form10-k.htm

 
 



 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

 
                 x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                      OF THE SECURITIES EXCHANGE ACT OF 1934
                      For the fiscal year ended December 31, 2007
 
OR
 
        o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF THE SECURITIES EXCHANGE ACT OF 1934
                         For the transition period from __________   to ______________

Commission file number 0-6233
 
corplogo
 
1 ST 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, Indiana
    46601
(Address of principal executive offices)
 
(Zip Code)

Registrant’s telephone number, including area code: (574) 235-2000
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of Class
Name of Each Exchange on Which Registered
Common Stock — without par value
                            The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None
 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes   o  No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.Yes   o  No  x

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. Yes x     No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer ” and “smaller reporting company ” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
  o
Accelerated filer
 x
Non-accelerated filer
  o
            Smaller Reporting Company
  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes  o   No  x
 
The aggregate market value of the voting common stock held by non-affiliates of the registrant as of June 30, 2007 was $344,792,173

The number of shares outstanding of each of the registrant’s classes of stock as of February 20, 2008:
Common Stock, without par value –– 24,092,110 shares
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the annual proxy statement for the 2008 annual meeting of shareholders to be held April 24, 2008, are incorporated by reference into Part III.
 
 


 
 
 
-1-


 
 
TABLE OF CONTENTS


Part I
   
     
Item 1.
  3
Item 1A.
  7
Item 1B.
  9
Item 2.
  9
Item 3.
  9
Item 4.
  9
     
     
Part II
   
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    9
Item 6.
  10
Item 7.
  10
Item 7A.
  23
Item 8
  24
    24
    26
    27
    28
    29
    30
Item 9
  47
Item 9A.
  48
Item 9B.
  48
     
     
Part III
   
Item 10.
  48
Item 11.
  48
Item 12.
  49
Item 13.
  49
Item 14.
  49
     
     
Part IV
   
Item 15.
  50
  52



-2-


 

 
PART I
 
ITEM 1. BUSINESS.
 
1st SOURCE CORPORATION
 
1st Source Corporation, an Indiana corporation incorporated in 1971, is a bank holding company headquartered in South Bend, Indiana that provides, through our subsidiaries (collectively referred to as "1st Source"), a broad array of financial products and services.  1st Source Bank and First National Bank, Valparaiso (collectively referred to as the "Banks"), our banking subsidiaries, offer commercial and consumer banking services, trust and investment management services, and insurance to individual and business clients through most of our 83 banking center locations in 17 counties in Indiana and Michigan.  1st Source Bank's Specialty Finance Group, with 24 locations nationwide, offers specialized financing services for new and used private and cargo aircraft, automobiles and light trucks for leasing and rental agencies, medium and heavy duty trucks, construction equipment, and environmental equipment. While concentrated in certain equipment types, we enjoy serving a very diverse client base.  We are not dependent upon any single industry or client.  At December 31, 2007, we had consolidated total assets of $4.45 billion, loans and leases of $3.19 billion, deposits of $3.47 billion, and total shareholders’ equity of $430.50 million.
 
Our principal executive office is located at 100 North Michigan Street, South Bend, Indiana 46601 and our telephone number is 574 235-2000. Access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports is available, free of charge, at www.1stsource.com soon after the material is electronically filed with the Securities Exchange Commission (SEC).  We will provide a printed copy of any of the aforementioned documents to any requesting shareholder.
 
1st SOURCE BANK
 
1st Source Bank is a wholly owned subsidiary of 1st Source Corporation that offers a broad range of consumer and commercial banking services through its lending operations, retail branches, and fee based businesses.
 
Commercial, Agricultural, and Real Estate Loans — 1st Source Bank provides commercial, agricultural, and real estate loans to primarily privately owned business clients mainly located within our regional market area.  Loans are made for a wide variety of general corporate purposes, including financing for industrial and commercial properties, financing for equipment, inventories and accounts receivable, and acquisition financing.  Other services include commercial leasing and cash management services.
 
