Companies: 10,793     total market cap: NZ$233.757 T
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1st Source
SRCE
#4976
Rank
NZ$2.98 B
Marketcap
๐Ÿ‡บ๐Ÿ‡ธ United States
Country
NZ$122.12
Share price
1.75%
Change (1 day)
18.14%
Change (1 year)
๐Ÿฆ Banks๐Ÿ’ณ Financial services
Categories
  1. 1st Source
  2. Quarterly Reports (10-Q)
  3. Submitted on 2020-07-23

1st Source - 10-Q quarterly report FY Q2


Text size:
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)

☒  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2020
OR
☐         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                     to                    
Commission file number 0-6233
1st Source Corporation
(Exact name of registrant as specified in its charter)
Indiana
 35-1068133
(State or other jurisdiction of 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)
Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading Symbol(s)Name of each exchange on which registered
Common Stock - without par valueSRCEThe NASDAQ Stock Market LLC

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 every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit 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, a smaller reporting company or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filerx Accelerated filer☐
Non-accelerated filer☐ Smaller reporting company☐
Emerging growth company☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  ☐ Yes  x No
Number of shares of common stock outstanding as of July 17, 2020 — 25,550,365 shares


Table of Contents
TABLE OF CONTENTS

  Page
   
 
   
 
 
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43
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44
   
45
   
EXHIBITS 
 
 
 
 

2


1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited - Dollars in thousands)
June 30,
2020		December 31,
2019
ASSETS  
Cash and due from banks$67,591  $67,215  
Federal funds sold and interest bearing deposits with other banks112,645  16,150  
Investment securities available-for-sale1,055,797  1,040,583  
Other investments30,619  28,414  
Mortgages held for sale36,508  20,277  
Loans and leases, net of unearned discount: 
Commercial and agricultural1,710,712  1,132,791  
Auto and light truck563,606  588,807  
Medium and heavy duty truck284,432  294,824  
Aircraft782,160  784,040  
Construction equipment739,027  705,451  
Commercial real estate942,971  908,177  
Residential real estate and home equity531,972  532,003  
Consumer137,442  139,434  
Total loans and leases5,692,322  5,085,527  
Reserve for loan and lease losses(131,283) (111,254) 
Net loans and leases5,561,039  4,974,273  
Equipment owned under operating leases, net86,183  111,684  
Net premises and equipment51,486  52,219  
Goodwill and intangible assets83,959  83,971  
Accrued income and other assets279,319  227,990  
Total assets$7,365,146  $6,622,776  
LIABILITIES  
Deposits:  
Noninterest-bearing demand$1,684,102  $1,216,834  
Interest-bearing deposits:
Interest-bearing demand1,866,415  1,677,200  
Savings942,891  814,794  
Time1,500,048  1,648,498  
Total interest-bearing deposits4,309,354  4,140,492  
Total deposits5,993,456  5,357,326  
Short-term borrowings:  
Federal funds purchased and securities sold under agreements to repurchase169,483  120,459  
Other short-term borrowings7,536  25,434  
Total short-term borrowings177,019  145,893  
Long-term debt and mandatorily redeemable securities81,760  71,639  
Subordinated notes58,764  58,764  
Accrued expenses and other liabilities152,494  140,518  
Total liabilities6,463,493  5,774,140  
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 28,205,674 at June 30, 2020 and December 31, 2019
436,538  436,538  
Retained earnings484,491  463,269  
Cost of common stock in treasury (2,655,319 shares at June 30, 2020 and 2,696,200 shares at December 31, 2019)
(75,922) (76,702) 
Accumulated other comprehensive income19,888  5,172  
Total shareholders’ equity864,995  828,277  
Noncontrolling interests$36,658  $20,359  
Total equity$901,653  $848,636  
Total liabilities and equity$7,365,146  $6,622,776  
The accompanying notes are a part of the unaudited consolidated financial statements.
3
1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited - Dollars in thousands, except per share amounts)
Three Months Ended
June 30,		Six Months Ended
June 30,
 2020201920202019
Interest income:    
Loans and leases$58,815  $65,599  $120,341  $128,282  
Investment securities, taxable4,487  5,186  10,037  10,701  
Investment securities, tax-exempt232  353  496  738  
Other316  499  662  937  
Total interest income63,850  71,637  131,536  140,658  
Interest expense:    
Deposits8,265  12,978  19,116  24,448  
Short-term borrowings90  540  344  1,471  
Subordinated notes835  928  1,719  1,856  
Long-term debt and mandatorily redeemable securities659  764  1,512  1,508  
Total interest expense9,849  15,210  22,691  29,283  
Net interest income54,001  56,427  108,845  111,375  
Provision for loan and lease losses10,375  4,247  21,728  9,165  
Net interest income after provision for loan and lease losses43,626  52,180  87,117  102,210  
Noninterest income:    
Trust and wealth advisory5,589  5,583  10,437  10,441  
Service charges on deposit accounts1,910  2,785  4,515  5,283  
Debit card3,601  3,669  6,974  6,889  
Mortgage banking3,315  999  5,651  1,935  
Insurance commissions1,695  1,518  3,576  3,692  
Equipment rental5,990  7,809  12,620  15,791  
(Losses) gains on investment securities available-for-sale(1) —  279  —  
Other3,142  3,301  5,811  5,757  
Total noninterest income25,241  25,664  49,863  49,788  
Noninterest expense:    
Salaries and employee benefits23,999  23,787  48,400  47,282  
Net occupancy2,504  2,481  5,225  5,253  
Furniture and equipment6,258  6,289  12,665  12,313  
Depreciation – leased equipment5,142  6,400  10,569  12,924  
Professional fees1,258  1,706  2,700  3,304  
Supplies and communication1,390  1,608  3,024  3,101  
FDIC and other insurance599  608  887  1,253  
Business development and marketing1,121  1,678  2,480  2,627  
Loan and lease collection and repossession838  230  1,601  1,591  
Other1,716  2,566  3,809  2,909  
Total noninterest expense44,825  47,353  91,360  92,557  
Income before income taxes24,042  30,491  45,620  59,441  
Income tax expense5,516  7,074  10,676  13,828  
Net income18,526  23,417  34,944  45,613  
Net (income) loss attributable to noncontrolling interests(24) (32) (29) (32) 
Net income available to common shareholders$18,502  $23,385  $34,915  $45,581  
Per common share:    
Basic net income per common share$0.72  $0.91  $1.36  $1.76  
Diluted net income per common share$0.72  $0.91  $1.36  $1.76  
Cash dividends$0.28  $0.27  $0.57  $0.54  
Basic weighted average common shares outstanding25,540,855  25,615,718  25,532,105  25,687,056  
Diluted weighted average common shares outstanding25,540,855  25,615,718  25,532,105  25,687,056  
The accompanying notes are a part of the unaudited consolidated financial statements.
4
1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited - Dollars in thousands)
Three Months Ended
June 30,		Six Months Ended
June 30,
 2020201920202019
Net income$18,526  $23,417  $34,944  $45,613  
Other comprehensive income:    
Unrealized appreciation of available-for-sale securities2,946  7,668  19,663  17,241  
Reclassification adjustment for realized losses (gains) included in net income1  —  (279) —  
Income tax effect(710) (1,847) (4,668) (4,152) 
Other comprehensive income, net of tax2,237  5,821  14,716  13,089  
Comprehensive income20,763  29,238  $49,660  $58,702  
Comprehensive (income) loss attributable to noncontrolling interests(24) (32) (29) (32) 
Comprehensive income available to common shareholders$20,739  $29,206  $49,631  $58,670  
The accompanying notes are a part of the unaudited consolidated financial statements.

5
1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Unaudited - Dollars in thousands, except per share amounts)
Three Months Ended
Preferred
Stock		Common
Stock		Retained
Earnings		Cost of
Common
Stock
in Treasury		Accumulated
Other
Comprehensive
Income (Loss), Net		Total Shareholders’ EquityNoncontrolling InterestsTotal Equity
Balance at April 1, 2019$—  $436,538  $414,428  $(69,136) $(3,408) $778,422  $2,679  $781,101  
Net income—  —  23,385  —  —  23,385  32  23,417  
Other comprehensive income—  —  —  —  5,821  5,821  —  5,821  
Issuance of 8,906 common shares under stock based compensation awards
—  —  217  177  —  394  —  394  
Cost of 141,627 shares of common stock acquired for treasury
—  —  —  (6,421) —  (6,421) —  (6,421) 
Common stock dividend ($0.27 per share)
—  —  (6,939) —  —  (6,939) —  (6,939) 
Contributions from noncontrolling interests—  —  —  —  —  —  7,313  7,313  
Balance at June 30, 2019$—  $436,538  $431,091  $(75,380) $2,413  $794,662  $10,024  804,686  
Balance at April 1, 2020$—  $436,538  $472,911  $(76,203) $17,651  $850,897  $26,405  $877,302  
Net income—  —  18,502  —  —  18,502  24  18,526  
Other comprehensive income—  —  —  —  2,237  2,237  —  2,237  
Issuance of 14,971 common shares under stock based compensation awards
—  —  244  281  —  525  —  525  
Cost of 0 shares of common stock acquired for treasury
—  —  —  —  —  —  —  —  
Common stock dividend ($0.28 per share)
—  —  (7,166) —  —  (7,166) —  (7,166) 
Contributions from noncontrolling interests—  —  —  —  —  —  10,301  10,301  
Distributions to noncontrolling interests—  —  —  —  —  —  (72) (72) 
Balance at June 30, 2020$—  $436,538  $484,491  $(75,922) $19,888  $864,995  $36,658  $901,653  

