Old National Bank - 10-Q quarterly report FY

 

 

(Exact name of Registrant as specified in its charter)

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, and (2) has been subject to the filing requirements for at least the past 90 days. Yesþ No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act.

Large accelerated filer þ      Accelerated filer o      Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).Yes oNo þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock. The Registrant has one class of common stock (no par value) with 66,423,000 shares outstanding at April 30, 2007.

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

The accompanying notes to consolidated financial statements are an integral part of these statements.

The accompanying notes to consolidated financial statements are an integral part of these statements.

The accompanying notes to consolidated financial statements are an integral part of these statements.

The accompanying unaudited consolidated financial statements include the accounts of Old National Bancorp and its wholly-owned affiliates (“Old National”) and have been prepared in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. Such principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The allowance for loan losses, goodwill and intangibles, derivative financial instruments and unrecognized tax positions are particularly subject to change. In the opinion of management, the consolidated financial statements contain all the normal and recurring adjustments necessary for a fair statement of the financial position of Old National as of March 31, 2007 and 2006, and December 31, 2006, and the results of its operations for the three months ended March 31, 2007 and 2006. Interim results do not necessarily represent annual results. These financial statements should be read in conjunction with Old National’s Annual Report for the year ended December 31, 2006.

All significant intercompany transactions and balances have been eliminated. Certain prior year amounts have been reclassified to conform with the 2007 presentation. Such reclassifications had no effect on net income.

FASB Interpretation No. 48 – In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (“FIN 48”), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 became effective for the Company on January 1, 2007. The impact of adopting FIN 48 is discussed in Note 14 to the consolidated financial statements.

SFAS No. 159 – In February 2007, the FASB issued Statement No. 159 – The Fair Value Option for Financial Assets and Financial Liabilities. The standard provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The new standard is effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS No. 159 on the consolidated financial statements.

EITF 06-5 – In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5,Accounting for Purchases of Life Insurance – Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance). This Issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract. It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis. Lastly, the Issue discusses whether the cash surrender value should be discounted when the policyholder is contractually limited in its ability to surrender a policy. EITF 06-5 became effective for the Company on January 1, 2007 and resulted in a $0.1 million reduction to retained earnings.

On February 1, 2007, Old National acquired St. Joseph Capital Corporation (''St. Joseph’’), a banking franchise headquartered in Mishawaka, Indiana, for $78.1 million, including acquisition costs. Pursuant to the merger agreement, the shareholders of St. Joseph received $40.00 in cash for each share of St. Joseph stock in an all-cash transaction. The purchase price was funded with the proceeds of a dividend of $76.0 million paid by Old National Bank to the parent company in January 2007. Goodwill of $46.5 million was recorded, of which none is deductible for tax purposes. In addition, intangible assets totaling $14.5 million related to core deposits and customer relationships were recorded and are being amortized over 10 to 11 years. See Note 9 to the consolidated financial statements for additional information. On the date of acquisition, unaudited financial statements of St. Joseph showed assets of $452.9 million, which included $336.6 million of loans and $78.6 million of securities, $357.3 million of deposits and year-to-date net interest income and other income of $0.8 million and net loss of $3.3 million.

During the first quarter of 2006, Old National sold its financial center located in O’Fallon, Illinois, selling approximately $27.9 million in loans and assigning $22.2 million in deposits. The financial center was in a market no longer considered consistent with the Company’s strategy. The sale resulted in a pre-tax gain of $3.0 million which was included in income from continuing operations during the first quarter.

Basic net income per share is computed by dividing net income by the weighted-average number of common shares outstanding during each period, adjusted to reflect all stock dividends. Diluted net income per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued.

The following table reconciles basic and diluted net income per share for the three months ended March 31:

The following table summarizes the amortized cost and fair value of the available-for-sale and held-to-maturity investment securities portfolio at March 31, 2007 and December 31, 2006 and the corresponding amounts of unrealized gains and losses therein:

During the first quarter of 2007, proceeds from the sales of investment securities available-for-sale were $145.5 million, resulting in a loss of $2.7 million.

At March 31, 2007, Old National does not believe any individual unrealized loss represents other-than-temporary impairment. The unrealized losses are primarily attributable to changes in interest rates. Factors considered in evaluating the securities included whether the securities were backed by U.S. Government-sponsored agencies and credit quality concerns surrounding the recovery of the full principal balance. Old National has both the intent and ability to hold securities with any individual unrealized loss for a time necessary to recover the amortized cost.

Residential loans held for sale are recorded at lower of cost or market value determined as of the balance sheet date. A portion of Old National’s residential loans held for sale have been hedged using fair value hedge accounting in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. The loans’ carrying basis reflects the effects of the SFAS No. 133 adjustments. At March 31, 2007 and December 31, 2006, Old National had residential loans held for sale of $19.0 million and $16.6 million, respectively. As of March 31, 2007 and December 31, 2006, ineffectiveness related to the hedge of a portion of the residential loans held for sale was immaterial.