Consumer Services — 1st Source Bank provides a full range of consumer banking services, including checking accounts, on-line banking including bill payment, telephone banking, savings programs, installment and real estate loans, home equity loans and lines of credit, drive-through and night deposit services, safe deposit facilities, automated teller machines, overdraft facilities, debit and credit card services, and brokerage services.
 
Trust Services — 1st Source Bank provides a wide range of trust, investment, agency, and custodial services for individual and corporate clients.  These services include the administration of estates and personal trusts, as well as the management of investment accounts for individuals, employee benefit plans, and charitable foundations.
 
Specialty Finance Group Services —  1st Source Bank, through its Specialty Finance Group,  provides a broad range of comprehensive equipment loan and lease finance products addressing the financing needs of diverse companies. This group can be broken down into four areas: auto, light truck, and environmental equipment financing; medium and heavy duty truck financing; aircraft financing; and construction equipment financing.
 
Auto, light truck, and environmental equipment financing consists of financings to automobile rental and leasing companies, light truck rental and leasing companies, and environmental equipment companies.  Auto, light truck, and environmental equipment finance receivables generally range from $50,000 to $15 million with fixed or variable interest rates and terms of two to seven years.
 
Medium and heavy duty truck financing consists of financings for highway tractors and trailers and delivery trucks to the commercial trucking industry.   Medium and heavy duty truck finance receivables generally range from $50,000 to $15 million with fixed or variable interest rates and terms of two to seven years.
 
Aircraft financing consists of financings for new and used general aviation aircraft for private and corporate aircraft users, aircraft distributors and dealers, air charter operators, and air cargo carriers.  We have selectively entered the business aircraft markets of Brazil, Canada and Mexico on a limited basis where desirable aircraft financing opportunities exist.  Aircraft finance receivables generally range from $250,000 to $15 million with fixed or variable interest rates and terms of two to fifteen years.
 
Construction equipment financing includes financing of equipment (i.e., asphalt and concrete plants, bulldozers, excavators, cranes, and loaders, etc.) to the construction industry.  Construction equipment finance receivables generally range from $100,000 to $15 million with fixed or variable interest rates and terms of three to seven years.
 
We also generate equipment rental income through the leasing of construction equipment, various trucks, and other equipment to clients through operating leases.
 
SPECIALITY FINANCE GROUP SUBSIDIARIES
 
The Specialty Finance Group also consists of separate wholly owned subsidiaries of 1st Source Bank which include:  Michigan Transportation Finance Corporation, 1st Source Specialty Finance, Inc., SFG Equipment Leasing, Inc., 1st Source Intermediate Holding, LLC, 1st Source Commercial Aircraft Leasing, Inc., and SFG Equipment Leasing Corporation I.
 
 
 
FIRST NATIONAL BANK, VALPARAISO
 
First National Bank, Valparaiso (First National) is a wholly owned subsidiary of 1st Source Corporation that was acquired on May 31, 2007.  First National offers a broad range of consumer and commercial banking services through its lending operations, retail branches, and fee based businesses.
 
Commercial, Agricultural, and Real Estate Loans —First National provides commercial, agricultural, and real estate loans to corporations and other business clients primarily located within Northwestern Indiana.  Loans are made for a wide variety of general corporate purposes, including financing for industrial and commercial properties, financing for equipment, inventories and accounts receivable, and acquisition financing.
 
Consumer Services —First National provides a full range of consumer banking services, including checking accounts, on-line banking, savings programs, installment and real estate loans, home equity loans and lines of credit, drive-through and night deposit services, safe deposit facilities, automated teller machines, overdraft facilities, and debit and credit card services.
 
TRUSTCORP MORTGAGE COMPANY
 
Trustcorp Mortgage Company (Trustcorp) is a mortgage banking company and is a wholly owned subsidiary of 1st Source Corporation.  During 2007, their mortgage activity was merged with 1st Source Bank.
 
1ST SOURCE INSURANCE, INC.
 
1st Source Insurance, Inc. is a wholly owned subsidiary of 1st Source Bank that provides insurance services to individuals and businesses covering corporate and personal property products, casualty insurance products, and individual and group health and life insurance products.
 
1ST SOURCE CORPORATION INVESTMENT ADVISORS, INC.
 
