1st Source - 10-Q quarterly report FY

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

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

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

Trustcorp Mortgage Company and 1st Source Bank (Bank), subsidiaries of 1st Source Corporation, grant mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

We issue letters of credit which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.

As of March 31, 2007 and December 31, 2006, 1st Source had commitments outstanding to originate and purchase mortgage loans aggregating $141.16 million and $113.25 million, respectively. Outstanding commitments to sell mortgage loans aggregated $87.84 million at March 31, 2007, and $73.87 million at December 31, 2006. Standby letters of credit totaled $83.38 million and $83.15 million at March 31, 2007, and December 31, 2006, respectively. Standby letters of credit have terms ranging from six months to one year.

As of March 31, 2007, we had five stock-based employee compensation plans, which are more fully described in Note K of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2006. These plans include two stock option plans, the Employee Stock Purchase Plan, the Executive Incentive Plan, and the Restricted Stock Award Plan.

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective transition method and, therefore, have not restated results for prior periods. Under this transition method, stock-based compensation expense for the first quarter of 2006 included compensation expense for all stock-based compensation awards granted prior to, but that remained unvested as of, January 1, 2006. Compensation expense was based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123.

Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006, is based on the grant-date fair value. For all awards except stock option awards, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date. For stock option awards, the grant date fair value is estimated using the Black-Scholes option pricing model. For all awards we recognize these compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term. We estimate forfeiture rates based on historical employee option exercise and employee termination experience. We have identified separate groups of awardees that exhibit similar option exercise behavior and employee termination experience and have considered them as separate groups in the valuation models and expense estimates.

The stock-based compensation expense recognized in the condensed consolidated statement of operations for the three months ended March 31, 2007 and 2006 was based on awards ultimately expected to vest, and accordingly has been adjusted by the amount of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based partially on historical experience.

The aggregate intrinsic value in the table below represents the total pretax intrinsic value (the difference between 1st Source’s closing stock price on the last trading day of the first quarter of 2007 (March 31, 2007) and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on March 31, 2007, this amount changes based on the fair market value of 1st Source’s stock. Total intrinsic value of options exercised for the three months ended March 31, 2007 was $267 thousand. Total fair value of options vested and expensed was $21 thousand, net of tax, for the three months ended March 31, 2007.

Tax years that remain open and subject to audit include federal 2003-2006 years and Indiana 2002-2006 years. Additionally, we have an open tax examination with the Indiana Department of Revenue for the tax years 2002-2004. Indiana is currently proposing adjustments for certain apportionment issues. We are appealing these adjustments.

On February 19, 2007, we entered into a definitive agreement of merger with FINA Bancorp, Inc. (FINA), in which 1st Source will acquire FINA in an exchange of cash and stock. FINA headquartered in Valparaiso, Indiana, owns First National Bank, Valparaiso, a full service bank with approximately $620.00 million in assets. The merger, approved by the directors of both companies, is valued at approximately $135.00 million, or $3,206.57 per FINA share. The price represents approximately 196% of book value and 41.5 times 2006 earnings before securities losses. 1st Source will pay a minimum of 40% and a maximum of 42% of the purchase price in shares of 1st Source common stock, and the remainder of the purchase price will be paid in cash. The precise exchange ratio will be established at closing based on 1st Source’s stock price prior to the completion of the merger. FINA shareholders will be able to choose whether to receive 1st Source common stock or cash pursuant to election procedures described in the definitive agreement, subject to 1st Source’s ability to reallocate elections on a proportionate basis. The merger is subject to customary closing conditions, including regulatory approval. The Federal Reserve Board of Governors has indicated that as a condition to its approval of the merger, we may be required to divest one or more branches located in Starke County, Indiana so that our market share in Starke County after the merger does not exceed set limits. We do not expect that this condition will have a material impact on the merger transaction which is expected to be completed in the second quarter of 2007. We believe the purchase of FINA is a natural extension of our service area and is consistent with our growth market expansion initiatives.

Except for historical information contained herein, the matters discussed in this document express “forward-looking statements.” Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” “should,” and similar expressions indicate forward-looking statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. We may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or U. S. generally accepted accounting principles; our competitive position within the markets we serve; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which we have credit concentrations; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K for 2006, which filings are available from the SEC. We undertake no obligation to publicly update or revise any forward-looking statements.