Six Months Ended
Preferred
Stock		Common
Stock		Retained
Earnings		Cost of
Common
Stock
in Treasury		Accumulated
Other
Comprehensive
Income (Loss), Net		Total Shareholders’ EquityNoncontrolling InterestsTotal Equity
Balance at January 1, 2019$—  $436,538  $398,980  $(62,760) $(10,676) $762,082  $1,508  $763,590  
Cumulative-effect adjustment—  —  (301) —  —  (301) —  (301) 
Balance at January 1, 2019, adjusted—  436,538  398,679  (62,760) (10,676) 761,781  1,508  763,289  
Net income—  —  45,581  —  —  45,581  32  45,613  
Other comprehensive income—  —  —  —  13,089  13,089  —  13,089  
Issuance of 47,271 common shares under stock based compensation awards
—  —  750  1,059  —  1,809  —  1,809  
Cost of 295,787 shares of common stock acquired for treasury
—  —  —  (13,679) —  (13,679) —  (13,679) 
Common stock dividend ($0.54 per share)
—  —  (13,919) —  —  (13,919) —  (13,919) 
Contributions from noncontrolling interests—  —  —  —  —  —  8,484  8,484  
Balance at June 30, 2019$—  $436,538  $431,091  $(75,380) $2,413  $794,662  $10,024  804,686  
Balance at January 1, 2020$—  $436,538  $463,269  $(76,702) $5,172  $828,277  $20,359  $848,636  
Net income—  —  34,915  —  —  34,915  29  34,944  
Other comprehensive income—  —  —  —  14,716  14,716  —  14,716  
Issuance of 40,881 common shares under stock based compensation awards
—  —  882  780  —  1,662  —  1,662  
Cost of 0 shares of common stock acquired for treasury
—  —  —  —  —  —  —  —  
Common stock dividend ($0.57 per share)—  —  (14,575) —  —  (14,575) —  (14,575) 
Contributions from noncontrolling interests—  —  —  —  —  —  16,441  16,441  
Distributions to noncontrolling interests—  —  —  —  —  —  (171) (171) 
Balance at June 30, 2020$—  $436,538  $484,491  $(75,922) $19,888  $864,995  $36,658  $901,653  
The accompanying notes are a part of the unaudited consolidated financial statements.
6
1st SOURCE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited - Dollars in thousands)
 Six Months Ended June 30,
 20202019
Operating activities:  
Net income$34,944  $45,613  
Adjustments to reconcile net income to net cash provided by operating activities:  
Provision for loan and lease losses21,728  9,165  
Depreciation of premises and equipment2,847  2,957  
Depreciation of equipment owned and leased to others10,569  12,924  
Stock-based compensation1,519  1,341  
Amortization of investment securities premiums and accretion of discounts, net2,356  1,737  
Amortization of mortgage servicing rights1,103  527  
Mortgage servicing rights impairments546  —  
Amortization of right of use assets1,410  1,581  
Deferred income taxes(7,786) (1,677) 
Gains on investment securities available-for-sale(279) —  
Originations of loans held for sale, net of principal collected(154,212) (52,505) 
Proceeds from the sales of loans held for sale142,680  45,610  
Net gain on sale of loans held for sale(4,699) (993) 
Net gain on sale of other real estate and repossessions(9) (470) 
Net gain on sale of premises and equipment—  (1,289) 
Change in interest receivable(1,851) (2,234) 
Change in interest payable(4,491) 3,953  
Change in other assets2,055  (8,474) 
Change in other liabilities(4,828) 9,938  
Other755  1,106  
Net change in operating activities44,357  68,810  
Investing activities:  
Proceeds from sales of investment securities available-for-sale8,403  —  
Proceeds from maturities and paydowns of investment securities available-for-sale198,105  59,683  
Purchases of investment securities available-for-sale(204,415) (76,137) 
Net change in partnership investments(30,356) (12,825) 
Net change in other investments(2,205) —  
Loans sold or participated to others8,004  16,740  
Proceeds from principal payments on direct finance leases25,238  27,446  
Proceeds from PPP lender origination fees 18,913  —  
Net change in loans and leases(662,772) (332,743) 
Net change in equipment owned under operating leases14,932  (5,109) 
Purchases of premises and equipment(2,126) (4,526) 
Proceeds from disposal of premises and equipment12  3,427  
Proceeds from sales of other real estate and repossessions4,547  5,964  
Net change in investing activities(623,720) (318,080) 
Financing activities:  
Net change in demand deposits and savings accounts784,580  59,626  
Net change in time deposits(148,450) 221,897  
Net change in short-term borrowings31,126  (13,335) 
Proceeds from issuance of long-term debt10,000  —  
Payments on long-term debt(2,343) (2,052) 
Stock issued under stock purchase plans39  49  
Acquisition of treasury stock—  (13,679) 
Net change in noncontrolling interests16,271  8,484  
Cash dividends paid on common stock(14,989) (14,311) 
Net change in financing activities676,234  246,679  
Net change in cash and cash equivalents96,871  (2,591) 
Cash and cash equivalents, beginning of year83,365  99,079  
Cash and cash equivalents, end of period$180,236  $96,488  
Supplemental Information:  
Non-cash transactions:  
Loans transferred to other real estate and repossessed assets$2,123  $9,961  
Common stock matching contribution to Employee Stock Ownership and Profit Sharing Plan622  300  
Right of use assets obtained in exchange for lease obligations31  1,383  
The accompanying notes are a part of the unaudited consolidated financial statements.
7
1ST SOURCE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 — Accounting Policies
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.
Basis of Presentation – The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, changes in 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 (2019 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, 2019 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements. Certain amounts in the prior period consolidated financial statements have been reclassified to conform to the current period presentation.
Use of Estimates in the Preparation of Financial Statements – Financial statements prepared in accordance with GAAP require the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reporting period. Actual results could differ from those estimates.
Loans and Leases – Loans are stated at the principal amount outstanding, net of unamortized deferred loan origination fees and costs and net of unearned income. Interest income is accrued as earned based on unpaid principal balances. Origination fees and direct loan and lease origination costs are deferred, and the net amount amortized to interest income over the estimated life of the related loan or lease. Loan commitment fees are deferred and amortized into other income over the commitment period.
Direct financing leases are carried at the aggregate of lease payments plus estimated residual value of the leased property, net of unamortized deferred lease origination fees and costs and unearned income. Interest income on direct financing leases is recognized over the term of the lease to achieve a constant periodic rate of return on the outstanding investment. Effective January 1, 2019, as part of the new leasing standard, only those costs incurred as a direct result of closing a lease transaction can be capitalized. All existing deferrals will continue to be amortized over the estimated life of the lease while all new incremental direct costs will be expensed immediately.
The accrual of interest on loans and leases is discontinued when a loan or lease becomes contractually delinquent for 90 days, or when an individual analysis of a borrower’s credit worthiness indicates a credit should be placed on nonperforming status, except for residential mortgage loans and consumer loans that are well secured and in the process of collection. Residential mortgage loans are placed on nonaccrual at the time the loan is placed in foreclosure. When interest accruals are discontinued, interest credited to income in the current year is reversed and interest accrued in the prior year is charged to the reserve for loan and lease losses. However, in some cases, the Company may elect to continue the accrual of interest when the net realizable value of collateral is sufficient to cover the principal and accrued interest. When a loan or lease is classified as nonaccrual and the future collectability of the recorded loan or lease balance is doubtful, collections on interest and principal are applied as a reduction to principal outstanding. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured, which is typically evidenced by a sustained repayment performance of at least six months.
A loan or lease is considered impaired, based on current information and events, if it is probable that the Company 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. Interest on impaired loans and leases, which are not classified as nonaccrual, is recognized on the accrual basis. The Company evaluates loans and leases exceeding $100,000 for impairment and establishes a specific reserve 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 or lease and the recorded investment in the loan or lease exceeds its fair value.
8
Table of Contents
Loans and leases that have been modified and economic concessions have been granted to borrowers who have experienced financial difficulties are considered a troubled debt restructuring (TDR) and, by definition, are deemed an impaired loan. These concessions typically result from the Company’s loss mitigation activities and may include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructuring and typically are returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period of at least six months.
When the Company modifies loans and leases in a TDR, it evaluates any possible impairment similar to other impaired loans based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan or lease agreement, or uses the current fair value of the collateral, less selling costs for collateral dependent loans. If the Company determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through a reserve for loan and lease losses estimate or a charge-off to the reserve for loan and lease losses. In periods subsequent to modification, the Company evaluates all TDRs, including those that have payment defaults, for possible impairment and recognizes impairment through the reserve for loan and lease losses.
Note 2 — Recent Accounting Pronouncements
Reference Rate Reform: In March 2020, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2020-04 “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.” These amendments provide temporary optional guidance to ease the potential burden in accounting for reference rate reform. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. It is intended to help stakeholders during the global market-wide reference rate transition period. The guidance is effective for all entities as of March 12, 2020 through December 31, 2022. The Company is implementing a transition plan to identify and modify its loans and other financial instruments with attributes that are either directly or indirectly influenced by LIBOR. The Company is assessing ASU 2020-04 and its impact on the Company’s transition away from LIBOR for its loan and other financial instruments.
Partnership Investments and Derivatives: In January 2020, the FASB issued ASU No. 2020-01 “Investments-Equity Securities (Topic 321), Investments-Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815) - Clarifying the Interactions between Topic 321, Topic 323, and Topic 815.” These amendments, among other things, clarify that a company should consider observable transactions that require a company to either apply or discontinue the equity method of accounting under Topic 323, Investments-Equity Method and Joint Ventures, for the purposes of applying the measurement alternative in accordance with Topic 321 immediately before applying or upon discontinuing the equity method. The amendments also clarify that, when determining the accounting for certain forward contracts and purchased options a company should not consider, whether upon settlement or exercise, if the underlying securities would be accounted for under the equity method or fair value option. The guidance is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early application is permitted, including early adoption in an interim period. An entity should apply ASU 2020-01 prospectively at the beginning of the interim period that includes the adoption date. The Company is assessing ASU 2020-01 and its impact on its accounting and disclosures.
Income Taxes: In December 2019, the FASB issued ASU 2019-12 “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes.” These amendments remove specific exceptions to the general principles in Topic 740 in GAAP. It eliminates the need for an organization to analyze whether the following apply in a given period: exception to the incremental approach for intraperiod tax allocation; exceptions to accounting for basis differences where there are ownership changes in foreign investments; and exception in interim period income tax accounting for year-to-date losses that exceed anticipated losses. It also improves financial statement preparers’ application of income tax-related guidance and simplifies GAAP for: franchise taxes that are partially based on income; transactions with a government that result in a step up in the tax basis of goodwill; separate financial statements of legal entities that are not subject to tax; and enacts changes in tax laws in interim periods. The guidance is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted. The Company is assessing ASU 2019-12 and its impact on its accounting and disclosure.
9
Measurement of Credit Losses on Financial Instruments: In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments-Credit Losses (Topic 326) - Measurement of Credit Losses on Financial Instruments (CECL).” The provisions of ASU 2016-13 were issued to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments that are not accounted for at fair value through net income, including loans held for investment, held-to-maturity debt securities, trade and other receivables, net investment in leases and other commitments to extend credit held by a reporting entity at each reporting date. ASU 2016-13 requires that financial assets measured at amortized cost be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The amendments in ASU 2016-13 eliminate the probable incurred loss recognition in current GAAP and reflect an entity’s current estimate of all expected credit losses. The measurement of expected credit losses is based upon historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the financial assets.
Credit losses relating to available-for-sale debt securities will be recorded through an allowance for credit losses rather than as a direct write-down to the security.
The FASB issued additional ASUs containing clarifying guidance, transition relief provisions and minor updates to the original ASU. These include ASU 2018-19 (issued November 2018), ASU 2019-04 (issued April 2019), ASU 2019-05 (issued May 2019), ASU 2019-10 (issued November 2019), ASU 2019-11 (issued November 2019), ASU 2020-02 (issued February 2020) and ASU 2020-03 (issued March 2020). ASU 2016-13 and subsequent ASUs are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. This amendment is required to be adopted using a modified retrospective approach with a cumulative-effect adjustment to beginning retained earnings, as of the beginning of the first reporting period in which the guidance is effective.
As previously disclosed, the Company formed a cross-functional team to work through its implementation plan. The Company’s cross-functional team is substantially complete with the assessment and documentation of processes, internal controls, data and model validation testing, parallel testing, qualitative factors and forecast periods as well as model development. The Company implemented a third-party software solution to assist in the application of the new standard including portfolio segmentation according to shared risk characteristics and modeling methodologies. The Company had finalized the formal review and approval process and the results of its CECL estimate as of year-end but has elected to delay its adoption of ASU 2016-13, as provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, until the date on which the national emergency related to the COVID-19 outbreak is terminated or December 31, 2020, whichever occurs first. Upon adoption of ASU 2016-13, the Company will recognize a one-time cumulative effect adjustment through retained earnings of $2.58 million to increase its allowance for credit losses and $0.78 million to increase the unfunded loan commitment liability as of January 1, 2020. As of June 30, 2020, the Company estimates an additional increase to its allowance for credit losses of between $0 million and $8 million which will be recognized through earnings after adoption.
Upon adopting ASU 2016-13, the Company will not record an allowance as of January 1, 2020 with respect to its available-for-sale debt securities as the majority of these securities are government agency-backed securities for which the risk of loss is minimal. The adoption of ASU 2016-13 is not expected to have a significant impact on the Company’s regulatory capital ratios.
Note 3 — Investment Securities Available-For-Sale
The following table shows investment securities available-for-sale.
(Dollars in thousands)Amortized CostGross Unrealized GainsGross Unrealized LossesFair Value
June 30, 2020    
U.S. Treasury and Federal agencies securities$533,794  $11,834  $(9) $545,619  
U.S. States and political subdivisions securities72,169  2,101  (158) 74,112  
Mortgage-backed securities — Federal agencies380,606  10,796  (124) 391,278  
Corporate debt securities42,332  1,756  —  44,088  
Foreign government and other securities700  —  —  700  
Total debt securities available-for-sale$1,029,601  $26,487  $(291) $1,055,797  
December 31, 2019    
U.S. Treasury and Federal agencies securities$524,896  $2,538  $(470) $526,964  
U.S. States and political subdivisions securities83,566  1,048  (109) 84,505  
Mortgage-backed securities — Federal agencies372,458  3,948  (1,017) 375,389  
Corporate debt securities52,151  890  (16) 53,025  
Foreign government and other securities700  —  —  700  
Total debt securities available-for-sale$1,033,771  $8,424  $(1,612) $1,040,583  
10
At June 30, 2020 and December 31, 2019, 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 following table shows the contractual maturities of investments in debt securities available-for-sale at June 30, 2020. 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.
(Dollars in thousands)Amortized CostFair Value
Due in one year or less$176,637  $177,803  
Due after one year through five years441,222  455,537  
Due after five years through ten years30,556  30,680  
Due after ten years580  499  
Mortgage-backed securities380,606  391,278  
Total debt securities available-for-sale$1,029,601  $1,055,797  
The following table summarizes gross unrealized losses and fair value by investment category and age. At June 30, 2020, the Company’s available-for-sale securities portfolio consisted of 595 securities, 61 of which were in an unrealized loss position.
 Less than 12 Months12 months or LongerTotal
(Dollars in thousands) Fair ValueUnrealized LossesFair ValueUnrealized LossesFair ValueUnrealized Losses
June 30, 2020      
U.S. Treasury and Federal agencies securities$30,051  $(9) $—  $—  $30,051  $(9) 
U.S. States and political subdivisions securities3,099  (158) —  —  3,099  (158) 
Mortgage-backed securities - Federal agencies18,921  (85) 7,825  (39) 26,746  (124) 
Corporate debt securities—  —  —  —  —  —  
Foreign government and other securities500  —  —  —  500  —  
Total debt securities available-for-sale$52,571  $(252) $7,825  $(39) $60,396  $(291) 
December 31, 2019      
U.S. Treasury and Federal agencies securities$87,352  $(171) $69,053  $(299) $156,405  $(470) 
U.S. States and political subdivisions securities9,283  (107) 1,042  (2) 10,325  (109) 
Mortgage-backed securities - Federal agencies81,951  (383) 51,165  (634) 133,116  (1,017) 
Corporate debt securities—  —  8,091  (16) 8,091  (16) 
Foreign government and other securities—  —  —  —  —  —  
Total debt securities available-for-sale$178,586  $(661) $129,351  $(951) $307,937  $(1,612) 
The initial indication of potential other-than-temporary-impairment (OTTI) for debt 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 debt securities available-for-sale 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 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 June 30, 2020, the Company does not have the intent to sell any of the debt securities available-for-sale 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. 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.
11
The following table shows the gross realized gains and losses from the available-for-sale debt securities portfolio. Realized gains and losses of all securities are computed using the specific identification cost basis.
Three Months Ended
June 30,		Six Months Ended
June 30,
(Dollars in thousands)2020201920202019
Gross realized gains$5  $—  $285  $—  
Gross realized losses(6) —  (6) —  
OTTI losses—  —  —  —  
Net realized gains (losses)$(1) $—  $279  $—  
At June 30, 2020 and December 31, 2019, investment securities available-for-sale with carrying values of $381.27 million and $281.38 million, respectively, were pledged as collateral for 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 and home equity 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 following table shows the credit quality grades of the recorded investment in loans and leases, segregated by class.
 Credit Quality Grades
(Dollars in thousands) 1-67-12Total
June 30, 2020   
Commercial and agricultural$1,650,853  $59,859  $1,710,712  
Auto and light truck512,482  51,124  563,606  
Medium and heavy duty truck282,038  2,394  284,432  
Aircraft757,575  24,585  782,160  
Construction equipment684,190  54,837  739,027  
Commercial real estate918,796  24,175  942,971  
Total$4,805,934  $216,974  $5,022,908  
December 31, 2019   
Commercial and agricultural$1,080,933  $51,858  $1,132,791  
Auto and light truck569,234  19,573  588,807  
Medium and heavy duty truck293,736  1,088  294,824  
Aircraft764,564  19,476  784,040  
Construction equipment668,076  37,375  705,451  
Commercial real estate888,154  20,023  908,177  
Total$4,264,697  $149,393  $4,414,090  
*Paycheck Protection Program (PPP) loans are included in the Commercial and agricultural category in the Grades 1-6 column above.
12
For residential real estate and home equity and consumer loans, credit quality is based on the aging status of the loan and by payment activity. The following table shows the recorded investment in residential real estate and home equity 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.
(Dollars in thousands) PerformingNonperformingTotal
June 30, 2020   
Residential real estate and home equity$529,773  $2,199  $531,972  
Consumer136,991  451  137,442  
Total$666,764  $2,650  $669,414  
December 31, 2019   
Residential real estate and home equity$529,557  $2,446  $532,003  
Consumer138,951  483  139,434  
Total$668,508  $2,929  $671,437  
The following table shows the recorded investment of loans and leases, segregated by class, with delinquency aging and nonaccrual status.
(Dollars in thousands) Current30-59 Days Past Due60-89 Days Past Due90 Days or More Past Due and AccruingTotal
Accruing 
Loans		NonaccrualTotal
Financing
Receivables
June 30, 2020       
Commercial and agricultural
$1,705,959  $1,722  $—  $—  $1,707,681  $3,031  $1,710,712  
Auto and light truck
530,884  1,806  —  —  532,690  30,916  563,606  
Medium and heavy duty truck283,363  —  —  —  283,363  1,069  284,432  
Aircraft754,386  12,701  13,102  —  780,189  1,971  782,160  
Construction equipment
715,389  1,376  2  —  716,767  22,260  739,027  
Commercial real estate939,186  2,318  304  —  941,808  1,163  942,971  
Residential real estate and home equity529,272  377  124  234  530,007  1,965  531,972  
Consumer136,733  212  46  23  137,014  428  137,442  
Total$5,595,172  $20,512  $13,578  $257  $5,629,519  $62,803  $5,692,322  
December 31, 2019       
Commercial and agricultural
$1,131,704  $118  $—  $—  $1,131,822  $969  $1,132,791  
Auto and light truck
586,212  1,268  77  —  587,557  1,250  588,807  
Medium and heavy duty truck293,736  14  —  —  293,750  1,074  294,824  
Aircraft772,846  7,026  3,293  —  783,165  875  784,040  
Construction equipment
702,671  819  609  —  704,099  1,352  705,451  
Commercial real estate906,468  58  —  —  906,526  1,651  908,177  
Residential real estate and home equity528,844  561  152  257  529,814  2,189  532,003  
Consumer138,132  632  187  54  139,005  429  139,434  
Total$5,060,613  $10,496  $4,318  $311  $5,075,738  $9,789  $5,085,527  
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The following table shows impaired loans and leases, segregated by class, and the corresponding reserve for impaired loan and lease losses.
(Dollars in thousands) Recorded InvestmentUnpaid Principal BalanceRelated Reserve
June 30, 2020   
With no related reserve recorded:   
Commercial and agricultural$182  $182  $—  
Auto and light truck16,629  16,629  —  
Medium and heavy duty truck955  955  —  
Aircraft1,971  1,971  —  
Construction equipment476  476  —  
Commercial real estate1,016  1,016  —  
Residential real estate and home equity—  —  —  
Consumer—  —  —  
Total with no related reserve recorded21,229  21,229  —  
With a reserve recorded:   
Commercial and agricultural10,339  10,339  5,622  
Auto and light truck14,032  14,029  2,559  
Medium and heavy duty truck114  114  34  
Aircraft—  —  —  
Construction equipment13,756  13,756  8,243  
Commercial real estate—  —  —  
Residential real estate and home equity333  335  113  
Consumer—  —  —  
Total with a reserve recorded38,574  38,573  16,571  
Total impaired loans$59,803  $59,802  $16,571  
December 31, 2019   
With no related reserve recorded:   
Commercial and agricultural$218  $218  $—  
Auto and light truck853  853  —  
Medium and heavy duty truck1,074  1,074  —  
Aircraft875  875  —  
Construction equipment615  615  —  
Commercial real estate1,487  1,487  —  
Residential real estate and home equity—  —  —  
Consumer—  —  —  
Total with no related reserve recorded5,122  5,122  —  
With a reserve recorded:   
Commercial and agricultural10,366  10,366  3,003  
Auto and light truck278  278  30  
Medium and heavy duty truck—  —  —  
Aircraft—  —  —  
Construction equipment736  736  75  
Commercial real estate—  —  —  
Residential real estate and home equity337  339  117  
Consumer—  —  —  
Total with a reserve recorded11,717  11,719  3,225  
Total impaired loans$16,839  $16,841  $3,225  
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The following table shows average recorded investment and interest income recognized on impaired loans and leases, segregated by class.
 Three Months Ended June 30,Six Months Ended June 30,
 2020201920202019
(Dollars in thousands) Average
Recorded
Investment		Interest
Income		Average
Recorded
Investment		Interest
Income		Average
Recorded
Investment		Interest
Income		Average
Recorded
Investment		Interest
Income
Commercial and agricultural$5,381  $35  $4,080  $13  $6,594  $138  $3,450  $13  
Auto and light truck
10,783  —  2,791  —  5,763  —  3,898  —  
Medium and heavy duty truck1,023  —  562  —  1,024  —  308  —  
Aircraft2,307  —  1,589  —  2,044  —  3,517  —  
Construction equipment14,302  —  1,417  —  11,040  4  1,673  —  
Commercial real estate1,028  —  1,834  —  1,200  —  1,846  —  
Residential real estate and home equity334  4  341  5  335  7  342  10  
Consumer—  —  —  —  —  —  —  —  
Total$35,158  $39  $12,614  $18  $28,000  $149  $15,034  $23  
There were two nonperforming loan and lease modifications classified as a troubled debt restructuring (TDR) during the three and six months ended June 30, 2020 and one nonperforming TDR during the three and six months ended June 30, 2019. The TDRs during the second quarter of 2020 were the result of issues that predated the COVID-19 pandemic. The classification between nonperforming and performing is determined at the time of modification. Modification programs focus on extending maturity dates or modifying payment patterns with most TDRs experiencing a combination of concessions. Modifications do not result in the contractual forgiveness of principal or interest. There were no modifications during the three and six months ended June 30, 2020 and 2019 that resulted in an interest rate below market rate. Consequently, the financial impact of the modification was immaterial.
There were no TDRs which had payment defaults within the twelve months following modification during the three months ended June 30, 2020 and 2019, respectively. There was one TDR which had a payment default within the twelve months following modification during the six months ended June 30, 2020 and 2019. Default occurs when a loan or lease is 90 days or more past due under the modified terms or transferred to nonaccrual.
The following table shows the recorded investment of loans and leases classified as troubled debt restructurings as of June 30, 2020 and December 31, 2019.
(Dollars in thousands)June 30,
2020		December 31,
2019
Performing TDRs$334  $10,238  
Nonperforming TDRs14,782  486  
Total TDRs$15,116  $10,724  
 