The following summarizes the changes in the allowance for loan losses:

The following presents information regarding the period-end balances of impaired loans:

For the three months ended March 31, 2007 and 2006, the average balance of impaired loans was $42.1 million and $38.9 million, respectively, for which no interest income was recorded. No additional funds are committed to be advanced in connection with impaired loans. Loans deemed impaired are evaluated primarily using the fair value of the underlying collateral.

The following table shows the changes in the carrying amount of goodwill by segment for the three months ended March 31, 2007 and 2006:

Goodwill is reviewed annually for impairment. Old National completed its most recent annual goodwill impairment test as of August 31, 2006 and determined that no impairment existed as of this date. Old National recorded $46.5 million of goodwill associated with the acquisition of St. Joseph Capital Corporation during the first quarter of 2007.

The gross carrying amount and accumulated amortization of other intangible assets at March 31, 2007 and December 31, 2006 was as follows:

Other intangible assets consist primarily of core deposit intangibles and customer relationship intangibles and are being amortized on a straight-line or accelerated basis over their estimated useful lives, generally over a period of 10 to 25 years. Old National reviews intangible assets for possible impairment whenever events or changes in circumstances indicate that carrying amounts may not be recoverable. Old National recorded $14.5 million of other intangibles associated with the acquisition of St. Joseph Capital Corporation during the first quarter of 2007. Total amortization expense associated with other intangible assets for the three months ended March 31 was $0.7 million in 2007 and $0.6 million in 2006.

Estimated amortization expense for the future years is as follows:

In March, 2007, Old National committed to a plan to sell eighty-four bank branch properties to an unrelated party for $198.7 million and to lease them back pursuant to individual ten, fifteen, and twenty-three year triple-net leases. The letter of intent will be executed in May 2007, and the transaction is expected to close during the third quarter. These assets are reported as held for sale at historical cost of $68.0 million. The $130.7 million gain will be deferred and amortized over the terms of the individual leases.

Also included in assets held for sale were four branch buildings associated with locations that were closed and consolidated into more profitable financial centers during the quarter.

The carrying amounts of the classes of assets included as held for sale were as follows at March 31, 2007:

The following table summarizes Old National’s other borrowings at March 31, 2007, and December 31, 2006:

Contractual maturities of other borrowings at March 31, 2007, were as follows:

FEDERAL HOME LOAN BANK
Federal Home Loan Bank advances had weighted-average rates of 5.20% and 5.37% at March 31, 2007, and December 31, 2006, respectively. These borrowings are collateralized by investment securities and residential real estate loans up to 145% of outstanding debt.

SUBORDINATED BANK NOTES
Subordinated bank notes qualify as Tier 2 Capital for regulatory purposes, subject to certain limitations, and are in accordance with the senior and subordinated global bank note program in which Old National Bank may issue and sell up to a maximum of $1 billion. Notes issued by Old National Bank under the global note program are not obligations of, or guaranteed by, Old National Bancorp.

JUNIOR SUBORDINATED DEBENTURES
Junior subordinated debentures related to trust preferred securities are classified in “other borrowings”. These securities qualify as Tier 1 capital for regulatory purposes, subject to certain limitations.

Old National guarantees the payment of distributions on the trust preferred securities issued by ONB Capital Trust II. ONB Capital Trust II issued $100 million in preferred securities in April 2002. The preferred securities have a liquidation amount of $25 per share with a cumulative annual distribution rate of 8.0% or $2.00 per share payable quarterly and maturing on April 15, 2032. Proceeds from the issuance of these securities were used to purchase junior subordinated debentures with the same financial terms as the securities issued by ONB Capital Trust II. Old National may redeem the junior subordinated debentures and thereby cause a redemption of the trust preferred securities in whole (or in part from time to time) on or after April 12, 2007, and in whole (but not in part) following the occurrence and continuance of certain adverse federal income tax or capital treatment events. Costs associated with the issuance of these trust preferred securities totaling $3.3 million in 2002 were capitalized and are being amortized through the maturity dates of the securities. The unamortized balance is included in other assets in the consolidated balance sheet.

During February 2007, Old National acquired St. Joseph Capital Trust I and St. Joseph Capital Trust II in conjunction with its acquisition of St. Joseph Capital Corporation. Old National guarantees the payment of distributions on the trust preferred securities issued by St. Joseph Capital Trust I and St. Joseph Capital Trust II. St. Joseph Capital Trust I issued $3.0 million in preferred securities in July 2003. The preferred securities carry a variable rate of interest priced at the three-month LIBOR plus 305 basis points, payable quarterly and maturing on July 11, 2033. Proceeds from the issuance of these securities were used to purchase junior subordinated debentures with the same financial terms as the securities issued by St. Joseph Capital Trust I. St. Joseph Capital Trust II issued $5.0 million in preferred securities in March 2005. The preferred securities have a cumulative annual distribution rate of 6.27% until March 2010 when it will carry a variable rate of interest priced at the three-month LIBOR plus 175 basis points, payable quarterly and maturing on March 17, 2035. Proceeds from the issuance of these securities were used to purchase junior subordinated debentures with the same financial terms as the securities issued by St. Joseph Capital Trust II. Old National may redeem the junior subordinated debentures and thereby cause a redemption of the trust preferred securities in whole (or in part from time to time) on or after September 30, 2008 (for debentures owned by St. Joseph Capital Trust I) and on or after March 31, 2010 (for debentures owned by St. Joseph Capital Trust II), and in whole (but not in part) following the occurrence and continuance of certain adverse federal income tax or capital treatment events.