1st Source Corporation Investment Advisors, Inc. is a wholly owned subsidiary of 1st Source Bank that provides investment advisory services to trust and investment clients of 1st Source Bank and to the 1st Source Monogram Funds.  1st Source Corporation Investment Advisors, Inc. is registered as an investment advisor with the Securities and Exchange Commission under the Investment Advisors Act of 1940. 1st Source Corporation Investment Advisors, Inc. serves strictly in an advisory capacity and, as such, does not hold any client securities.

OTHER CONSOLIDATED SUBSIDIARIES
 
We have other subsidiaries that are not significant to the consolidated entity.
 
1ST SOURCE CAPITAL TRUST II, III, IV, AND 1ST SOURCE MASTER TRUST
 
Our unconsolidated subsidiaries include 1st Source Capital Trust III, IV, and 1st Source Master Trust. These subsidiaries were created for the purposes of issuing $10.00 million, $30.00 million, and $57.00 million of trust preferred securities, respectively, and lending the proceeds to 1st Source.  We guarantee, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities.  1st Source Capital Trust II was not active as of December 31, 2007.
 
COMPETITION

The activities in which we and the Banks engage are highly competitive. These activities and the geographic markets served involve competition with other banks, some of which are affiliated with large bank holding companies headquartered outside of our principal market. We generally compete on the basis of client service and responsiveness to client needs, available loan and deposit products, the rates of interest charged on loans and leases, the rates of interest paid for funds, other credit and service charges, the quality of services rendered, the convenience of banking facilities, and in the case of loans and leases to large commercial borrowers, relative lending limits.
 
In addition to competing with other banks within our primary service areas, the Banks also compete with other financial service companies, such as credit unions, industrial loan associations, securities firms, insurance companies, small loan companies, finance companies, mortgage companies, real estate investment trusts, certain governmental agencies, credit organizations, and other enterprises. Additional competition for depositors’ funds comes from United States Government securities, private issuers of debt obligations, and suppliers of other investment alternatives for depositors. Many of our non-bank competitors are not subject to the same extensive Federal regulations that govern bank holding companies and banks. Such non-bank competitors may, as a result, have certain advantages over us in providing some services.
 
We compete against these financial institutions by offering a full array of products and highly personalized services. We also rely on our history in our core market dating back to 1863, as well as relationships that our long-term colleagues have with our clients, and the capacity we have for quick local decision-making.
 
EMPLOYEES
 
At December 31, 2007, we had approximately 1,350 employees on a full-time equivalent basis. We provide a wide range of employee benefits and consider employee relations to be good.
 
REGULATION AND SUPERVISION
 
General — 1st Source and the Banks are extensively regulated under Federal and State law.  To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable laws or regulations may have a material effect on our business and our prospective business. Our operations may be affected by legislative changes and by the policies of various regulatory authorities. We are unable to predict the nature or the extent of the effects on our business and earnings that fiscal or monetary policies, economic controls, or new Federal or State legislation may have in the future.
 
 
 
 
We are a registered bank holding company under the Bank Holding Company Act of 1956 (BHCA) and, as such, we are subject to regulation, supervision, and examination by the Board of Governors of the Federal Reserve System (Federal Reserve). We are required to file annual reports with the Federal Reserve and to provide the Federal Reserve such additional information as it may require.
 
1st Source Bank, as an Indiana state bank and member of the Federal Reserve System, is supervised by the Indiana Department of Financial Institutions (DFI) and the Federal Reserve. As such, 1st Source Bank is regularly examined by and subject to regulations promulgated by the DFI and the Federal Reserve. First National, as a national bank, is supervised by the Office of the Comptroller of the Currency (OCC).  As such, First National is regularly examined by and subject to regulations promulgated by the OCC.  Because the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance to 1st Source Bank and First National, both are also subject to supervision and regulation by the FDIC (even though the FDIC is not their primary Federal regulator).
 