The following management’s discussion and analysis is presented to provide information concerning our financial condition as of March 31, 2007, as compared to December 31, 2006, and the results of operations for the three months ended March 31, 2007 and 2006. 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 2006 Annual Report.

Our total assets at March 31, 2007, were $3.80 billion, relatively unchanged from December 31, 2006. Total loans and leases increased 1.81% and total deposits remained stable over the comparable figures at the end of 2006.

On February 19, 2007, we announced the agreement and plan of merger with FINA Bancorp, Inc., the parent company of First National Bank, Valparaiso. Pending customary closing conditions, including regulatory approval, we expect the merger to be complete in the second quarter of 2007. We believe this acquisition provides us with an opportunity to join two strong local banks with similar values, history, and legacies. First National Bank, Valparaiso is located in the fastest growing area of our retain market and will serve as a platform for future expansion.

Nonperforming assets at March 31, 2007, were $14.02 million, which was a 20.67% improvement over the $17.67 million reported at December 31, 2006. During the first quarter of 2007 nonperforming assets decreased as compared to year-end 2006, across all loan and lease portfolios with the exception of loans secured by real estate. The most significant improvement in 2007 year-to-date nonperforming loans and leases was in aircraft financing compared to December 31, 2006. At March 31, 2007, nonperforming assets were 0.50% of net loans and leases compared to 0.64% at December 31, 2006.

As of March 31, 2007, total shareholders' equity was $375.06 million, up 1.67% from the $368.90 million at December 31, 2006. In addition to net income of $8.52 million, other significant changes in shareholders’ equity during the first three months of 2007 included $0.17 million in treasury stock purchases, and $3.16 million of dividends paid. The accumulated other comprehensive income/(loss) component of shareholders’ equity totaled $0.36 million at March 31, 2007, compared to $(0.26) million at December 31, 2006. The improvement in accumulated other comprehensive income/(loss) for the first quarter of 2007 over the same period of 2006 was primarily a result of changes in unrealized gain/(loss) on securities in the available-for-sale portfolio. Our equity-to-assets ratio was 9.86% as of March 31, 2007, compared to 9.69% at December 31, 2006. Book value per common share rose to $16.66 at March 31, 2007, up from $16.40 at December 31, 2006.

We declared and paid dividends per common share of $0.14 during the first quarter of 2007. The trailing four quarters dividend payout ratio, representing dividends per share divided by diluted earnings per share, was 32.95%. The dividend payout is continually reviewed by management and the Board of Directors.

The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations. The actual capital amounts and ratios of 1st Source and our largest subsidiary, the Bank, as of March 31, 2007, are presented in the table below:

The Bank’s liquidity is monitored and closely managed by the Asset/Liability Committee (ALCO), which is comprised of the Bank’s senior management. Asset and liability management includes the management of interest rate sensitivity and the maintenance of an adequate liquidity position. The purpose of interest rate sensitivity management is to stabilize net interest income during periods of changing interest rates.

Liquidity management is the process by which the Bank ensures that adequate liquid funds are available to meet financial commitments on a timely basis. Financial institutions must maintain liquidity to meet day-to-day requirements of depositors and borrowers, take advantage of market opportunities and provide a cushion against unforeseen needs.

Liquidity of the Bank is derived primarily from core deposits, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability funded liquidity is deposit growth and retention of the core deposit base. The principal sources of asset funded liquidity are available-for-sale investment securities, cash and due from banks, Federal funds sold, securities purchased under agreements to resell, and loans and interest bearing deposits with other banks maturing within one year. Additionally, liquidity is provided by bank lines of credit, repurchase agreements, and the ability to borrow from the Federal Reserve Bank and Federal Home Loan Bank.

The ALCO monitors and manages the relationship of earning assets to interest bearing liabilities and the responsiveness of asset yields, interest expense, and interest margins to changes in market interest rates. At March 31, 2007, the consolidated statement of financial condition was rate sensitive by $370.10 million more liabilities than assets scheduled to reprice within one year, or approximately 0.85%.