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.
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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.

The following table shows the changes in the reserve for loan and lease losses, segregated by class, for the three months ended June 30, 2020 and 2019.
(Dollars in thousands)Commercial and
agricultural		Auto and
light truck		Medium and
heavy duty truck		AircraftConstruction
equipment		Commercial
real estate		Residential
real estate
and home
equity		ConsumerTotal
June 30, 2020         
Balance, beginning of period$23,179  $15,471  $4,356  $30,069  $22,693  $19,588  $3,908  $1,534  $120,798  
Charge-offs42  —  —  254  129  —  —  187  612  
Recoveries136  58  —  55  379  13  3  78  722  
Net charge-offs (recoveries)(94) (58) —  199  (250) (13) (3) 109  (110) 
Provision (recovery of provision)5,734  1,842  293  1,231  929  335  (90) 101  10,375  
Balance, end of period$29,007  $17,371  $4,649  $31,101  $23,872  $19,936  $3,821  $1,526  $131,283  
June 30, 2019         
Balance, beginning of period$18,307  $14,259  $4,409  $33,440  $10,883  $15,834  $3,386  $1,334  $101,852  
Charge-offs9  57  1,132  1  1  —  —  313  1,513  
Recoveries28  20  —  117  15  51  3  91  325  
Net charge-offs (recoveries)(19) 37  1,132  (116) (14) (51) (3) 222  1,188  
Provision (recovery of provision)726  2,119  1,394  (1,638) 1,387  (128) 129  258  4,247  
Balance, end of period$19,052  $16,341  $4,671  $31,918  $12,284  $15,757  $3,518  $1,370  $104,911  

The following table shows the changes in the reserve for loan and lease losses, segregated by class, for the six months ended June 30, 2020 and 2019.
(Dollars in thousands)Commercial and
agricultural loans		Auto and
light truck		Medium and
heavy duty truck		AircraftConstruction
equipment		Commercial
real estate		Residential
real estate
and home
equity		Consumer
loans		Total
June 30, 2020         
Balance, beginning of period$23,671  $14,400  $4,612  $31,058  $14,120  $18,350  $3,609  $1,434  $111,254  
Charge-offs571  34  —  840  1,561  1  13  430  3,450  
Recoveries302  140  —  503  590  28  30  158  1,751  
Net charge-offs (recoveries)269  (106) —  337  971  (27) (17) 272  1,699  
Provision (recovery of provision)5,605  2,865  37  380  10,723  1,559  195  364  21,728  
Balance, end of period$29,007  $17,371  $4,649  $31,101  $23,872  $19,936  $3,821  $1,526  $131,283  
June 30, 2019         
Balance, beginning of period$17,063  $14,689  $4,303  $33,047  $10,922  $15,705  $3,425  $1,315  $100,469  
Charge-offs88  466  1,132  3,001  196  —  21  563  5,467  
Recoveries62  29  —  302  119  60  6  166  744  
Net charge-offs (recoveries)26  437  1,132  2,699  77  (60) 15  397  4,723  
Provision (recovery of provision)2,015  2,089  1,500  1,570  1,439  (8) 108  452  9,165  
Balance, end of period$19,052  $16,341  $4,671  $31,918  $12,284  $15,757  $3,518  $1,370  $104,911  
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The following table shows the reserve for loan and lease losses and recorded investment in loans and leases, segregated by class, separated between individually and collectively evaluated for impairment as of June 30, 2020 and December 31, 2019.
(Dollars in thousands)Commercial and
agricultural loans		Auto and
light truck		Medium and
heavy duty truck		AircraftConstruction
equipment		Commercial
real estate		Residential
real estate
and home
equity		Consumer
loans		Total
June 30, 2020         
Reserve for loan and lease losses         
Ending balance, individually evaluated for impairment
$5,622  $2,559  $34  $—  $8,243  $—  $113  $—  $16,571  
Ending balance, collectively evaluated for impairment
23,385  14,812  4,615  31,101  15,629  19,936  3,708  1,526  114,712  
Total reserve for loan and lease losses
$29,007  $17,371  $4,649  $31,101  $23,872  $19,936  $3,821  $1,526  $131,283  
Recorded investment in loans         
Ending balance, individually evaluated for impairment
$10,521  $30,661  $1,069  $1,971  $14,232  $1,016  $333  $—  $59,803  
Ending balance, collectively evaluated for impairment
1,700,191  532,945  283,363  780,189  724,795  941,955  531,639  137,442  5,632,519  
Total recorded investment in loans$1,710,712  $563,606  $284,432  $782,160  $739,027  $942,971  $531,972  $137,442  $5,692,322  
December 31, 2019         
Reserve for loan and lease losses         
Ending balance, individually evaluated for impairment
$3,003  $30  $—  $—  $75  $—  $117  $—  $3,225  
Ending balance, collectively evaluated for impairment
20,668  14,370  4,612  31,058  14,045  18,350  3,492  1,434  108,029  
Total reserve for loan and lease losses
$23,671  $14,400  $4,612  $31,058  $14,120  $18,350  $3,609  $1,434  $111,254  
Recorded investment in loans         
Ending balance, individually evaluated for impairment
$10,584  $1,131  $1,074  $875  $1,351  $1,487  $337  $—  $16,839  
Ending balance, collectively evaluated for impairment
1,122,207  587,676  293,750  783,165  704,100  906,690  531,666  139,434  5,068,688  
Total recorded investment in loans$1,132,791  $588,807  $294,824  $784,040  $705,451  $908,177  $532,003  $139,434  $5,085,527  

