM 1A. Risk Factors.
There have been no material changes in risks faced by 1st Source since December 31, 2012. For information regarding our risk factors, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2012.
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
of shares
price paid per
as part of publicly announced
that may yet be purchased under
Period
purchased
share
plans or programs*
the plans or programs
July 01 - 31, 2013
942,963
Aug 01 - 31, 2013
22,334
26.16
920,629
Sept 01 - 30, 2013
40,470
26.28
880,159
* 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 1,119,841 shares.
ITEM 3. Defaults Upon Senior Securities.
None
ITEM 4. Mine Safety Disclosures.
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
October 24, 2013
/s/ CHRISTOPHER J. MURPHY III
Christopher J. Murphy III
Chairman of the Board, President and CEO
/s/ ANDREA G. SHORT
Andrea G. Short
Treasurer and Chief Financial Officer Principal Accounting Officer