Net income for the three month period ended March 31, 2007, was $8.52 million, compared to $9.93 million for the same period in 2006. Diluted net income per common share was $0.37 for the three month period ended March 31, 2007, compared to $0.43 for the same period in 2006. Return on average common shareholders' equity was 9.24% for the three months ended March 31, 2007, compared to 11.53% in 2006. The return on total average assets was 0.94% for the three months ended March 31, 2007, compared to 1.18% in 2006.

The decrease in net income for the three months ended March 31, 2007, over the first three months of 2006, was primarily the result of a decrease in total noninterest income and an increase in total noninterest expense. These negative impacts to net income were somewhat offset by an increase in net interest income and a decrease in the income tax provision. Details of the changes in the various components of net income are discussed further below.

The taxable equivalent net interest income for the three months ended March 31, 2007, was $26.97 million, an increase of 4.83% over the same period in 2006. The net interest margin on a fully taxable equivalent basis was 3.17% for the three months ended March 31, 2007, compared to 3.29% for the three months ended March 31, 2006.

During the first quarter of 2007, average earning assets increased $279.72 million or 8.82% while average interest-bearing liabilities increased $294.64 million or 11.19% over the comparable period one year ago. The yield on average earning assets increased 65 basis points to 6.66% for the first quarter of 2007 from 6.01% for the first quarter of 2006. The rate earned on assets continued to experience positive impacts from the increases in short-term market interest rates from a year ago. Total cost of average interest-bearing liabilities increased 83 basis points to 4.11% as of March 31, 2007 from 3.28% at March 31, 2006, as liabilities were also affected by short-term market interest rates. The result was a decrease of 12 basis points to the net interest margin, or the difference between interest income on earning assets and expense on interest-bearing liabilities.

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.

In the first quarter 2007, loan and lease delinquencies were 0.25% as compared to 0.76% on March 31, 2006, and 0.17% at the end of 2006. For comparative purposes the rise and fall in delinquencies for the first quarter of 2007, year-end 2006, and the first quarter of 2006, were mainly in the turbine aircraft portfolio. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.13% as compared to 2.38% one year ago and 2.18% at December 31, 2006. A summary of loan and lease loss experience during the three month periods ended March 31, 2007 and 2006 is provided below.

Repossessions consisted mainly of aircraft, automobiles, light trucks, and construction equipment at March 31, 2007. 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.

For financial statements purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets. Net credit losses include net charge-offs on loans and leases and valuation adjustments and gains and losses on disposition of repossessions and defaulted operating leases.

Noninterest income for the three-month periods ended March 31, 2007 and 2006 was $17.49 million and $19.01 million, respectively. The predominant factor behind the decrease in 2007 was a significant decrease in market value adjustments resulting in lower gains on venture capital investments and a decline in mortgage banking income, partially offset by an increase in equipment rental income.

Gains on venture partnership investment, due to market value adjustments, totaled $0.03 million for the first quarter of 2007 compared to gains of $2.05 million for the first quarter of 2006. Mortgage banking income decreased in the first quarter of 2007 as compared to the first quarter of 2006 primarily due a decline in production volume of approximately 29.00% which resulted in lower gains on sales of mortgage servicing assets and a decline in loan servicing fee income due to a reduction in the portfolio from servicing sales in the second and third quarters of 2006.

Equipment rental income generated from operating leases increased during the first quarter of 2007 as compared to the first quarter of 2006 primarily due to an increase of 29.00% in the operating lease portfolio from one year ago. Other income increased from the three-month period ended March 31, 2007 as compared to the same period of 2006, mainly due to fees generated from customer related interest rate swaps and mutual fund income. Additionally, trust fees and service charges on deposit accounts increased during the first quarter of 2007 as compared to the first quarter 2006.

Noninterest expense for the three-month periods ended March 31, 2007 and 2006 was $31.80 million and $29.41 million, respectively.

These increases in noninterest expense were slightly offset by decreases in intangible asset amortization (due mainly to the effects of the complete amortization of intangible assets associated with acquisitions which occurred during 2001) supplies and communication, furniture and equipment expense, and other expense for the period ending March 31, 2006 from March 31, 2007.

There have been no material changes in market risks faced by 1st Source since December 31, 2006. For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2006.

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 March 31, 2007, our disclosure controls and procedures were effective in accumulating and communicating to management (including such officers) the information relating to 1st Source (including its consolidated subsidiaries) required to be included in our periodic SEC filings.