Note 6 — Lease Investments
As a lessor, the Company’s loan and lease portfolio includes direct finance leases, which are included in commercial and agricultural, auto and light truck, medium and heavy duty truck, aircraft, and construction equipment on the Consolidated Statements of Financial Condition. The Company also finances various types of construction equipment, medium and heavy duty trucks, automobiles and other equipment under leases classified as operating leases, which are included in Equipment Owned Under Operating Leases, net, on the Consolidated Statements of Financial Condition.
The following table shows interest income recognized from direct finance lease payments and operating lease equipment rental income and related depreciation expense.
Three Months Ended
June 30,		Six Months Ended
June 30,
(Dollars in thousands)2020201920202019
Direct finance leases:
Interest income on lease receivable$2,097  $3,241  $4,430  $6,419  
Operating leases:
Income related to lease payments$5,990  $7,809  $12,620  $15,791  
Depreciation expense5,142  6,400  10,569  12,924  
Income related to reimbursements from lessees for personal property tax on operating leased equipment for the three months ended June 30, 2020 and 2019 was $0.17 million and $0.11 million, respectively and for the six months ended June 30, 2020 and 2019 was $0.42 million and $0.35 million, respectively. Expense related to personal property tax payments on operating leased equipment for the three months ended June 30, 2020 and 2019 was $0.17 million and $0.11 million, respectively and for the six months ended June 30, 2020 and 2019 was $0.42 million and $0.35 million, respectively.
17
Note 7 — Mortgage Servicing Rights
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. The unpaid principal balance of residential mortgage loans serviced for third parties was $766.15 million and $740.91 million at June 30, 2020 and December 31, 2019, respectively.
Mortgage servicing rights (MSRs) are evaluated for impairment at each reporting date. For purposes of impairment measurement, MSRs 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.
The following table shows changes in the carrying value of MSRs and the associated valuation allowance.
Three Months Ended
June 30,		Six Months Ended
June 30,
(Dollars in thousands)2020201920202019
Mortgage servicing rights:    
Balance at beginning of period$4,153  $4,247  $4,200  $4,283  
Additions835  188  1,197  385  
Amortization(694) (294) (1,103) (527) 
Sales—  —  —  —  
Carrying value before valuation allowance at end of period4,294  4,141  4,294  4,141  
Valuation allowance:    
Balance at beginning of period—  —  —  —  
Impairment charges(546) —  (546) —  
Balance at end of period$(546) $—  $(546) $—  
Net carrying value of mortgage servicing rights at end of period$3,748  $4,141  $3,748  $4,141  
Fair value of mortgage servicing rights at end of period$4,023  $5,987  $4,023  $5,987  
At June 30, 2020 and 2019, the fair value of MSRs exceeded the carrying value reported in the Consolidated Statements of Financial Condition by $0.28 million and $1.85 million, respectively. This difference represents increases in the fair value of certain MSRs that could not be recorded above cost basis.
Mortgage loan contractual servicing fees, including late fees and ancillary income, were $0.81 million and $0.63 million for the three months ended June 30, 2020 and 2019, respectively. Mortgage loan contractual servicing fees, including late fees and ancillary income, were $1.50 million and $1.25 million for the six months ended June 30, 2020 and 2019, respectively. Mortgage loan contractual servicing fees are included in Mortgage Banking on the Consolidated Statements of Income.
Note 8 — Commitments and Financial Instruments with Off-Balance-Sheet Risk
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 following table shows financial instruments whose contract amounts represent credit risk.
(Dollars in thousands)June 30, 2020December 31, 2019
Amounts of commitments:
Loan commitments to extend credit$1,072,937  $1,095,054  
Standby letters of credit$25,871  $27,549  
Commercial and similar letters of credit$4,005  $2,332  
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.
18
The Company 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.
Standby letters of credit are conditional commitments that guarantee the performance of a client to a third party. The credit risk involved in and collateral obtained when issuing standby letters of credit is essentially the same as that involved in extending loan commitments to clients. Standby letters of credit generally have terms ranging from two months to one year.
Commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and the third party. Commercial letters of credit generally have terms ranging from two months to six months.
Note 9 — 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 8 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 Consolidated Statements of Financial Condition and do not 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.
The following table shows the amounts of non-hedging derivative financial instruments.
  Asset derivativesLiability derivatives
(Dollars in thousands)Notional or contractual amountStatement of Financial Condition classificationFair valueStatement of Financial Condition classificationFair value
June 30, 2020     
Interest rate swap contracts$1,154,479  Other assets$55,782  Other liabilities$56,793  
Loan commitments36,271  Mortgages held for sale1,071  N/A—  
Forward contracts - mortgage loan35,725  N/A—  Mortgages held for sale101  
Total$1,226,475   $56,853   $56,894  
December 31, 2019     
Interest rate swap contracts$1,074,809  Other assets$21,975  Other liabilities$22,352  
Loan commitments9,950  Mortgages held for sale185  N/A—  
Forward contracts - mortgage loan23,632  N/A—  Mortgages held for sale38  
Total$1,108,391   $22,160   $22,390  
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The following table shows the amounts included in the Consolidated Statements of Income for non-hedging derivative financial instruments.
  Gain (loss)
 Three Months Ended
June 30,		Six Months Ended
June 30,
(Dollars in thousands)Statement of Income classification2020201920202019
Interest rate swap contractsOther expense$(114) $(192) $(633) $(249) 
Interest rate swap contractsOther income446  505  537  784  
Loan commitmentsMortgage banking(310) 15  886  92  
Forward contracts - mortgage loanMortgage banking257  (49) (63) (39) 
Total $279  $279  $727  $588  
The following table shows the offsetting of financial assets and derivative assets.
Gross Amounts Not Offset in the Statement of Financial Condition
(Dollars in thousands)Gross Amounts of Recognized AssetsGross Amounts Offset in the Statement of Financial ConditionNet Amounts of Assets Presented in the Statement of Financial ConditionFinancial InstrumentsCash Collateral ReceivedNet Amount
June 30, 2020      
Interest rate swaps$60,579  $4,797  $55,782  $—  $—  $55,782  
December 31, 2019      
Interest rate swaps$22,279  $304  $21,975  $—  $—  $21,975  
 The following table shows the offsetting of financial liabilities and derivative liabilities.
Gross Amounts Not Offset in the Statement of Financial Condition
(Dollars in thousands)Gross Amounts of Recognized LiabilitiesGross Amounts Offset in the Statement of Financial ConditionNet Amounts of Liabilities Presented in the Statement of Financial ConditionFinancial InstrumentsCash Collateral PledgedNet Amount
June 30, 2020      
Interest rate swaps$61,590  $4,797  $56,793  $56,352  $—  $441  
Repurchase agreements169,483  —  169,483  169,483  —  —  
Total$231,073  $4,797  $226,276  $225,835  $—  $441  
December 31, 2019      
Interest rate swaps$22,656  $304  $22,352  $23,482  $—  $(1,130) 
Repurchase agreements120,459  —  120,459  120,459  —  —  
Total$143,115  $304  $142,811  $143,941  $—  $(1,130) 
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. At June 30, 2020 and December 31, 2019, repurchase agreements had a remaining contractual maturity of $167.34 million and $119.45 million in overnight and $2.14 million and $1.01 million in up to 30 days, respectively and were collateralized by U.S. Treasury and Federal agencies securities.
Note 10 — Variable Interest Entities
A variable interest entity (VIE) is a partnership, limited liability company, trust or other legal entity that meets any one of the following criteria:
•The entity does not have sufficient equity to conduct its activities without additional subordinated financial support from another party.
•The entity’s investors lack the power to direct the activities that most significantly affect the entity’s economic performance.
•The entity’s at-risk holders do not have the obligation to absorb the losses or the right to receive residual returns.
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•The voting rights of some investors are not proportional to their economic interests in the entity, and substantially all of the entity’s activities involve, or are conducted on behalf of, investors with disproportionately few voting rights.
The Company is involved in various entities that are considered to be VIEs. The Company’s investments in VIEs are primarily related to investments promoting affordable housing, community development and renewable energy sources. Some of these tax-advantaged investments support the Company’s regulatory compliance with the Community Reinvestment Act. The Company’s investments in these entities generate a return primarily through the realization of federal and state income tax credits, and other tax benefits, such as tax deductions from operating losses of the investments, over specified time periods. These tax credits are recognized as a reduction of tax expense or, for investments qualifying as investment tax credits, as a reduction to the related investment asset. The Company recognized federal income tax credits related to its affordable housing and community development tax-advantaged investments in tax expense of $0.43 million and $0.35 million for the three months ended June 30, 2020 and 2019, respectively and $0.86 million and $0.70 million for the six months ended June 30, 2020 and 2019, respectively. The Company also recognized $5.60 million and $3.95 million of investment tax credits for the three months ended June 30, 2020 and 2019, respectively and $7.84 million and $5.55 million for the six months ended June 30, 2020 and 2019, respectively.
The Company is not required to consolidate VIEs in which it has concluded it does not have a controlling financial interest, and thus is not the primary beneficiary. In such cases, the Company does not have both the power to direct the entities’ most significant activities and the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIEs. As a limited partner in these operating partnerships, we are allocated credits and deductions associated with the underlying properties. The Company has determined that it is not the primary beneficiary of these investments because the general partners have the power to direct activities that most significantly influence the economic performance of their respective partnerships.
The Company’s investments in these unconsolidated VIEs are carried in Other Assets on the Consolidated Statements of Financial Condition. The Company’s unfunded capital and other commitments related to these unconsolidated VIEs are generally carried in Other Liabilities on the Consolidated Statements of Financial Condition. The Company’s maximum exposure to loss from these unconsolidated VIEs include the investment recorded on the Company’s Consolidated Statements of Financial Condition, net of unfunded capital commitments, and previously recorded tax credits which remain subject to recapture by taxing authorities based on compliance features required to be met at the project level. While the Company believes potential losses from these investments are remote, the maximum exposure was determined by assuming a scenario where the community-based business, housing projects and renewable energy projects completely fail and do not meet certain taxing authority compliance requirements resulting in recapture of the related tax credits.
The following table provides a summary of investments in affordable housing, community development and renewable energy VIEs that the Company has not consolidated.
(Dollars in thousands)June 30, 2020December 31, 2019
Investment carrying amount$24,312  $19,843  
Unfunded capital and other commitments18,801  17,420  
Maximum exposure to loss45,119  37,904  
The Company is required to consolidate VIEs in which it has concluded it has significant involvement in and the ability to direct the activities that impact the entity’s economic performance. The Company is the managing general partner of entities to which it shares interest in tax-advantaged investments with third parties. At June 30, 2020 and December 31, 2019, approximately $52.83 million and $41.24 million of the Company’s assets and $12.20 million and $18.68 million of its liabilities included on the Consolidated Statements of Financial Condition were related to tax-advantaged investment VIEs which the Company has consolidated, respectively. The assets of the consolidated VIEs are reported in Other Assets, the liabilities are reported in Other Liabilities and the non-controlling interest is reported in Equity on the Consolidated Statements of Financial Condition. The assets of a particular VIE are the primary source of funds to settle its obligations. The creditors of the VIE do not have recourse to the general credit of the Company. The Company’s exposure to the consolidated VIE is generally limited to the carrying value of its variable interest plus any related tax credits previously recognized.
Additionally, the Company sponsors one trust, 1st Source Master Trust (Capital Trust) of which 100% of the common equity is owned by the Company. The Capital Trust was formed in 2007 for the purpose of issuing corporation-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of the capital securities solely in junior subordinated debenture securities of the Company (the subordinated notes). The subordinated notes held by the Capital Trust are the sole assets of the Capital Trust. The Capital Trust qualifies as a variable interest entity for which the Company is not the primary beneficiary and therefore reported in the financial statements as an unconsolidated subsidiary. The junior subordinated debentures are reflected as subordinated notes in the Statements of Financial Condition with the corresponding interest distributions reflected as Interest Expense in the Statements of Income. The common shares issued by the Capital Trust are included in Other Assets in the Statements of Financial Condition.
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Distributions on the capital securities issued by the Capital Trust are payable quarterly at a rate per annum equal to the interest rate being earned by the Capital Trust on the subordinated notes held by the Capital Trust. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated notes. The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of each of the guarantees. The capital securities held by the Capital Trust qualify as Tier 1 capital under Federal Reserve Board guidelines.
The following table shows subordinated notes at June 30, 2020.
(Dollars in thousands)Amount of Subordinated NotesInterest RateMaturity Date
June 2007 issuance (1)$41,238  7.22 %6/15/2037
August 2007 issuance (2)17,526  1.79 %9/15/2037
Total$58,764    

(1) Fixed rate through life of debt.
(2) 3-Month LIBOR +1.48% through remaining life of debt.

Note 11 — 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. There were no stock options outstanding as of June 30, 2020 and 2019.
The following table presents a reconciliation of the number of shares used in the calculation of basic and diluted earnings per common share.
Three Months Ended
June 30,		Six Months Ended
June 30,
(Dollars in thousands - except per share amounts)2020201920202019
Distributed earnings allocated to common stock$7,149  $6,930  $14,548  $13,896  
Undistributed earnings allocated to common stock11,245  16,323  20,186  31,425  
Net earnings allocated to common stock18,394  23,253  34,734  45,321  
Net earnings allocated to participating securities108  132  181  260  
Net income allocated to common stock and participating securities$18,502  $23,385  $34,915  $45,581  
Weighted average shares outstanding for basic earnings per common share25,540,855  25,615,718  25,532,105  25,687,056  
Dilutive effect of stock compensation—  —  —  —  
Weighted average shares outstanding for diluted earnings per common share25,540,855  25,615,718  25,532,105  25,687,056  
Basic earnings per common share$0.72  $0.91  $1.36  $1.76  
Diluted earnings per common share$0.72  $0.91  $1.36  $1.76  
 
Note 12 — Stock Based Compensation
As of June 30, 2020, the Company had four active stock-based employee compensation plans, which are more fully described in Note 16 of the Consolidated Financial Statements in 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2019. These plans include three executive stock award plans, the Executive Incentive Plan, the Restricted Stock Award Plan, the Strategic Deployment Incentive Plan; and the Employee Stock Purchase Plan. The 2011 Stock Option Plan was approved by the shareholders on April 21, 2011 but the Company had not made any grants through June 30, 2020.
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Table of Contents
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 on a straight-line basis over the requisite service period of the award, for which the Company uses the related vesting term.
Total fair value of options vested and expensed was zero for the six months ended June 30, 2020 and 2019. As of June 30, 2020 and 2019 there were no outstanding stock options. There were no stock options exercised during the six months ended June 30, 2020 and 2019. All shares issued in connection with stock option exercises are issued from available treasury stock.
As of June 30, 2020, there was $8.51 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 3.71 years.
Note 13 — Accumulated Other Comprehensive Income (Loss)
The following table presents reclassifications out of accumulated other comprehensive income (loss) related to unrealized gains and losses on available-for-sale securities.
 Three Months Ended June 30,Six Months Ended June 30,Affected Line Item in the Statements of Income
(Dollars in thousands)2020201920202019
Realized (losses) gains included in net income$(1) $—  $279  $—  (Losses) gains on investment securities available-for-sale
 (1) —  279  —  Income before income taxes
Tax effect—  —  (65) —  Income tax expense
Net of tax$(1) $—  $214  $—  Net income
 
Note 14 — Income Taxes
The total amount of unrecognized tax benefits that would affect the effective tax rate if recognized was zero at June 30, 2020 and December 31, 2019. Interest and penalties are recognized through the income tax provision. For the three and six months ended June 30, 2020 and 2019, the Company recognized no interest or penalties. There were no accrued interest and penalties at June 30, 2020 and December 31, 2019.
Tax years that remain open and subject to audit include the federal 2016-2019 years and the Indiana 2016-2019 years. The Company does not anticipate a significant change in the amount of uncertain tax positions within the next 12 months.
Note 15 — 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.
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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 and for its best-efforts forward sales commitments. The Company economically hedges its mortgages held for sale by either selling corresponding forward contracts on agency securities (free-standing derivatives) or obtaining best-efforts forward sales commitments with an investor to sell the loans at an agreed-upon price at the time the interest rate locks are issued to customers. The Company believes the election for mortgages held for sale will reduce certain timing differences and better match changes in the value of these assets with changes in the value of derivatives or best-best efforts forward sales commitments. At June 30, 2020 and December 31, 2019, all mortgages held for sale were carried at fair value.
The following table shows 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.
(Dollars in thousands)Fair value carrying
amount		Aggregate
unpaid principal		Excess of fair value carrying amount over (under) unpaid principal 
June 30, 2020    
Mortgages held for sale reported at fair value$36,508  $34,478  $2,030  (1)
December 31, 2019    
Mortgages held for sale reported at fair value$20,277  $19,890  $387  (1)