CAPITAL LEASE OBLIGATION
On January 1, 2004, Old National entered into a long-term capital lease obligation for a new branch office building in Owensboro, Kentucky, which extends for 25 years with one renewal option for 10 years. The economic substance of this lease is that Old National is financing the acquisition of the building through the lease and accordingly, the building is recorded as an asset and the lease is recorded as a liability. The fair value of the capital lease obligation was estimated using a discounted cash flow analysis based on Old National’s current incremental borrowing rate for similar types of borrowing arrangements.

At March 31, 2007, the future minimum lease payments under the capital lease were as follows:

RETIREMENT PLAN
Old National maintains a funded noncontributory defined benefit plan (the “Retirement Plan”) that was frozen as of December 31, 2005. Retirement benefits are based on years of service and compensation during the highest paid five years of employment. The freezing of the plan provides that future salary increases will not be considered. Old National’s policy is to contribute at least the minimum funding requirement determined by the plan’s actuary.

Old National also maintains an unfunded pension restoration plan (the “Restoration Plan”) which provides benefits for eligible employees that are in excess of the limits under Section 415 of the Internal Revenue Code of 1986, as amended, that apply to the Retirement Plan. The Restoration Plan is designed to comply with the requirements of ERISA. The entire cost of the plan, which was also frozen as of December 31, 2005, is supported by contributions from the Corporation.

Old National does not expect to contribute any cash to these pension plans in 2007, except $0.7 million to cover future benefit payments from the Restoration Plan.

The net periodic benefit cost and its components were as follows for the three months ended March 31:

Under the 1999 Equity Incentive Plan, Old National is authorized to grant up to 7.6 million shares of common stock. At March 31, 2007, 6.5 million shares were outstanding under the plan, including 5.9 million stock options and 0.6 million shares of restricted stock, 0.5 million shares have been exercised or released, and 0.6 million shares were available for issuance. In addition, Old National assumed 0.1 million stock options outstanding through various mergers.

Stock Options
Old National recorded $0.1 million of stock based compensation expense, net of tax, during the first three months of 2007 as compared to $0.1 million for the first three months of 2006. The Company granted 218,100 stock options during 2007 and substituted 47,604 St. Joseph stock options for Old National stock options in connection with its acquisition of St. Joseph. Using the Black-Scholes option pricing model, the Company estimated the fair value of the stock options granted during 2007 to be $0.5 million. The Company will expense this amount ratably over the three-year vesting period. The assumptions used in the option pricing model and the determination of stock option expense were an expected volatility of 15.3%; a risk free interest rate of 4.85%; an expected option term of six years; a 4.23% dividend yield; and a forfeiture rate of 7%. These options expire in ten years.

Restricted Stock
Old National recorded expense of $0.1 million, net of tax benefit, during the first three months of 2007, compared to expense of $0.4 million during the first three months of 2006 related to the vesting of restricted share awards. Included in the first three months of 2007 is the reversal of $0.7 million of expense associated with certain performance-based restricted stock grants.

The Company granted 122 thousand shares of performance based restricted stock awards to certain key officers during 2007, with shares vesting at the end of a thirty-six month period based on the achievement of certain targets. In addition, the Company granted 50 thousand time-based restricted stock awards to certain key officers during 2007, with shares vesting at the end of a thirty-six month period. Compensation expense is recognized on a straight-line basis over the vesting period. Shares are subject to certain restrictions and risk of forfeiture by the participants. As of March 31, 2007, unrecognized compensation expense was estimated to be $7.1 million for unvested restricted share awards.

The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), on January 1, 2007 and, as the cumulative effect of applying its provisions, recognized a $3.4 million reduction to the balance of retained earnings on that date with a corresponding decrease in deferred tax assets which are reported as other assets on the balance sheet. The amount of unrecognized tax benefits as of January 1, 2007 totaled $10.3 million, all of which, if recognized, would affect the effective tax rate. Unrecognized state income tax benefits are reported net of their related deferred federal income tax benefit.

It is the Company’s policy to recognize interest and penalties accrued relative to unrecognized tax benefits in their respective federal or state income tax accounts. As of January 1, 2007, $2.7 million in interest, and no penalties, had been accrued on the Company’s balance sheet .