Bank Holding Company Act — Under the BHCA, as amended, our activities are limited to business so closely related to banking, managing, or controlling banks as to be a proper incident thereto. We are also subject to capital requirements applied on a consolidated basis in a form substantially similar to those required of the Banks. The BHCA also requires a bank holding company to obtain approval from the Federal Reserve before (i) acquiring, or holding more than 5% voting interest in any bank or bank holding company, (ii) acquiring all or substantially all of the assets of another bank or bank holding company, or (iii) merging or consolidating with another bank holding company.
 
The BHCA also restricts non-bank activities to those which, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or of managing or controlling banks. As discussed below, the Gramm-Leach-Bliley Act, which was enacted in 1999, established a new type of bank holding company known as a "financial holding company" that has powers that are not otherwise available to bank holding companies.
 
Financial Institutions Reform, Recovery and Enforcement Act of 1989 — The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) reorganized and reformed the regulatory structure applicable to financial institutions generally.
 
The Federal Deposit Insurance Corporation Improvement Act of 1991 — The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was adopted to supervise and regulate a wide variety of banking issues. In general, FDICIA provides for the recapitalization of the Bank Insurance Fund (BIF), deposit insurance reform, including the implementation of risk-based deposit insurance premiums, the establishment of five capital levels for financial institutions ("well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized") that would impose more scrutiny and restrictions on less capitalized institutions, along with a number of other supervisory and regulatory issues.  At December 31, 2007, the Banks were categorized as "well capitalized," meaning that their total risk-based capital ratio exceeded 10.00%, their Tier 1 risk-based capital ratio exceeded 6.00%, their leverage ratio exceeded 5.00%, and they were not subject to a regulatory order, agreement, or directive to meet and maintain a specific capital level for any capital measure.
 
Federal Deposit Insurance Reform Act — On February 1, 2006, Congress approved the Federal Deposit Insurance Reform Act of 2005 (FDIRA).  Among other things, the FDIRA provides for the merger of the Bank Insurance Fund with the Savings Association Insurance Fund and for an immediate increase in Federal deposit insurance for certain retirement accounts up to $250,000.  The statute further provides for the indexing of the maximum deposit insurance coverage for all types of deposit accounts in the future to account for inflation.  The FDIRA also requires the FDIC to provide certain banks and thrifts that were in existence prior to December 31, 1996 with one-time credits against future premiums based on the amount of their payments to the Bank Insurance Fund or Savings Association Insurance Fund prior to that date.
 
Securities and Exchange Commission (SEC) and The Nasdaq Stock Market (Nasdaq) — We are under the jurisdiction of the SEC and certain state securities commissions for matters relating to the offering and sale of our securities and our investment advisory services.  We are subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC.  We are listed on the Nasdaq Global Select Market under the trading symbol "SRCE," and we are subject to the rules of Nasdaq for listed companies.
 
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 — Congress enacted the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Interstate Act) in September 1994. Beginning in September 1995, bank holding companies have the right to expand, by acquiring existing banks, into all states, even those which had theretofore restricted entry. The legislation also provides that, subject to future action by individual states, a holding company has the right to convert the banks which it owns in different states to branches of a single bank. The states of Indiana and Michigan have adopted the interstate branching provisions of the Interstate Act.
 
Economic Growth and Regulatory Paperwork Reduction Act of 1996 — The Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA) was signed into law on September 30, 1996. Among other things, EGRPRA streamlined the non-banking activities application process for well-capitalized and well-managed bank holding companies.
 
Gramm-Leach-Bliley Act of 1999 — The Gramm-Leach-Bliley Act of 1999 (GLBA) is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry, and other financial service providers. It provides financial organizations with the flexibility of structuring such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations. The GLBA establishes a new type of bank holding company, known as a financial holding company, which may engage in an expanded list of activities that are "financial in nature," which include securities and insurance brokerage, securities underwriting, insurance underwriting, and merchant banking. The GLBA also sets forth a system of functional regulation that makes the Federal Reserve the "umbrella supervisor" for holding companies, while providing for the supervision of the holding company’s subsidiaries by other Federal and state agencies. A bank holding company may not become a financial holding company if any of its subsidiary financial institutions are not well-capitalized or well-managed. Further, each bank subsidiary of the holding company must have received at least a satisfactory Community Reinvestment Act (CRA) rating. The GLBA also expands the types of financial activities a national bank may conduct through a financial subsidiary, addresses state regulation of insurance, generally prohibits unitary thrift holding companies organized after May 4, 1999 from participating in new activities that are not financial in nature, provides privacy protection for nonpublic customer information of financial institutions, modernizes the Federal Home Loan Bank system, and makes miscellaneous regulatory improvements. The Federal Reserve and the Secretary of the Treasury must coordinate their supervision regarding approval of new financial activities to be conducted through a financial holding company or through a financial subsidiary of a bank. While the provisions of the GLBA regarding activities that may be conducted through a financial subsidiary directly apply only to national banks, those provisions indirectly apply to state-chartered banks. In addition, the Banks are subject to other provisions of the GLBA, including those relating to CRA and privacy, regardless of whether we elect to become a financial holding company or to conduct activities through a financial subsidiary.  We do not, however, currently intend to file notice with the Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary.
 