(1)The excess of fair value carrying amount over (under) unpaid principal is included in mortgage banking income and includes changes in fair value at and subsequent to funding and 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.
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.
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•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, which includes a credit spread assumption.
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 embedded in these portfolios. Any change in the mid-market derivative valuation adjustment will be recognized immediately through the Consolidated Statements of Income.
The following table shows the balance of assets and liabilities measured at fair value on a recurring basis.
(Dollars in thousands)Level 1Level 2Level 3Total
June 30, 2020    
Assets:    
Investment securities available-for-sale:    
U.S. Treasury and Federal agencies securities$82,605  $463,014  $—  $545,619  
U.S. States and political subdivisions securities—  70,933  3,179  74,112  
Mortgage-backed securities — Federal agencies—  391,278  —  391,278  
Corporate debt securities—  44,088  —  44,088  
Foreign government and other securities—  700  —  700  
Total debt securities available-for-sale82,605  970,013  3,179  1,055,797  
Mortgages held for sale—  36,508  —  36,508  
Accrued income and other assets (interest rate swap agreements)—  55,782  —  55,782  
Total$82,605  $1,062,303  $3,179  $1,148,087  
Liabilities:    
Accrued expenses and other liabilities (interest rate swap agreements)$—  $56,793  $—  $56,793  
Total$—  $56,793  $—  $56,793  
December 31, 2019    
Assets:    
Investment securities available-for-sale:    
U.S. Treasury and Federal agencies securities$80,393  $446,571  $—  $526,964  
U.S. States and political subdivisions securities—  82,213  2,292  84,505  
Mortgage-backed securities — Federal agencies—  375,389  —  375,389  
Corporate debt securities—  53,025  —  53,025  
Foreign government and other securities—  700  —  700  
Total debt securities available-for-sale80,393  957,898  2,292  1,040,583  
Mortgages held for sale—  20,277  —  20,277  
Accrued income and other assets (interest rate swap agreements)—  21,975  —  21,975  
Total$80,393  $1,000,150  $2,292  $1,082,835  
Liabilities:    
Accrued expenses and other liabilities (interest rate swap agreements)$—  $22,352  $—  $22,352  
Total$—  $22,352  $—  $22,352  
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The following table shows changes in Level 3 assets measured at fair value on a recurring basis for the quarter ended June 30, 2020 and 2019.
(Dollars in thousands)U.S. States and
political
subdivisions
securities
Beginning balance April 1, 2020$5,295  
Total gains or losses (realized/unrealized): 
Included in earnings—  
Included in other comprehensive income(97) 
Purchases—  
Issuances—  
Sales—  
Settlements—  
Maturities(2,019) 
Transfers into Level 3—  
Transfers out of Level 3—  
Ending balance June 30, 2020$3,179  
Beginning balance April 1, 2019$5,064  
Total gains or losses (realized/unrealized): 
Included in earnings—  
Included in other comprehensive income16  
Purchases—  
Issuances—  
Sales—  
Settlements—  
Maturities(19) 
Transfers into Level 3—  
Transfers out of Level 3—  
Ending balance June 30, 2019$5,061  
There were no gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2020 or 2019.
The following table shows the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a recurring basis.
(Dollars in thousands)Fair ValueValuation MethodologyUnobservable InputsRange of InputsWeighted Average
June 30, 2020    
Debt securities available-for sale    
Direct placement municipal securities
$3,179  Discounted cash flowsCredit spread assumption
0.16% - 3.99%
3.10 %
December 31, 2019    
Debt securities available-for sale
    
Direct placement municipal securities
$2,292  Discounted cash flowsCredit spread assumption
0.12% - 2.85%
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.
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The Credit Policy Committee (CPC), 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 CPC 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 the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues. The CPC 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 gains and losses on sales of similar assets. The Loan and Funds Management Committee of the Board of Directors is responsible for overseeing the CPC.
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 is generally valued using trade publications and auction values, discounted by 20%. Real estate is valued based on appraisals or evaluations, discounted by 20% 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 of 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.
The Company has established 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 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 June 30, 2020: impaired loans - $0.00 million; mortgage servicing rights - $0.55 million; repossessions - $0.00 million; and other real estate - $0.00 million.
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The following table shows the carrying value of assets measured at fair value on a non-recurring basis.
(Dollars in thousands)Level 1Level 2Level 3Total
June 30, 2020    
Impaired loans - collateral based$—  $—  $22,002  $22,002  
Accrued income and other assets (mortgage servicing rights)—  —  3,748  3,748  
Accrued income and other assets (repossessions)—  —  6,132  6,132  
Accrued income and other assets (other real estate)—  —  303  303  
Total$—  $—  $32,185  $32,185  
December 31, 2019    
Impaired loans - collateral based$—  $—  $8,492  $8,492  
Accrued income and other assets (mortgage servicing rights)—  —  4,200  4,200  
Accrued income and other assets (repossessions)—  —  8,623  8,623  
Accrued income and other assets (other real estate)—  —  522  522  
Total$—  $—  $21,837  $21,837  
The following table below shows the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a non-recurring basis.
(Dollars in thousands)Carrying ValueFair ValueValuation MethodologyUnobservable InputsRange of InputsWeighted Average
June 30, 2020     
Impaired loans$22,002  $22,002  Collateral based measurements including appraisals, trade publications, and auction valuesDiscount for lack of marketability and current conditions
10% - 50%
18 %
Mortgage servicing rights3,748  4,023  Discounted cash flowsConstant prepayment rate (CPR)
14.4% - 25.1%
19.9 %
    Discount rate
8.6% - 11.5%
8.9 %
Repossessions6,132  6,474  Appraisals, trade publications and auction valuesDiscount for lack of marketability
3% - 19%
5 %
Other real estate303  324  AppraisalsDiscount for lack of marketability
0% - 6%
6 %
December 31, 2019     
Impaired loans$8,492  $8,492  Collateral based measurements including appraisals, trade publications, and auction valuesDiscount for lack of marketability and current conditions
0% - 90%
Mortgage servicing rights4,200  5,986  Discounted cash flowsConstant prepayment rate (CPR)
10.2% - 28.1%
    Discount rate
9.3% - 12.1%
Repossessions8,623  9,211  Appraisals, trade publications and auction valuesDiscount for lack of marketability
3% - 25%
Other real estate522  564  AppraisalsDiscount for lack of marketability
0% - 11%
GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring or non-recurring basis.
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The following table shows the fair values of the Company’s financial instruments.
(Dollars in thousands)Carrying or Contract ValueFair ValueLevel 1Level 2Level 3
June 30, 2020     
Assets:     
Cash and due from banks$67,591  $67,591  $67,591  $—  $—  
Federal funds sold and interest bearing deposits with other banks112,645  112,645  112,645  —  —  
Investment securities, available-for-sale1,055,797  1,055,797  82,605  970,013  3,179  
Other investments30,619  30,619  30,619  —  —  
Mortgages held for sale36,508  36,508  —  36,508  —  
Loans and leases, net of reserve for loan and lease losses5,561,039  5,645,890  —  —  5,645,890  
Mortgage servicing rights3,748  4,023  —  —  4,023  
Accrued interest receivable20,976  20,976  —  20,976  —  
Interest rate swaps55,782  55,782  —  55,782  —  
Liabilities:     
Deposits$5,993,456  $6,009,207  $4,493,408  $1,515,799  $—  
Short-term borrowings177,019  177,019  169,982  7,037  —  
Long-term debt and mandatorily redeemable securities81,760  82,954  —  82,954  —  
Subordinated notes58,764  51,391  —  51,391  —  
Accrued interest payable9,427  9,427  —  9,427  —  
Interest rate swaps56,793  56,793  —  56,793  —  
Off-balance-sheet instruments *—  288  —  288  —  
December 31, 2019     
Assets:     
Cash and due from banks$67,215  $67,215  $67,215  $—  $—  
Federal funds sold and interest bearing deposits with other banks16,150  16,150  16,150  —  —  
Investment securities, available-for-sale1,040,583  1,040,583  80,393  957,898  2,292  
Other investments28,414  28,414  28,414  —  —  
Mortgages held for sale20,277  20,277  —  20,277  —  
Loans and leases, net of reserve for loan and lease losses4,974,273  4,992,684  —  —  4,992,684  
Mortgage servicing rights4,200  5,986  —  —  5,986  
Accrued interest receivable19,125  19,125  —  19,125  —  
Interest rate swaps21,975  21,975  —  21,975  —  
Liabilities:     
Deposits$5,357,326  $5,362,633  $3,708,828  $1,653,805  $—  
Short-term borrowings145,893  145,893  120,891  25,002  —  
Long-term debt and mandatorily redeemable securities71,639  71,084  —  71,084  —  
Subordinated notes58,764  61,469  —  61,469  —  
Accrued interest payable13,918  13,918  —  13,918  —  
Interest rate swaps22,352  22,352  —  22,352  —  
Off-balance-sheet instruments *—  281  —  281  —  