The Company and its subsidiaries file a consolidated U.S. federal income tax return, as well as filing various state returns. The company is currently under audit by the Internal Revenue Service for the years 2003 and 2004. The federal statute of limitations has been extended on 2002 as a part of this audit and remains open currently. It is likely that the examination phase of this audit will conclude in 2007. It is possible that a reduction in unrecognized tax benefits will occur upon completion of the audit, however, the amount of any possible reduction can not be estimated at this time.

The following is a summary of the major items comprising the differences in taxes from continuing operations computed at the federal statutory rate and as recorded in the consolidated statement of income for the three months ended March 31:

For the three months ended March 31, 2007, the effective tax rate on income from continuing operations was lower than for the three months ended March 31, 2006. The lower effective tax rate resulted from a higher percentage of tax-exempt income to income before income taxes compared to the three months ended March 31, 2006.

Old National designates its derivatives based upon criteria established by SFAS No. 133, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an Amendment to FASB Statement No. 133, and SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.

The following table summarizes the derivative financial instruments utilized by Old National:

As of December 31, 2006, Old National had receive-fixed interest rate swaps on certain of its retail certificates of deposit and subordinated debt. Certain of these derivative instruments, having a notional amount of $323.1 million, were terminated in the first quarter of 2007 and a notional amount of $16.6 million were dedesignated and included as stand-alone derivatives on March 1, 2007.

Old National enters into certain matched customer hedges to accommodate the business needs of its customers. Upon the origination of a customer hedge, Old National simultaneously enters into an offsetting contract with a third party to mitigate its exposure.

LITIGATION
In the normal course of business, various legal actions and proceedings, which are being vigorously defended, are pending against Old National and its affiliates. Management does not believe any of these claims will have a material impact on Old National’s results of operations.

CREDIT-RELATED FINANCIAL INSTRUMENTS
In the normal course of business, Old National’s banking affiliates have entered into various agreements to extend credit, including loan commitments of $1.244 billion, commercial letters of credit of $75 thousand and standby letters of credit of $122.9 million at March 31, 2007. At December 31, 2006, loan commitments were $1.165 billion, commercial letters of credit were $40 thousand and standby letters of credit were $121.7 million. These commitments are not reflected in the consolidated financial statements. Management believes the reserve for unfunded commitments is adequate as of March 31, 2007.

At March 31, 2007 and December 31, 2006, Old National had credit extensions of $69.4 million and $75.4 million, respectively, with various unaffiliated banks related to letter of credit commitments issued on behalf of Old National’s clients. At March 31, 2007 and December 31, 2006, Old National provided collateral to the unaffiliated banks to secure credit extensions totaling $51.1 million and $54.5 million, respectively. Old National did not provide collateral for the remaining credit extensions.

Old National holds instruments, in the normal course of business with clients, that are considered financial guarantees in accordance with FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which requires the Company to record the instruments at fair value. Standby letters of credit guarantees are issued in connection with agreements made by clients to counterparties. Standby letters of credit are contingent upon failure of the client to perform the terms of the underlying contract. Credit risk associated with standby letters of credit is essentially the same as that associated with extending loans to clients and is subject to normal credit policies. The term of these standby letters of credit is typically one year or less. At March 31, 2007, the notional amount of standby letters of credit was $122.9 million, which represents the maximum amount of future funding requirements, and the carrying value was $0.4 million.

Old National operates in two operating segments: community banking and treasury. The community banking segment serves customers in both urban and rural markets providing a wide range of financial services including commercial, real estate and consumer loans; lease financing; checking, savings, time deposits and other depository accounts; cash management services; and debit cards and other electronically accessed banking services and Internet banking. Treasury manages investments, wholesale funding, interest rate risk, liquidity and leverage for Old National. Additionally, treasury provides other miscellaneous capital markets products for its corporate banking clients.

In order to measure performance for each segment, Old National allocates capital, corporate overhead and income tax provision to each segment. Capital and corporate overhead are allocated to each segment using various methodologies, which are subject to periodic changes by management. Income taxes are allocated using the effective tax rate. Intersegment sales and transfers are not significant.

Old National uses a funds transfer pricing (“FTP”) system to eliminate the effect of interest rate risk from net interest income in the community banking segment and from companies included in the “other” column. The FTP system is used to credit or charge each segment for the funds the segments create or use. The net FTP credit or charge is reflected in segment net interest income.

The financial information for each operating segment is reported on the basis used internally by Old National’s management to evaluate performance and is not necessarily comparable with similar information for any other financial institution. Summarized financial information concerning segments is shown in the following table for the three months ended March 31:

The following discussion is an analysis of Old National’s results of operations for the three months ended March 31, 2007 and 2006, and financial condition as of March 31, 2007, compared to March 31, 2006, and December 31, 2006. This discussion and analysis should be read in conjunction with Old National’s consolidated financial statements and related notes. This discussion contains forward-looking statements concerning Old National’s business that are based on estimates and involves certain risks and uncertainties. Therefore, future results could differ significantly from management’s current expectations and the related forward-looking statements.