 
 
Financial Privacy — In accordance with the GLBA, Federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about customers to nonaffiliated third parties.  These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party.  The privacy provisions of the GLBA affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
 
USA Patriot Act of 2001 — The USA Patriot Act of 2001 (USA Patriot Act) was signed into law following the terrorist attacks of September 11, 2001.  The USA Patriot Act is comprehensive anti-terrorism legislation that, among other things, substantially broadened the scope of anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations on financial institutions.
 
The regulations adopted by the United States Treasury Department under the USA Patriot Act impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering, and terrorist financing.  Additionally, the regulations require that we, upon request from the appropriate Federal regulatory agency, provide records related to anti-money laundering, perform due diligence of private banking and correspondent accounts, establish standards for verifying customer identity, and perform other related duties.
 
Failure of a financial institution to comply with the USA Patriot Act's requirements could have serious legal and reputational consequences for the institution.
 
Regulations Governing Capital Adequacy — The Federal bank regulatory agencies use capital adequacy guidelines in their examination and regulation of bank holding companies and banks. If capital falls below the minimum levels established by these guidelines, a bank holding company or bank will be required to submit an acceptable plan for achieving compliance with the capital guidelines and will be subject to denial of applications and appropriate supervisory enforcement actions. The various regulatory capital requirements that we are subject to are disclosed in Part II, Item 8, Financial Statements and Supplementary Data — Note R of the Notes to Consolidated Financial Statements. Our management believes that the risk-weighting of assets and the risk-based capital guidelines do not have a material adverse impact on our operations or on the operations of the Banks.
 
Community Reinvestment Act — The Community Reinvestment Act of 1977 requires that, in connection with examinations of financial institutions within their jurisdiction, the Federal banking regulators must evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. Federal banking regulators are required to consider a financial institution's performance in these areas as they review applications filed by the institution to engage in mergers or acquisitions or to open a branch or facility.
 
Regulations Governing Extensions of Credit — 1st Source Bank and First National are subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to 1st Source or our subsidiaries, or investments in our securities and on the use of our securities as collateral for loans to any borrowers. These regulations and restrictions may limit our ability to obtain funds from the Banks for our cash needs, including funds for acquisitions and for payment of dividends, interest and operating expenses. Further, the BHCA, certain regulations of the Federal Reserve, state laws and many other Federal laws govern the extensions of credit and generally prohibit a bank from extending credit, engaging in a lease or sale of property, or furnishing services to a customer on the condition that the customer obtain additional services from the bank’s holding company or from one of its subsidiaries.
 
1st Source Bank and First National are also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders, or any related interest of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, and subject to credit underwriting procedures that are at least as stringent as those prevailing at the time for comparable transactions with non affiliates, and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. The Banks are also subject to certain lending limits and restrictions on overdrafts to such persons.
 
Reserve Requirements — The Federal Reserve requires all depository institutions to maintain reserves against their transaction account deposits. The Banks must maintain reserves of 3.00% against net transaction accounts greater than $8.50 million and less than $45.80 million (subject to adjustment by the Federal Reserve) and reserves of 10.00% must be maintained against that portion of net transaction accounts in excess of $45.80 million.
 