* Represents estimated cash outflows required to currently settle the obligations at current market rates.
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 the Company 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.
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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 June 30, 2020, as compared to December 31, 2019, and the results of operations for the three and six months ended June 30, 2020 and 2019. 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 2019 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 GAAP; 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; more recently, potential impacts of the COVID-19 pandemic; and other matters discussed in our filings with the SEC, including our Annual Report on Form 10-K  for 2019, 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 June 30, 2020 were $7.37 billion, an increase of $742.37 million or 11.21% from December 31, 2019. Total investment securities, available-for-sale were $1.06 billion, an increase of $15.21 million or 1.46% from December 31, 2019. Federal funds sold and interest bearing deposits with other banks were $112.65 million, an increase of $96.50 million or 597.49% from December 31, 2019.
Total loans and leases were $5.69 billion, an increase of $606.80 million or 11.93% from December 31, 2019. The largest contributor to the increase in loans and leases was PPP loans funded during the second quarter of 2020. PPP loans are discussed in the “COVID-19 Impact” section below. Our foreign loan and lease balances, all denominated in U.S. dollars were $160.41 million and $184.24 million as of June 30, 2020 and December 31, 2019, respectively. Foreign loans and leases are in aircraft financing. Loan and lease balances to borrowers in Brazil and Mexico were $44.28 million and $109.36 million as of June 30, 2020, respectively, compared to $58.29 million and $111.91 million as of December 31, 2019, respectively. As of June 30, 2020 and December 31, 2019 there was not a significant concentration in any other country. Solar loan and lease balances were $248.40 million as of June 30, 2020, an increase of $78.78 million or 46.45% from the $169.62 million at December 31, 2019. Solar loan and lease balances are included in commercial and agricultural loans. Equipment owned under operating leases was $86.18 million, a decrease of $25.50 million, or 22.83% compared to December 31, 2019. The largest contributor to the decrease in equipment owned under operating leases was reduced leasing volume primarily due to a change in customer preferences.
Total deposits were $5.99 billion, an increase of $636.13 million or 11.87% from the end of 2019. The largest contributors to the increase in total deposits was PPP loan fundings into business accounts and government stimulus payments. Short-term borrowings were $177.02 million, an increase of $31.13 million or 21.33% from December 31, 2019. Long-term debt and mandatorily redeemable securities were $81.76 million, an increase of $10.12 million or 14.13% from December 31, 2019.
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The following table shows accrued income and other assets.
(Dollars in thousands)June 30,
2020		December 31,
2019
Accrued income and other assets:  
Bank owned life insurance cash surrender value$69,879  $68,774  
Operating lease right of use assets22,744  24,147  
Accrued interest receivable20,976  19,125  
Mortgage servicing rights3,748  4,200  
Other real estate303  522  
Repossessions6,132  8,623  
Partnership investments carrying amount77,147  61,083  
All other assets78,390  41,516  
Total accrued income and other assets$279,319  $227,990  
The largest contributors to the increase in accrued income and other assets from December 31, 2019 was an increase in the fair value of interest rate swaps contracts with customers and higher partnership investment carrying amounts.
CORONAVIRUS (COVID-19) IMPACT
The following is a description of the impact the Coronavirus (COVID-19) pandemic is having on our financial condition and results of operations and certain risks to our business that the pandemic creates or exacerbates.
Operational Impact
As part of our contingency and disaster recovery plans for pandemic outbreaks, we created a dedicated executive COVID-19 response team that is closely monitoring developments and providing guidance for additional precautions and initiatives. We have established separate teams within departments to help ensure that infection will not spread across entire departments. We are encouraging virtual meetings and conference calls in place of in-person meetings, including our annual shareholder meeting which was held virtually this year. Employees with health conditions putting them at higher risk of adverse effects from coronavirus infection are working remotely. Additionally, travel has been restricted. We are promoting social distancing, frequent hand washing, thorough disinfection of all surfaces, and the use of masks or nose and mouth coverings have been mandated in all of our locations. Our banking center lobbies have been closed except for advance appointments only. Banking center drive-ups, ATMs and online/mobile banking services continue to operate. It remains undetermined how long our banking centers will operate at these service levels. Infection rates in the communities we serve vary by region and we will make prudent decisions for the safety of our colleagues and our clients.
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Loan and lease modifications
We began receiving requests from our borrowers for loan and lease deferrals in March. Modifications include the deferral of principal payments or the deferral of principal and interest payments for terms generally 90 - 180 days. Requests are evaluated individually and approved modifications are based on the unique circumstances of each borrower. We are committed to working with our clients to allow time to work through the challenges of this pandemic. At this time, it is uncertain what future impact loan and lease modifications related to COVID-19 difficulties will have on our financial condition, results of operations and reserve for loan and lease losses. The following table shows coronavirus loan and lease modifications approved as of June 30, 2020.
(Dollars in millions)Principal Only DeferralsPrincipal and Interest DeferralsTotal COVID-19 Related ModificationsRecorded Investment at
June 30, 2020		Modifications as a % of June 30, 2020 Balance
Auto and light truck rental$13  $211  $224  $411  55 %
Specialty vehicle(1)
—  75  75  153  49 %
Medium and heavy duty truck7  80  87  284  31 %
Aircraft19  74  93  782  12 %
Construction16  123  139  739  19 %
Commercial49  161  210  2,654  8 %
Residential real estate and home equity—  4  4  532  1 %
Consumer—  8  8  137  6 %
Total loans104  736  840  5,692  15 %
PPP loans, net of unearned discount(2)
—  —  —  573  — %
Total loans less PPP loans$104  $736  $840  $5,119  16 %
(1) Includes motor coaches, shuttle buses, step vans, work trucks and funeral cars.
(2) PPP loan balances are located within the Commercial category above.
Paycheck Protection Program (PPP) and Liquidity
As part of the CARES Act, approved by the President on March 27, 2020 and extended on July 4, 2020, the Small Business Administration (SBA) has been authorized to guarantee loans under the PPP through August 8, 2020 for businesses who meet the necessary eligibility requirements in order to keep their workers on the payroll. We began accepting applications on April 3, 2020. PPP loans are fully guaranteed by the SBA and as such do not represent a credit risk. The following table shows PPP loan disbursements as of June 30, 2020.
Number of Loans$ of Loans (000's)Average Loan Size
Phase One2,024  $520,583  $257,000  
Phase Two1,326  71,649  54,000  
Total3,350  $592,232  $177,000  
As of June 30, 2020, PPP loans were $573.15 million which is net of an unearned discount of $16.43 million and located within the commercial and agricultural portfolio. At June 30, 2020, specialty finance customers had $103.43 million of PPP loans and traditional commercial banking customers had $469.72 million of PPP loans.
On April 9, 2020, the FDIC, Federal Reserve and OCC created the Paycheck Protection Program Liquidity Facility (PPPLF) to bolster the effectiveness of the PPP by providing liquidity to and neutralizing the regulatory capital effects on participating financial institutions. We intend to utilize the liquidity relief offered by the PPPLF to the extent needed and as such do not expect our participation in the PPP to have a negative impact on our liquidity position, capital resources, financial condition or results of operations. As of June 30, 2020, we had not yet utilized the PPPLF.
See Part I Financial Information, Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations under the heading “Capital” for more information regarding the COVID-19 impact on share repurchases and dividend activity.
Asset impairment
Our MSRs have experienced a decrease in their fair value as of June 30, 2020 resulting in impairment charges of $0.55 million due to decreased mortgage rates leading to faster prepayment speeds. We will continue to evaluate MSRs at each reporting date to determine whether further valuation allowances are appropriate.
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We evaluate goodwill for impairment during the fourth quarter of each year, with financial data as of September 30. Based on the analysis performed as of October 1, 2019, we determined that goodwill for our reporting units was not impaired. During the first quarter of 2020, management determined that the deterioration in general economic conditions as a result of the COVID-19 pandemic and responses thereto represented a triggering event prompting an evaluation of goodwill impairment. Based on the analyses performed during the first and second quarters of 2020, we determined that goodwill was not impaired.
At this time, we do not believe there exists any impairment to our intangible assets, long-lived assets, right of use assets, or available-for-sale investment securities due to the COVID-19 pandemic. It is uncertain whether prolonged effects of the COVID-19 pandemic will result in future impairment charges related to any of the aforementioned assets.
Risks
See Part II Other Information, Item 1A, Risk Factors for more information.
Reserve for loan and lease losses
We have experienced increasing downgrades and defaults as a result of the impact COVID-19 is having on our borrowers as evidenced by increasing special attention and non-performing loan balances. Special attention loan balances increased $46.72 million in the second quarter of 2020 and $67.58 million since December 31, 2019 and we anticipate further downgrades during the latter half of 2020 and into 2021. Likewise, non-performing loans increased by $36.56 million during the second quarter and $52.96 million since year-end. Second quarter 2020 downgrades were concentrated in auto rental and bus segments within the auto and light truck portfolio as well as a couple of industry specific downgrades in the construction equipment portfolio. We are in communication with our customers to gain a better understanding of our highest risk exposures and probable defaults. This quarter, we sent questionnaires to all of our bus customers in order to better understand their current situations, their customer bases and the likely long-term impact of the economic downturn on their business models, i.e. their ability to withstand reduced revenues for an extended period of time. As a result of the responses and discussions with our customers, we downgraded an additional eleven bus accounts to special attention and placed several of these accounts on nonaccrual status. We anticipate further defaults in our bus lending during the third quarter of 2020. Furthermore, the bus collateral may be difficult to liquidate, particularly in this environment. We believe our auto rental customers will continue to struggle; however, vehicle auctions are well established and are an effective means of liquidating collateral and used vehicle values, to date, have remained strong, so our loss exposure, with the exception of possible fraud, is well managed. Our local market customers have been buoyed in the short-term with funds from the PPP program. Thus far, we have not seen many downgrades or defaults in our commercial lending, but we anticipate this will change particularly as businesses continue to struggle. During the last recession, we also noted a delayed impact on our commercial lending as compared to our specialty finance lending. Our losses year-to-date remain low but we continue to build reserves as we anticipate some of the current and future downgrades and defaults will eventually result in losses.
See Part I Financial Information, Note 5 to the Consolidated Financial Statements and Part I Financial Information, Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations under the heading “Provision and Reserve for Loan and Lease Losses” for more information.
CAPITAL
As of June 30, 2020, total shareholders’ equity was $865.00 million, up $36.72 million, or 4.43% from the $828.28 million at December 31, 2019. In addition to net income of $34.92 million, other significant changes in shareholders’ equity during the first six months of 2020 included $14.58 million of dividends paid. The accumulated other comprehensive income component of shareholders’ equity totaled $19.89 million at June 30, 2020, compared to $5.17 million at December 31, 2019. Our shareholders’ equity-to-assets ratio was 11.74% as of June 30, 2020, compared to 12.51% at December 31, 2019. Book value per common share rose to $33.85 at June 30, 2020, from $32.47 at December 31, 2019.
We declared and paid cash dividends per common share of $0.28 during the second quarter of 2020. The trailing four quarters dividend payout ratio, representing cash dividends per common share divided by diluted earnings per common share, was 35.65%. The dividend payout is continually reviewed by management and the Board of Directors subject to the Company’s capital and dividend policy. Due to COVID-19, we have temporarily suspended the repurchase of common shares from the open market. Management and the Board of Directors will evaluate future share repurchases and dividend payments based on a careful examination of facts and circumstances at such time and in accordance with 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.
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The actual capital amounts and ratios of 1st Source Corporation and 1st Source Bank as of June 30, 2020, are presented in the table below.
 ActualMinimum Capital AdequacyMinimum Capital Adequacy with Capital BufferTo Be Well Capitalized Under Prompt Corrective Action Provisions
(Dollars in thousands)AmountRatioAmountRatioAmountRatioAmountRatio
Total Capital (to Risk-Weighted Assets):      
1st Source Corporation$934,880  15.58 %$479,935  8.00 %$629,915  10.50 %$599,919  10.00 %
1st Source Bank848,568  14.13  480,442  8.00  630,580  10.50  600,553  10.00  
Tier 1 Capital (to Risk-Weighted Assets):      
1st Source Corporation859,152  14.32  359,951  6.00  509,931  8.50  479,935  8.00  
1st Source Bank772,761  12.87  360,332  6.00  510,470  8.50  480,442  8.00  
Common Equity Tier 1 Capital (to Risk-Weighted Assets):
1st Source Corporation765,494  12.76  269,964  4.50  419,943  7.00  389,947  6.50  
1st Source Bank736,103  12.26  270,249  4.50  420,387  7.00  390,359  6.50  
Tier 1 Capital (to Average Assets):      
1st Source Corporation859,152  12.12  283,609  4.00  N/AN/A354,511  5.00  
1st Source Bank772,761  10.90  283,585  4.00  N/AN/A354,481  5.00  
As part of the CARES Act, PPP loan balances have been assigned a zero percent risk weight and therefore had no impact on our total risk-weighted assets at June 30, 2020.
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, access to the national brokered certificates of deposit market, national listing service certificates of deposit, 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 June 30, 2020, we had no borrowings in the federal funds market. We could borrow $225.00 million in additional funds for a short time from these banks on a collective basis. As of June 30, 2020, we had $55.48 million outstanding in FHLB advances and could borrow an additional $550.54 million contingent on the FHLB activity-based stock ownership requirement. We also had no outstandings with the FRB and could borrow $449.80 million as of June 30, 2020.
Our loan to asset ratio was 77.29% at June 30, 2020 compared to 76.79% at December 31, 2019 and 76.83% at June 30, 2019. Cash and cash equivalents totaled $180.24 million at June 30, 2020 compared to $83.37 million at December 31, 2019 and $96.49 million at June 30, 2019. The largest contributors to the increase in cash and cash equivalents was higher deposit balances from PPP loan fundings, customer receipts from the government’s Economic Impact Payment program and the Treasury Department’s and Internal Revenue Service’s decision to delay the deadline for tax filings and payments. At June 30, 2020, the Consolidated Statements of Financial Condition was rate sensitive by $303.41 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 $807 million.
RESULTS OF OPERATIONS
Net income available to common shareholders for the three and six month periods ended June 30, 2020 was $18.50 million and $34.92 million, compared to $23.39 million and $45.58 million for the same periods in 2019. Diluted net income per common share was $0.72 and $1.36 for the three and six month periods ended June 30, 2020, compared to $0.91 and $1.76 for the same periods in 2019. Return on average common shareholders’ equity was 8.23% for the six months ended June 30, 2020, compared to 11.75% in 2019. The return on total average assets was 1.02% for the six months ended June 30, 2020, compared to 1.44% in 2019.
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Net income decreased for the six months ended June 30, 2020 compared to the first six months of 2019. Net interest income decreased and the provision for loan and lease losses increased which was offset by a decrease in noninterest expense. Details of the changes in the various components of net income are discussed further below.
NET INTEREST INCOME
The following tables provide an analysis of net interest income and illustrates the interest income 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 21% rate. Nonaccrual loans and leases are included in the average loan and lease balance outstanding.
DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS’ EQUITY
INTEREST RATES AND INTEREST DIFFERENTIAL
Three Months Ended
June 30, 2020March 31, 2020June 30, 2019
(Dollars in thousands)Average
Balance		Interest Income/ExpenseYield/
Rate		Average
Balance		Interest Income/ExpenseYield/
Rate		Average
Balance		Interest Income/ExpenseYield/
Rate
ASSETS
Investment securities available-for-sale:
Taxable$995,776  $4,487  1.81 %$973,421  $5,550  2.29 %$929,264  $5,186  2.24 %
Tax exempt(1)
49,534  286  2.32 %57,219  325  2.28 %71,878  437  2.44 %
Mortgages held for sale27,016  198  2.95 %11,294  96  3.42 %12,014  127  4.24 %
Loans and leases, net of unearned discount(1)
5,565,160  58,700  4.24 %5,098,397  61,520  4.85 %5,001,392  65,565  5.26 %
Other investments89,525  316  1.42 %41,463  346  3.36 %53,323  499  3.75 %
Total earning assets(1)
6,727,011  63,987  3.83 %6,181,794  67,837  4.41 %6,067,871  71,814  4.75 %
Cash and due from banks73,523  65,407   67,448    
Reserve for loan and lease losses
(124,186) (112,239)  (102,787)   
Other assets509,058  476,159   455,212    
Total assets$7,185,406  $6,611,121   $6,487,744    
LIABILITIES AND SHAREHOLDERS’ EQUITY
     
Interest-bearing deposits$4,248,478  $8,265  0.78 %$4,076,270  $10,851  1.07 %$4,137,118  $12,978  1.26 %
Short-term borrowings191,411  90  0.19 %202,545  254  0.50 %201,401  540  1.08 %
Subordinated notes58,764  835  5.71 %58,764  884  6.05 %58,764  928  6.33 %
Long-term debt and mandatorily redeemable securities
81,766  659  3.24 %77,973  853  4.40 %71,308  764  4.30 %
Total interest-bearing liabilities
4,580,419  9,849  0.86 %4,415,552  12,842  1.17 %4,468,591  15,210  1.37 %
Noninterest-bearing deposits
1,562,100    1,196,106    1,127,794    
Other liabilities151,281    131,858    98,475    
Shareholders’ equity862,209    844,724    789,009    
Noncontrolling interests
29,397  22,881  3,875  
Total liabilities and equity
$7,185,406    $6,611,121    $6,487,744    
Less: Fully tax-equivalent adjustments(137) (151) (177) 
Net interest income/margin (GAAP-derived)(1)
 $54,001  3.23 % $54,844  3.57 % $56,427  3.73 %
Fully tax-equivalent adjustments
137  151  177  
Net interest income/margin - FTE(1)
 $54,138  3.24 % $54,995  3.58 % $56,604  3.74 %
(1) See “Reconciliation of Non-GAAP Financial Measures” at the end of this section for additional information on this performance measure/ratio.
Quarter Ended June 30, 2020 compared to the Quarter Ended June 30, 2019
The taxable-equivalent net interest income for the three months ended June 30, 2020 was $54.14 million, a decrease of 4.36% over the same period in 2019. The net interest margin on a fully taxable-equivalent basis was 3.24% for the three months ended June 30, 2020, compared to 3.74% for the three months ended June 30, 2019.
During the three month period ended June 30, 2020, average earning assets increased $659.14 million, up 10.86% over the comparable period in 2019. Average interest-bearing liabilities increased $111.83 million or 2.50%. The yield on average earning assets decreased 92 basis points to 3.83% from 4.75% primarily due to lower rates on loans and leases and investment securities. Total cost of average interest-bearing liabilities decreased 51 basis points to 0.86% from 1.37% as a result of a lower interest rate environment during 2020. The result to the net interest margin, or the ratio of net interest income to average earning assets, was a decrease of 50 basis points.
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The largest contributor to the reduced yield on average earning assets for the three months ended June 30, 2020, compared to the three months ended June 30, 2019, was a decrease in yields on net loans and leases of 102 basis points primarily due to market conditions as a result of several Federal Reserve interest rate decreases during the second half of 2019 and first three months of 2020. The yield on net loans and leases was also negatively impacted by a net 16 basis points due to PPP loans which earn interest at 1.00% and negatively impacted by two basis points due to net interest reversals of $0.26 million in the second quarter of 2020. Average net loans and leases increased $563.77 million or 11.27% with the largest increase due to average PPP loans of $464.38 million in the commercial and agricultural loan portfolio. The construction equipment and commercial real estate portfolios also increased during the quarter as a result of market demand. Total average investment securities increased $44.17 million or 4.41%. Average mortgages held for sale increased $15.00 million or 124.87%. 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 (FHLB) stock and commercial paper increased $36.20 million or 67.89% from the second quarter of 2019.
Average interest-bearing deposits increased $111.36 million or 2.69% for the second quarter of 2020 over the same period in 2019 primarily due to government stimulus payments. The effective rate paid on average interest-bearing deposits decreased 48 basis points to 0.78% from 1.26%. The decrease in the average cost of interest-bearing deposits was primarily the result of lower rates and a shift in the deposit mix from the second quarter of 2019. Average noninterest-bearing deposits grew $434.31 million or 38.51% for the second quarter of 2020 over the same period in 2019 primarily due to PPP loan fundings in business accounts.
Average short-term borrowings decreased $9.99 million or 4.96% for the second quarter of 2020 compared to the same period in 2019. Interest paid on short-term borrowings decreased 89 basis points. Interest paid on subordinated notes decreased 62 basis points during the second quarter of 2020 from the same period a year ago due to a variable rate on one traunche. Average long-term debt and mandatorily redeemable securities balances increased $10.46 million or 14.67%. Interest paid on long-term debt and mandatorily redeemable securities decreased 106 basis points during the second quarter of 2020 from the same period in 2019 primarily due to lower rates on mandatorily redeemable securities.
Six Months Ended
June 30, 2020June 30, 2019
(Dollars in thousands)Average
Balance		Interest Income/ExpenseYield/
Rate		Average
Balance		Interest Income/ExpenseYield/
Rate
ASSETS
Investment securities available-for-sale:
Taxable$984,598  $10,037  2.05 %$919,398  $10,701  2.35 %
Tax exempt(1)
53,377  611  2.30 %75,007  909  2.44 %
Mortgages held for sale19,155  294  3.09 %10,429  228  4.41 %
Loans and leases, net of unearned discount(1)
5,331,779  120,220  4.53 %4,930,183  128,242  5.25 %
Other investments65,494  662  2.03 %47,740  937  3.96 %
Total earning assets(1)
6,454,403  131,824  4.11 %5,982,757  141,017  4.75 %
Cash and due from banks69,465  65,677    
Reserve for loan and lease losses
(118,212) (102,245)   
Other assets492,608  443,421    
Total assets$6,898,264  $6,389,610    
LIABILITIES AND SHAREHOLDERS’ EQUITY
   