On February 1, 2007, Old National closed on its purchase of St. Joseph Capital Corporation (“St. Joseph”), a banking franchise headquartered in Mishawaka, Indiana. This is Old National’s first bank acquisition in seven years and leads the Company’s entry into the higher growth markets of Northern Indiana.

In conjunction with the acquisition, the Company focused on balance sheet restructuring and reducing operating expenses during the quarter. This restructuring included a reduction of the investment portfolio, the early extinguishment of certain debt, and the consolidation of select branches with low growth potential into other Old National financial centers within close proximity. In addition, there were personnel reductions in select areas related to productivity improvement projects which are currently under way. These actions are designed to address the Company’s operating challenges which are to successfully integrate St. Joseph, to mitigate the margin pressure resulting from the competitive Midwest environment in which the Company operates, and to contain expense.

Subsequent to quarter-end, management executed a letter of intent to sell and leaseback substantially all of the bank’s financial center locations. Reducing these non-earning assets will allow the Company to deploy the cash proceeds into interest earning assets or to pay-down higher cost borrowings. Occupancy expense will increase as a result of the transaction, however, management believes that margin and overall earnings should improve.

Old National continues to focus on its key strategic initiatives: (1) strengthen the risk profile; (2) enhance management discipline; and (3) achieve consistent quality earnings.

Fundamental credit quality remains stable to improved. Nonperforming loans totaled 1.23% of total loans at March 31, 2007, up from 0.88% at December 31, 2006. The increase is primarily due to the acquisition of St. Joseph Capital Corporation. The allowance for loan losses equaled 1.46% of total loans at March 31, 2007, compared to 1.44% at December 31, 2006 and 1.59% at March 31, 2006. Net charge-offs were 0.38% of average loans in the first quarter of 2007 compared to 0.46% in the first quarter of 2006.

Loan and deposit growth remains challenging. Total loans at March 31, 2007 increased 3.9% compared to December 31, 2006. The March 31, 2007 loan balance includes $342.9 million related to the acquisition of St. Joseph during the first quarter of 2007. Commercial loans increased 7.6% year-over-year, but were offset by declines in commercial real estate loans due to the challenging Midwest market environment and the Company’s stated desire to lower future potential credit risk by being cautious towards the real estate market. Year-over-year, deposits have increased $391.6 million. Included in the increase was $323.6 million of deposits associated with the St. Joseph acquisition.

Net income was $10.8 million for the three months ended March 31, 2007, a decrease of $9.9 million from the $20.7 million recorded for the three months ended March 31, 2006. On a diluted per share basis, net income was $0.16 for the three months ended March 31, 2007, compared to $0.31 for the three months ended March 31, 2006. Included in net income for the first quarter of 2007 is approximately $5.0 million of expense, net of tax, or $0.08 on a diluted per share basis, associated with the restructuring and productivity improvement projects discussed above.

The following table sets forth certain income statement information of Old National for the three months ended March 31, 2007 and 2006:

Net Interest Income
Net interest income is Old National’s most significant component of earnings, comprising over 60% of revenues at March 31, 2007. Net interest income and margin are influenced by many factors, primarily the volume and mix of earning assets, funding sources and interest rate fluctuations. Other factors include prepayment risk on mortgage and investment-related assets and the composition and maturity of earning assets and interest-bearing liabilities. Loans typically generate more interest income than investment securities with similar maturities. Funding from client deposits generally cost less than wholesale funding sources. Factors, such as general economic activity, Federal Reserve Board monetary policy and price volatility of competing alternative investments, can also exert significant influence on Old National’s ability to optimize its mix of assets and funding and its net interest income and margin.

Net interest income and net interest margin in the following discussion are presented on a fully taxable equivalent basis, which adjusts tax-exempt or nontaxable interest income to an amount that would be comparable to interest subject to income taxes using the federal statutory tax rate of 35% in effect for all periods. Net income is unaffected by these taxable equivalent adjustments as the offsetting increase of the same amount is made to income tax expense. Net interest income includes taxable equivalent adjustments of $4.2 million and $5.1 million for the three months ended March 31, 2007 and 2006, respectively.

Taxable equivalent net interest income was $56.0 million for the three months ended March 31, 2007, down from the $59.5 million reported for the three months ended March 31, 2006. The net interest margin was 3.00% for the three months ended March 31, 2007, compared to 3.18% reported for the three months ended March 31, 2006. The decrease in both net interest income and net interest margin is primarily due to the increase in the cost of funding being greater than the increase in earning asset yields, combined with a change in the mix of interest earning assets and interest-bearing liabilities. The yield on average earning assets increased 33 basis points from 6.18% to 6.51%. The cost of interest-bearing liabilities increased 59 basis points from 3.34% to 3.93%.

Average earning assets were $7.463 billion for the three months ended March 31, 2007, compared to $7.488 billion for the three months ended March 31, 2006, a decrease of 0.3%, or $25.4 million. Significantly affecting average earning assets at March 31, 2007 compared to March 31, 2006, was management’s decision to restructure the investment portfolio and the acquisition of St. Joseph. In addition, commercial and commercial real estate loans have been affected by continued weak loan demand in Old National’s markets and more stringent loan underwriting standards. During the third quarter of 2006, the Company sold investment securities of $273.1 million and $28.8 million of commercial and commercial real estate loans. During the first quarter of 2007, the Company sold $148.2 million of investment securities and $3.8 million of commercial real estate loans. Year over year, commercial loans, which have an average yield higher than the investment portfolio, have increased as a percent of interest earning assets.

Also affecting margin were decreases in borrowed funding due to the maturity of $50 million of senior unsecured bank notes in the second quarter of 2006 and the retirement of $89 million of Federal Home Loan Bank advances and $74 million of repurchase agreements in the first quarter of 2007. Old National also retired $23 million of Federal Home Loan Bank advances which were acquired from St. Joseph and a $15 million Federal Home Loan Bank advance acquired from St. Joseph also matured in the first quarter of 2007. Year over year, deposits, which have an average interest rate lower than borrowed funds, have increased as a percent of interest-bearing liabilities as long-term borrowings have decreased as a percent of interest-bearing liabilities.

Provision for Loan Losses
The provision for loan losses was $2.4 million for the three months ended March 31, 2007, compared to $3.5 million for the three months ended March 31, 2006. The lower provision in 2007 is attributable to a decrease in net charge-offs combined with a decrease in criticized loans and enhanced credit administration and underwriting functions.

Noninterest Income
Old National generates revenues in the form of noninterest income through client fees and sales commissions from its core banking franchise and other related businesses, such as wealth management, investment consulting, investment products and insurance. Noninterest income for the three months ended March 31, 2007, was $33.5 million, a decrease of $9.3 million, or 21.8%, from the $42.9 million reported for the three months ended March 31, 2006.

Net securities losses were $2.7 million for the three months ended March 31, 2007, compared to $0.1 million for the three months ended March 31, 2006, an increase of $2.6 million. The primary reason for the increase in net securities losses was management’s decision to reduce the size of the investment portfolio.

Gains on derivatives decreased by $1.6 million in the first quarter of 2007 as compared to the first quarter of 2006, primarily as a result of a change in the mix of derivatives used in hedging relationships.

During the first quarter of 2006, Old National recorded a $3.0 million gain from the sale of the O’Fallon, Illinois financial center. There was no corresponding sale in the first quarter of 2007.

During the first quarter of 2007, Old National recorded a $1.2 million loss on the extinguishment of debt. The loss was related to the early retirement of Federal Home Loan Bank advances and repurchase agreements.

Decreases in letter of credit fees and customer derivative fees were the primary reason for the decrease in other income in the first quarter of 2007 compared to the first quarter of 2006.

Noninterest Expense
Noninterest expense for the three months ended March 31, 2007, totaled $71.8 million, an increase of $3.3 million, or 4.8%, from the $68.5 million recorded for the three months ended March 31, 2006.

Salaries and benefits is the largest component of noninterest expense. For the three months ended March 31, 2007, salaries and benefits were $41.3 million. Included in salaries and benefits expense for 2007 is approximately $0.6 million of personnel expense associated with the acquisition of St. Joseph Capital Corporation, which was offset by the reversal of $0.7 million of expense associated with certain performance-based restricted stock grants. Severance costs were relatively constant compared to the first quarter of 2006.

Occupancy expense increased $1.1 million to $6.4 million for the three months ended March 31, 2007, compared to $5.2 million for the three months ended March 31, 2006. The increase is primarily related to the sale of the Company’s corporate office buildings in Evansville, Indiana in December, 2006 and the lease of those buildings back to the Company. Old National Bank is obligated to pay annual rent of $6.6 million to lease those buildings from the landlords through December 31, 2029; no rent is payable for the final two years of the initial 25-year term. For financial reporting purposes, the rent will be expensed ratably over the 25-year term at an annual rate of $6.0 million.

Other losses totaled $2.4 million for the three months ended March 31, 2007, an increase of $1.8 million compared to $0.6 million for the three months ended March 31, 2006. The increase in other losses was primarily attributable to impairment charges on buildings that the Company identified for consolidation and charges to terminate leases on buildings that the Company no longer occupies.

Provision for Income Taxes
Old National records a provision for income taxes currently payable and for income taxes payable or benefits to be received in the future, which arise due to timing differences in the recognition of certain items for financial statement and income tax purposes. The major difference between the effective tax rate applied to Old National’s financial statement income and the federal statutory tax rate is caused by interest on tax-exempt securities and loans. The provision for income taxes on continuing operations, as a percentage of pre-tax income, was 2.6% for the three months ended March 31, 2007, compared to 18.0% for the three months ended March 31, 2006. The decreased effective tax rate in 2007 resulted from a higher percentage of tax-exempt income to income before income taxes than in 2006.