Interest-bearing deposits$4,162,374  $19,116  0.92 %$4,036,578  $24,448  1.22 %
Short-term borrowings196,978  344  0.35 %226,252  1,471  1.31 %
Subordinated notes58,764  1,719  5.88 %58,764  1,856  6.37 %
Long-term debt and mandatorily redeemable securities
79,870  1,512  3.81 %70,897  1,508  4.29 %
Total interest-bearing liabilities
4,497,986  22,691  1.01 %4,392,491  29,283  1.34 %
Noninterest-bearing deposits
1,379,103    1,126,126    
Other liabilities141,570    85,899    
Shareholders’ equity853,467    782,370    
Noncontrolling interests
26,138  2,724  
Total liabilities and equity
$6,898,264    $6,389,610    
Less: Fully tax-equivalent adjustments(288) (359) 
Net interest income/margin (GAAP-derived)(1)
 $108,845  3.39 % $111,375  3.75 %
Fully tax-equivalent adjustments
288  359  
Net interest income/margin - FTE(1)
 $109,133  3.40 % $111,734  3.77 %
(1) See “Reconciliation of Non-GAAP Financial Measures” at the end of this section for additional information on this performance measure/ratio.

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Six Months Ended June 30, 2020 compared to the Six Months Ended June 30, 2019

The taxable-equivalent net interest income for the six months ended June 30, 2020 was $109.13 million, a decrease of 2.33% over the comparable period in 2019. The net interest margin on a fully taxable-equivalent basis was 3.40% compared to a net interest margin of 3.77% for the same period in 2019.

During the six month period ended June 30, 2020, average earning assets increased $471.65 million or 7.88% over the comparable period in 2019. Average interest-bearing liabilities increased $105.50 million or 2.40%. The yield on average earning assets decreased 64 basis points to 4.11% from 4.75% primarily due to lower rates on loans and leases and taxable investment securities available-for-sale. The total cost of average interest-bearing liabilities decreased 33 basis points to 1.01% from 1.34%. The result to the net interest margin, or the ratio of net interest income to average earning assets, was a decrease of 37 basis points.

The largest contributor to the lower yield on average earning assets for the six months ended June 30, 2020, compared to the six months ended June 30, 2019, was a decrease in yields on net loans and leases of 72 basis points primarily due to market conditions as a result of several Federal Reserve interest rate decreases during the second half of 2019 and first three months of 2020. The yield on net loans and leases was also negatively impacted by a net nine basis points due to PPP loan balances that earn interest at 1.00% and negatively impacted by two basis points due to net interest reversals of $0.17 million in 2020 vs. net interest recoveries of $0.08 million in 2019. Average net loans and leases increased $401.60 million or 8.15% primarily due to average PPP loan balances of $232.19 million in the commercial and agricultural portfolio and also due to increases in the commercial real estate portfolio as a result of market demand. Total average investment securities increased $43.57 million or 4.38%. Average mortgages held for sale increased $8.73 million or 83.67%. Average other investments, which include federal funds sold, time deposits with other banks, Federal Reserve bank excess balances, Federal Reserve Bank and FHLB stock and commercial paper, increased $17.75 million or 37.19%.

Average interest-bearing deposits increased $125.80 million or 3.12% for the first six months of 2020 over the same period in 2019 largely due to government stimulus payments in the second quarter. The effective rate paid on average interest-bearing deposits decreased 30 basis points to 0.92% compared to 1.22%. The decrease in the average cost of interest-bearing deposits was primarily the result of lower rates and a shift in the deposit mix. Average noninterest-bearing deposits grew $252.98 million or 22.46% for the first six months of 2020 over the same period in 2019 primarily due to PPP loan fundings in business accounts.

Average short-term borrowings decreased $29.27 million or 12.94% for the first six months of 2020 compared to the same period in 2019. Interest paid on short-term borrowings decreased 96 basis points. The decrease in short-term borrowings was primarily the result of lower borrowings with the FHLB. Interest paid on subordinated notes decreased 49 basis points due to a variable rate associated with one traunche. Average long-term debt and mandatorily redeemable securities increased $8.97 million or 12.66%. Interest paid on long-term debt and mandatorily redeemable securities decreased 48 basis points due to lower rates on mandatorily redeemable securities.

Reconciliation of Non-GAAP Financial Measures
The accounting and reporting policies of 1st Source conform to generally accepted accounting principles (“GAAP”) in the United States and prevailing practices in the banking industry. However, certain non-GAAP performance measures are used by management to evaluate and measure the Company’s performance. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures provide users of the Company’s financial information a more meaningful view of the performance of the interest-earning assets and interest-bearing liabilities.
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Management reviews yields on certain asset categories and the net interest margin of the Company and its banking subsidiaries on a fully taxable-equivalent (“FTE”) basis. In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources.
Three Months EndedSix Months Ended
(Dollars in thousands)June 30,
2020		March 31, 2020June 30,
2019		June 30,
2020		June 30,
2019
Calculation of Net Interest Margin
(A)Interest income (GAAP)$63,850  $67,686  $71,637  $131,536  $140,658  
Fully tax-equivalent adjustments:
(B)- Loans and leases83  90  93  173  188  
(C)- Tax-exempt investment securities54  61  84  115  171  
(D)Interest income - FTE (A+B+C)63,987  67,837  71,814  131,824  141,017  
(E)Interest expense (GAAP)9,849  12,842  15,210  22,691  29,283  
(F)Net interest income (GAAP) (A–E)54,001  54,844  56,427  108,845  111,375  
(G)Net interest income - FTE (D–E)54,138  54,995  56,604  109,133  111,734  
(H)Annualization factor4.022  4.022  4.011  2.011  2.017  
(I)Total earning assets$6,727,011  $6,181,794  $6,067,871  $6,454,403  $5,982,757  
Net interest margin (GAAP-derived) (F*H)/I3.23 %3.57 %3.73 %3.39 %3.75 %
Net interest margin - FTE (G*H)/I3.24 %3.58 %3.74 %3.40 %3.77 %

PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES
The provision for loan and lease losses for the three and six months ended June 30, 2020 was $10.38 million and $21.73 million compared to a provision for loan and lease losses in the three and six months ended June 30, 2019 of $4.25 million and $9.17 million. Net recoveries of $0.11 million or (0.01)% of average loans and leases were recorded for the second quarter 2020, compared to net charge-offs of $1.19 million or 0.10% of average loans and leases for the same quarter a year ago. Year-to-date net charge-offs of $1.70 million or 0.06% of average loans and leases have been recorded in 2020, compared to net charge-offs of $4.72 million or 0.19% of average loans and leases through June 30, 2019.
The provision for the three months ended June 30, 2020 was principally driven by increases in special attention loan balances and nonperforming loans. Loan growth this quarter was related to the PPP loan program. The Bank funded $592 million under this program, which carries a 100% SBA guarantee and a debt forgiveness component by the CARES Act, thus PPP loans did not drive a material increase in the provision. The Bank established a small reserve against this pool of loans to cover procedural and other unanticipated risks. Five accounts with loan balances greater than $5 million were downgraded to special attention this quarter, three in the auto and light truck portfolio, one in the construction equipment portfolio and one construction-related account which is included in the commercial and agricultural portfolio as our exposure is a line of credit secured by accounts receivable and inventory. Of these five accounts, two of the auto and light truck accounts and the line of credit were placed in nonaccrual status in June. The line of credit has a large impairment reserve and the nonperforming auto account also has an impairment reserve. The construction equipment account downgraded last quarter which had a sizeable impairment reserve continues to have a similar impairment reserve this quarter. We continued to have COVID-19 related downgrades this quarter, including all five large-dollar accounts plus numerous additional accounts with less exposure. There were 21 accounts greater than $100,000 downgraded to special attention this quarter compared to 29 last quarter and 40 accounts for all of 2019. The initial wave of customers experiencing difficulties related to shutdowns imposed to reduce the spread of the coronavirus were primarily in the transportation (including auto rental and bus) and hotel industries. As of June 30, 2020, COVID-19 related loan modifications for our bus lending were $70.05 million or 76% of our total bus loan balances and COVID-19 related loan modifications for the hotel industry were $83.33 million or 53% of our total hotel loan balances. This quarter, we also continued to see downgrades in these industries as well as in construction equipment. We extended PPP loans to 45 of our special attention customers aggregating $19.87 million.
We continue to evaluate risks which may impact our loan portfolios. Last quarter, as a result of the coronavirus pandemic and resultant business shutdowns and unemployment spikes, we reviewed our loan portfolio segments, assessing the likely impact of COVID-19 on each segment and established specific qualitative adjustment factors which we believe continue to be appropriate. We remain concerned that geopolitical events, particularly in the aftermath of the pandemic, will have the potential to further negatively impact the U.S. economy. Current concerns include slower growth projections for world economies and the sharp decline in global trade growth exacerbated by trade supply concerns raised during the pandemic and ongoing tariff disputes, particularly between China and the U.S. Political uncertainty continues in Latin America, with governments facing increased pressures with the pandemic and ongoing corruption scandals, fueling U.S. border concerns. Concerns continue to be heightened globally due to actual and potential terrorist attacks.
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Another area of concern continues to be our aircraft portfolio where we have a collateral concentration and $160 million in foreign exposure. The majority of our foreign exposure is in Mexico and Brazil. As we ended 2019, the Brazilian economy was on a path of gradual improvement and Mexico’s economy, although stronger, was beginning to exhibit some weaknesses. Now, considering the pandemic, both are projected to contract in 2020. We continue to monitor individual customer performance and assess risks in the portfolio as a whole.
On June 30, 2020, 30 day and over loan and lease delinquencies as a percentage of loan and lease balances were 0.60%, compared to 0.37% on June 30, 2019. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.31% compared to 2.05% one year ago. The reserve as a percentage of loans and leases outstanding, net of PPP loans, was 2.54%. The increase in the reserve as a percent of loans and leases outstanding was primarily due to higher special attention loan outstanding balances and qualitative adjustment factors related to COVID-19 concerns. A summary of loan and lease loss experience during the three and six months ended June 30, 2020 and 2019 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 a specific reserve 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 or lease and the recorded investment in the loan or lease exceeds its fair value. A summary of impaired loans as of June 30, 2020 and December 31, 2019 is reflected in Note 4 of the Consolidated Financial Statements.
Current Expected Credit Losses (CECL)
As permitted by the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act), we opted to delay adoption of CECL until the earlier of the end of the coronavirus national emergency or December 31, 2020. We will recognize a one-time cumulative effect adjustment through retained earnings of $2.58 million to increase the allowance for credit losses as of January 1, 2020. As of June 30, 2020, we estimate an additional increase to the allowance for credit losses of between $0 million and $8 million which will be recognized through earnings after adoption. We believe that as of June 30, 2020, a forecast adjustment is necessary as well as qualitative factor adjustments for portfolio segments most severely impacted by the COVID-19 business shutdowns. Given the shelter in place orders, resultant business shutdowns and skyrocketing unemployment, we project the next twelve-month period as the most adverse and applied a more severe forecast adjustment. Furthermore, we reviewed portfolio segments on a granular level, adjusting for greater loss potential in segments immediately impacted such as transportation and hotels, as evidenced by deferral requests. Additionally, the forecast factor adjustment and the life of loan methodology have a more significant impact on longer duration portfolios.
NONPERFORMING ASSETS
The following table shows nonperforming assets.
(Dollars in thousands)June 30,
2020		December 31,
2019		June 30,
2019
Loans and leases past due 90 days or more$256  $309  $156  
Nonaccrual loans and leases62,800  9,789  12,212  
Other real estate303  522  543  
Repossessions6,132  8,623  8,799  
Equipment owned under operating leases57  —  —  
Total nonperforming assets$69,548  $19,243  $21,710  
Nonperforming assets as a percentage of loans and leases were 1.20% at June 30, 2020, 0.37% at December 31, 2019, and 0.41% at June 30, 2019. Excluding PPP loans, nonperforming assets as a percentage of loan and leases were 1.33% at June 30, 2020, 0.37% at December 31, 2019, and 0.14% at June 30, 2019. Nonperforming assets totaled $69.55 million at June 30, 2020, an increase of 261.42% from the $19.24 million reported at December 31, 2019, and a 220.35% increase from the $21.71 million reported at June 30, 2019. The increase in nonperforming assets during the first six months of 2020 was related to higher nonaccrual loans and leases. The increase in nonperforming assets at June 30, 2020 from June 30, 2019 also occurred primarily in nonaccrual loans and leases.
The increase in nonaccrual loans and leases at June 30, 2020 from December 31, 2019 occurred primarily in the auto and light truck, construction equipment and commercial and agricultural. During the first half of 2020, two relationships of a combined $25.70 million in the auto and light truck portfolio and two relationships of a combined $21.49 million in the construction equipment portfolio went into nonaccrual. The increase in nonaccrual loans and leases at June 30, 2020 from June 30, 2019 occurred primarily in the auto and light truck and construction equipment. A summary of nonaccrual loans and leases and past due aging for the period ended June 30, 2020 and December 31, 2019 is located in Note 4 of the Consolidated Financial Statements.
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Other real estate is the result of foreclosing on real estate in the local market for which we have a current appraisal and are well secured. Other real estate decreased over the past year due to sales of existing properties outpacing current foreclosures.
Repossessions consisted mainly of aircraft and auto and light trucks. At the time of repossession, the recorded amount of the loan or lease is written down to the fair value of the equipment or vehicle by a charge to the reserve for loan and lease losses or other income, if a positive adjustment, unless the equipment is in the process of immediate sale. Any subsequent fair value write-downs or write-ups, to the extent of previous write-downs, are included in noninterest expense.
The following table shows a summary of other real estate and repossessions.
(Dollars in thousands)June 30,
2020		December 31,
2019		June 30,
2019
Commercial and agricultural$—  $—  $16  
Auto and light truck630  1,865  3,810  
Medium and heavy duty truck—  —  554  
Aircraft5,450  6,707  4,400  
Construction equipment35  35  —  
Commercial real estate303  303  —  
Residential real estate and home equity—  219  543  
Consumer17  16  19  
Total$6,435  $9,145  $9,342  
For financial statement purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets.
NONINTEREST INCOME
The following table shows the details of noninterest income.
Three Months Ended
June 30,		Six Months Ended
June 30,
(Dollars in thousands)20202019$ Change% Change20202019$ Change% Change
Noninterest income:    
Trust and wealth advisory$5,589  $5,583  6  0.11 %$10,437  $10,441  (4) (0.04)%
Service charges on deposit accounts1,910  2,785  (875) (31.42)%4,515  5,283  (768) (14.54)%
Debit card3,601  3,669  (68) (1.85)%6,974  6,889  85  1.23 %
Mortgage banking3,315  999  2,316  NM5,651  1,935  3,716  NM
Insurance commissions1,695  1,518  177  11.66 %3,576  3,692  (116) (3.14)%
Equipment rental5,990  7,809  (1,819) (23.29)%12,620  15,791  (3,171) (20.08)%
(Losses) gains on investment securities available-for-sale
(1) —  (1) NM279  —  279  NM
Other3,142  3,301  (159) (4.82)%5,811  5,757  54  0.94 %
Total noninterest income$25,241  $25,664  (423) (1.65)%$49,863  $49,788  75  0.15 %
NM = Not Meaningful
Trust and wealth advisory fees (which include investment management fees, estate administration fees, mutual fund fees, annuity fees, and fiduciary fees) were flat during the three and six months ended June 30, 2020 compared with the same periods a year ago. Trust and wealth advisory fees are largely based on the number and size of client relationships and the market value of assets under management. The market value of trust assets under management at June 30, 2020, December 31, 2019, and June 30, 2019 was $4.20 billion, $4.48 billion, and $4.25 billion, respectively.
Service charges on deposit accounts decreased for the three and six months ended June 30, 2020 over the comparable periods in 2019. The decrease in service charges on deposit accounts primarily reflects a lower volume of nonsufficient fund transactions and reduced ATM fees. Higher deposit balances from government stimulus payments resulted in fewer overdrawn accounts.
Debit card income was relatively flat in the three and six months ended June 30, 2020 over the same periods a year ago.
Mortgage banking income increased in the three and six months ended June 30, 2020 as compared to the same periods in 2019. The increase was primarily caused by increased gains on a higher volume of loan sales as a result of more loans originated for the secondary market offset by higher mortgage servicing rights amortization expense and a $0.55 million impairment charge on mortgage servicing rights.
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Insurance commissions were higher during the three months ended June 30, 2020 compared to the same period a year ago and were lower during the six months ended June 30, 2020 over the same period a year ago. The increase in insurance commissions during the second quarter was primarily due to increased business. The decrease over the first six months of 2020 was the result of a reduction in contingent commissions received offset by higher insurance commissions primarily from increased business.
Equipment rental income decreased for the three and six months ended June 30, 2020 over the comparable periods in 2019. The decrease was the result of reduced leasing volume primarily in the construction equipment, aircraft and auto and light truck portfolios resulting in the average equipment rental portfolio decreasing by 18.3% over the same period a year ago.
Gains on investment securities available-for-sale during the six months ended June 30, 2019 were primarily from the sale of corporate securities in managing portfolio risk.
Other income decreased for the three months ended June 30, 2020 compared to one year ago and was relatively stable for the six months ended June 30, 2020 over the comparable period in 2019. The decrease during the second quarter was primarily a result of lower claim proceeds from bank owned life insurance, reduced rental income on a repossessed asset, and a decrease in customer swap fees offset by higher partnership investment gains.
NONINTEREST EXPENSE
The following table shows the details of noninterest expense.
Three Months Ended
June 30,		Six Months Ended
June 30,
(Dollars in thousands)20202019$ Change% Change20202019$ Change% Change
Noninterest expense:    
Salaries and employee benefits$23,999  $23,787  212  0.89 %$48,400  $47,282  1,118  2.36 %
Net occupancy2,504  2,481  23  0.93 %5,225  5,253  (28) (0.53)%
Furniture and equipment6,258  6,289  (31) (0.49)%12,665  12,313  352  2.86 %
Depreciation – leased equipment5,142  6,400  (1,258) (19.66)%10,569  12,924  (2,355) (18.22)%
Professional fees1,258  1,706  (448) (26.26)%2,700  3,304  (604) (18.28)%
Supplies and communication1,390  1,608  (218) (13.56)%3,024  3,101  (77) (2.48)%
FDIC and other insurance599  608  (9) (1.48)%887  1,253  (366) (29.21)%
Business development and marketing
1,121  1,678  (557) (33.19)%2,480  2,627  (147) (5.60)%
Loan and lease collection and repossession
838  230  608  NM1,601  1,591  10  0.63 %
Other1,716  2,566  (850) (33.13)%3,809  2,909  900  30.94 %
Total noninterest expense$44,825  $47,353  (2,528) (5.34)%$91,360  $92,557  (1,197) (1.29)%
NM = Not Meaningful
Salaries and employee benefits increased during the three and six months ended June 30, 2020 compared to the same periods in 2019. The increase was mainly due to higher base salaries as a result of normal merit increases and a slight increase in average staffing levels along with a rise in commission compensation primarily in our mortgage area offset by a decrease in group insurance claims and incentive compensation.
Net occupancy expense was relatively flat during the three and six months ended June 30, 2020 compared to the same periods a year ago.
Furniture and equipment expense, including depreciation, was flat during the three months ended June 30, 2020 compared to one year ago and increased during the six months ended June 30, 2020 compared to the same period a year ago. Furniture and equipment expense was higher in the first six months of 2020 mainly due to higher computer processing charges, increased software maintenance costs and a rise in general furniture and equipment expense from new branch openings/remodels and COVID-19 related items offset by a reduction in equipment depreciation.
Depreciation on leased equipment decreased for the three and six months ended June 30, 2020 compared to the same periods in 2019. Depreciation on leased equipment correlates with the decrease in equipment rental income.
Professional fees decreased during the second quarter and first six months of 2020 compared to the same periods a year ago. The decrease was mainly due to reduced utilization of consulting services offset by an increase in board of director fees.
Supplies and communication decreased during the second quarter and first six months of 2020 compared to the same periods a year ago. The decrease resulted primarily from lower printing costs and reduced telephone line and equipment expenses.
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FDIC and other insurance was lower during the three and six months ended June 30, 2020 compared to the same periods in 2019. The decrease in 2020 was mainly due to $0.55 million in FDIC insurance premium credits received in 2020.
Business development and marketing expense decreased during the second quarter and first six months of 2020 compared to the same periods a year ago. The decrease during the first six months of 2020 was primarily due to lower business development expense as a result of fewer business entertainment and travel opportunities tied to COVID-19 precautions offset by higher marketing promotions compared to 2019.
Loan and lease collection and repossession expense increased during the second quarter 2020 compared to the same period in 2019 and was flat during the first half of 2020 compared to the first half of 2019. The increase in the second quarter was mainly due to higher collection expenses related to the repossession of an aircraft and fewer gains on the sale of repossessed assets.
Other expenses decreased during the second quarter of 2020 compared to the same period in 2019 and increased during the first six months of 2020 compared to the same period in 2019. The decrease during the second quarter of 2020 was primarily the result of lower employee training expenses due to COVID-19 precautions, a decrease in the provision for unfunded loan commitments, a reduced valuation provision for interest rate swaps with customers, and a trust loss recovery of $0.17 million. The increase during the first six months was primarily the result of lower gains on the sale of fixed assets, a higher provision for interest rate swaps with customers offset by increased gains on the sale of operating lease equipment.
INCOME TAXES
The provision for income taxes for the three and six month periods ended June 30, 2020 was $5.52 million and $10.68 million, compared to $7.07 million and $13.83 million for the same periods in 2019. The effective tax rate was 22.94% and 23.20% for the quarter ended June 30, 2020 and 2019, respectively and 23.40% and 23.26% for the first six months ended June 30, 2020 and 2019, respectively.
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, 2019. For information regarding our market risk, refer to 1st Source’s Annual Report on Form 10-K for the year ended December 31, 2019.
ITEM 4.
CONTROLS AND PROCEDURES
As of the end of the period covered by this report an evaluation was carried out, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at June 30, 2020, our disclosure controls and procedures were effective in ensuring that information required to be disclosed by 1st Source in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and are designed to ensure that information required to be disclosed in those reports is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure.
In addition, there were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the second fiscal quarter of 2020 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II.  OTHER INFORMATION
ITEM 1.         Legal Proceedings.
1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of 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.
1st Source has made the following addition to the risk factors disclosed in Item 1A of Part 1 of its Annual Report on Form 10-K for the year ended December 31, 2019.
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We may be adversely affected by the world-wide coronavirus (COVID-19) pandemic.
The coronavirus (COVID-19) outbreak may have an adverse impact on certain of our customers directly or indirectly. Entire industries within our loan and lease portfolio such as motor coach, shuttle bus and auto rental have been impacted due to reduced demand related to quarantines and travel restrictions. Other industries within our loan and lease portfolio or the communities we serve are likely to experience similar disruptions and economic hardships as the current coronavirus pandemic persists. In addition, such events could affect the stability of our deposit base, lead to mass layoffs and furloughs which could impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, result in lost revenue or cause us to incur additional expenses.
Additionally, the Federal Reserve has reduced interest rates substantially in an attempt to boost consumer spending due to the coronavirus pandemic which could have a sustained negative impact on our results of operations. The U.S. Congress has also passed a massive stimulus package (the “Coronavirus Aid, Relief, and Economic Security Act”) intended to provide relief to consumers and small businesses, however the effectiveness of this package could be disrupted by operational challenges in successfully implementing all of its provisions in a timely manner and could ultimately prove to be insufficient in scale.
Even with operational precautions we have implemented such as mask utilization, social distancing and thorough disinfection of surfaces, the continued spread or prolonged impact of the coronavirus could negatively impact the availability of key personnel or significant numbers of our staff, who are necessary to conduct our business. Such a spread or outbreak could also impact the business and operations of third party service providers who perform critical services for our business. Similarly, the adverse impacts already seen by our commercial and retail customers from the pandemic, may be exacerbated or more prolonged than we currently anticipate. If the coronavirus spreads or the containment and mitigation response is unsuccessful for a prolonged period of time, we could experience a material adverse effect on our business, financial condition, and results of operations.
ITEM 2.         Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
PeriodTotal Number of Shares PurchasedAverage Price Paid Per ShareTotal Number of Shares Purchased as Part of Publicly Announced Plans or Programs*Maximum Number (or Approximate Dollar Value) of Shares that may yet be Purchased Under the Plans or Programs
April 01 - 30, 2020—  $—  —  859,374  
May 01 - 31, 2020—  —  —  859,374  
June 01 - 30, 2020—  —  —  859,374  

* 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on July 24, 2014. Under the terms of the plan, 1st Source may repurchase up to 2,000,000 shares of its common stock from time to time to mitigate the potential dilutive effects of stock-based incentive plans and other potential uses of common stock for corporate purposes. Since the inception of the plan, 1st Source has repurchased a total of 1,140,626 shares.
ITEM 3.         Defaults Upon Senior Securities.
None
ITEM 4.         Mine Safety Disclosures.
None
ITEM 5.         Other Information.
None
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ITEM 6.         Exhibits
The following exhibits are filed with this report:
 
 
 
 
101.INS XBRL Instance Document — The instance document does not appear in the interactive data file because its XBRL tags are embedded within the Inline XBRL 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
104Cover Page Interactive Data File (embedded within the Inline XBRL document and included in Exhibit 101)

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


  1st Source Corporation
   
   
   
DATEJuly 23, 2020 /s/ CHRISTOPHER J. MURPHY III
  Christopher J. Murphy III
Chairman of the Board, President and CEO
   
   
DATEJuly 23, 2020 /s/ ANDREA G. SHORT
  Andrea G. Short
Treasurer and Chief Financial Officer
Principal Accounting Officer

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