Overview
Old National’s assets at March 31, 2007, were $8.332 billion, a 1.1% increase compared to March 31, 2006 assets of $8.245 billion, and an annualized increase of 8.9% compared to December 31, 2006 assets of $8.150 billion. The higher level of assets is primarily due the acquisition of St. Joseph, which was partially offset by the reduction of the investment portfolio. The Company continues to reduce its reliance on wholesale funding. Year over year, deposits, which have an average interest rate lower than borrowed funds, have increased as a percent of interest-bearing liabilities as long-term borrowings have decreased as a percent of interest-bearing liabilities.

Earning Assets
Old National’s earning assets are comprised of investment securities, loans and loans held for sale, and money market investments. Earning assets were $7.531 billion at March 31, 2007, an increase of 1.3% from March 31, 2006, and an annualized increase of 8.2% since December 31, 2006. Investment securities have decreased over the past twelve months as Old National has reduced its investment portfolio. In the third quarter of 2006, Old National sold $273.1 million of investment securities. In the first quarter of 2007, Old National sold $148.2 million of investment securities. At March 31, 2007, total loans, including loans held for sale, increased $68.7 million compared to March 31, 2006, and increased $183.6 million compared to December 31, 2006. Included in total loans at March 31, 2007 is $342.9 million of loans acquired from St. Joseph. In the third quarter of 2006, $28.8 million of loans were sold. In the first quarter of 2007, $3.8 million of loans were sold.

Investment Securities
Old National classifies investment securities primarily as available-for-sale to give management the flexibility to sell the securities prior to maturity if needed, based on fluctuating interest rates or changes in the Company’s funding requirements. At March 31, 2007, Old National does not believe any individual unrealized loss on available-for-sale securities represents other-than-temporary impairment. The unrealized losses are primarily attributable to changes in interest rates. As of March 31, 2007, Old National had both the intent and ability to hold the securities for a time necessary to recover the amortized cost.

At March 31, 2007, the investment securities portfolio was $2.271 billion compared to $2.573 billion at March 31, 2006, a decrease of $303.1 million or 11.8%. Investment securities decreased $105.5 million at March 31, 2007, compared to December 31, 2006, an annualized decrease of 17.8%. Investment securities represented 30.2% of earning assets at March 31, 2007, compared to 34.6% at March 31, 2006, and 32.2% at December 31, 2006. In the third quarter of 2006, Old National sold $273.1 million of investment securities. In the first quarter of 2007, Old National sold $148.2 million of investment securities. Included in investment securities at March 31, 2007, is $3.1 million from St. Joseph. Old National has reduced the size of the investment portfolio during the past twelve months and used the cash flows generated by the declining investment portfolio to reduce borrowed funds. Stronger commercial loan demand in the future could result in increased investments in loans and a continued reduction in the investment securities portfolio.

The investment securities available-for-sale portfolio had net unrealized losses of $19.7 million at March 31, 2007, a decrease of $25.6 million compared to net unrealized losses of $45.4 million at March 31, 2006, and a decrease of $7.9 million compared to net unrealized losses of $27.6 million at December 31, 2006. The decrease over the past twelve months was primarily the result of the smaller portfolio of securities available-for-sale, the shorter duration and the lower level of interest rates at March 31, 2007, compared to March 31, 2006.

The investment portfolio had an average duration of 2.94 years at March 31, 2007, compared to 3.43 years at March 31, 2006, and 2.90 years at December 31, 2006. The annualized average yields on investment securities, on a taxable equivalent basis, were 5.09% for the three months ended March 31, 2007, compared to 4.93% for the three months ended March 31, 2006, and 5.01% for the three months ended December 31, 2006.

Federal Home Loan Bank stock decreased $8.5 million from the March 31, 2006 balance of $49.6 million to $41.2 million at March 31, 2007. This decrease is primarily the result of the Federal Home Loan Banks’ decision to repurchase excess stock during the third quarter of 2006.

Residential Loans Held for Sale
Residential loans held for sale were $19.0 million at March 31, 2007, compared to $22.0 million at March 31, 2006, and compared to $16.6 million at December 31, 2006. Residential loans held for sale are loans that are closed, but not yet purchased by investors. The amount of residential loans held for sale on the balance sheet varies depending on the amount of originations and timing of loan sales to the secondary market. The decrease in residential loans held for sale from March 31, 2006, is primarily attributable to lower loan production and the timing of loan sales to the secondary market.

Commercial and Commercial Real Estate Loans
Commercial and commercial real estate loans are the largest classification within the earning assets of Old National, representing 41.5% of earning assets at March 31, 2007, an increase from 41.0% at March 31, 2006, and an increase from 40.9% at December 31, 2006. At March 31, 2007, commercial and commercial real estate loans were $3.121 billion, an increase of $71.3 million since March 31, 2006, and an increase of $105.1 million since December 31, 2006. Included in the increase were $96.4 million of commercial loans and $124.0 million of commercial real estate loans associated with the St. Joseph acquisition. Commercial loans have increased $117.2 million since March 31, 2006 while commercial real estate loans have decreased $46.0 million since March 31, 2006. In the third quarter of 2006, $28.8 million of commercial and commercial real estate loans were sold. In the first quarter of 2007, the Company sold $3.8 million of commercial real estate loans. Weak loan demand in Old National’s markets continues to affect loan growth. Old National also has continued to tighten its underwriting standards, which has slowed potential loan growth.

Consumer Loans
At March 31, 2007, consumer loans, including automobile loans, personal and home equity loans and lines of credit, and student loans, decreased $48.0 million or 3.8% compared to March 31, 2006, and increased $0.3 million or, annualized, 0.1% since December 31, 2006. Included in consumer loans at March 31, 2007 is $28.7 million of consumer loans from the St. Joseph acquisition.

Residential Real Estate Loans
Residential real estate loans, primarily 1-4 family properties, have decreased in significance to the loan portfolio over the past five years due to higher levels of loan sales into the secondary market, primarily to private investors. Old National sells the majority of residential real estate loans originated as a strategy to better manage interest rate risk and liquidity.

At March 31, 2007, residential real estate loans were $560.8 million, an increase of $48.4 million, or 9.5%, from March 31, 2006. The acquisition of St. Joseph was the primary reason for the increase in residential real estate loans.

Goodwill and Other Intangible Assets
Goodwill and other intangible assets at March 31, 2007, totaled $194.4 million, an increase of $58.6 million compared to $135.8 million at March 31, 2006, and an increase of $60.2 million compared to $134.2 million at December 31, 2006. The increase is primarily the result of $61.0 million in goodwill and intangible assets related to the February 1, 2007 acquisition of St. Joseph Capital Corporation.

Funding
Total funding, comprised of deposits and wholesale borrowings, was $7.583 billion at March 31, 2007, an increase of 1.5% from $7.473 billion at March 31, 2006, and an annualized increase of 10.9% from $7.382 billion at December 31, 2006. Included in total funding were deposits of $6.610 billion at March 31, 2007, an increase of $391.6 million, or 6.3%, compared to March 31, 2006, and an annualized increase of 18.2% compared to December 31, 2006. Included in total deposits at March 31, 2007 is $323.6 million from the St. Joseph acquisition, which was the primary reason for the increase in deposits. Demand deposits increased 4.8% or $39.3 million compared to March 31, 2006. NOW deposits increased 12.2 % or $177.4 million and time deposits increased 5.1% or $130.4 million compared to March 31, 2006. Year over year, Old National experienced a shift from money market deposits into time deposits.

Old National uses wholesale funding to augment deposit funding and to help maintain its desired interest rate risk position. At March 31, 2007, wholesale borrowings, including short-term borrowings and other borrowings, decreased $281.7 million, or 22.4%, from March 31, 2006 and decreased $87.0 million, or 32.8%, annualized, from December 31, 2006, respectively. Wholesale funding as a percentage of total funding was 12.8% at March 31, 2007, compared to 16.8% at March 31, 2006, and 14.4% at December 31, 2006. The primary causes for the reduction in wholesale funding were the retirement of $89 million of Federal Home Loan Bank advances and $74 million of repurchase agreements in the first quarter of 2007. Old National also retired $23 million of Federal Home Loan Bank advances which were acquired from St. Joseph and a $15 million Federal Home Loan Bank advance acquired from St. Joseph matured in the first quarter of 2007. The reduction of the investment portfolio during 2006 and 2007 has reduced the Company’s reliance on wholesale funding.

Capital
Shareholders’ equity totaled $640.7 million at March 31, 2007, compared to $642.4 million at March 31, 2006, and $642.4 million at December 31, 2006.

Old National paid cash dividends of $0.22 per share for the three months ended March 31, 2007, which decreased equity by $14.5 million, compared to cash dividends of $0.21 per share for the three months ended March 31, 2006, which decreased equity by $14.1 million. Old National purchased shares of its stock in the open market under an ongoing repurchase program, reducing shareholders’ equity by $9.5 million during the three months ended March 31, 2006. Although approved, Old National did not repurchase shares during the first quarter of 2007. The change in unrealized losses on investment securities increased equity by $3.1 million during the three months ended March 31, 2007, and decreased equity by $6.1 million during the three months ended March 31, 2006. Shares issued for stock options, restricted stock and stock purchase plans increased shareholders’ equity by $0.6 million during the three months ended March 31, 2007, compared to $1.3 million during the three months ended March 31, 2006. The adoption of FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, resulted in a $3.4 million reduction in equity. The adoption of EITF 06-5 resulted in a $0.1 million reduction in equity.

Capital Adequacy
Old National and the banking industry are subject to various regulatory capital requirements administered by the federal banking agencies. Old National’s consolidated capital position remains strong as evidenced by the following comparisons of key industry ratios. The decline in the Company’s capital ratios can be attributed primarily to the cash purchase of St. Joseph.