Dividends — The ability of the Banks to pay dividends is limited by state and Federal Regulations that require 1st Source Bank and First National to obtain the prior approval of the DFI or the OCC, respectively, before paying a dividend that, together with other dividends it has paid during a calendar year, would exceed the sum of its retained net income for the year to date combined with its retained net income for the previous two years. The amount of dividends the Banks may pay may also be limited by certain covenant agreements and by the principles of prudent bank management.
 
Monetary Policy and Economic Control — The commercial banking business in which we engage is affected not only by general economic conditions, but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowing, availability of borrowing at the "discount window," open market operations, the imposition of changes in reserve requirements against member banks deposits and assets of foreign branches, and the imposition of, and changes in, reserve requirements against certain borrowings by banks and their affiliates are some of the instruments of monetary policy available to the Federal Reserve. These monetary policies are used in varying combinations to influence overall growth and distributions of bank loans, investments, and deposits, and such use may affect interest rates charged on loans and leases or paid on deposits. The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks and are expected to do so in the future. The monetary policies of the Federal Reserve are influenced by various factors, including inflation, unemployment, short-term and long-term changes in the international trade balance, and in the fiscal policies of the U.S. Government. Future monetary policies and the effect of such policies on our future business and earnings, and the effect on the future business and earnings of the Banks cannot be predicted.
 
Sarbanes-Oxley Act of 2002 — On July 30, 2002, the Sarbanes-Oxley Act of 2002 (SOA) was signed into law.  The SOA's stated goals include enhancing corporate responsibility, increasing penalties for accounting and auditing improprieties at publicly traded companies and protecting investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.  The SOA generally applies to all companies that file or are required to file periodic reports with the SEC under the Securities Exchange Act of 1934 (Exchange Act.)
 
 
 
 
Among other things, the SOA creates the Public Company Accounting Oversight Board as an independent body subject to SEC supervision with responsibility for setting auditing, quality control, and ethical standards for auditors of public companies.  The SOA also requires public companies to make faster and more-extensive financial disclosures, requires the chief executive officer and the chief financial officer of public companies to provide signed certifications as to the accuracy and completeness of financial information filed with the SEC, and provides enhanced criminal and civil penalties for violations of the Federal securities laws.
 
The SOA also addresses functions and responsibilities of audit committees of public companies.  The statute, by mandating certain stock exchange listing rules, makes the audit committee directly responsible for the appointment, compensation, and oversight of the work of the company's outside auditor, and requires the auditor to report directly to the audit committee.  The SOA authorizes each audit committee to engage independent counsel and other advisors, and requires a public company to provide the appropriate funding, as determined by its audit committee, to pay the company's auditors and any advisors that its audit committee retains.  The SOA also requires public companies to prepare an internal control report and assessment by management, along with an attestation to this report prepared by the company's registered public accounting firm, in their annual reports to stockholders.
 
Pending Legislation — Because of concerns relating to competitiveness and the safety and soundness of the banking industry, Congress often considers a number of wide-ranging proposals for altering the structure, regulation, and competitive relationships of the nation’s financial institutions. We cannot predict whether or in what form any proposals will be adopted or the extent to which our business may be affected thereby.
 
ITEM 1A.  RISK FACTORS.
 

An investment in our common stock is subject to risks inherent to our business.  The material risks and uncertainties that we believe affect us are described below.  See “Forward Looking Statements” under Item 7 of this report for a discussion of other important factors that can affect our business.

Fluctuations in interest rates could reduce our profitability and affect the value of our assets — Like other financial institutions, we are subject to interest rate risk.  Our primary source of income is net interest income, which is the difference between interest earned on loans and leases and investments, and interest paid on deposits and borrowings.  We expect that we will periodically experience imbalances in the interest rate sensitivities of our assets and liabilities and the relationships of various interest rates to each other.  Over any defined period of time, our interest-earning assets may be more sensitive to changes in market interest rates than our interest-bearing liabilities, or vice-versa.  In addition, the individual market interest rates underlying our loan and lease and deposit products may not change to the same degree over a given time period.  In any event, if market interest rates should move contrary to our position, earnings may be negatively affected.  In addition, loan and lease volume and quality and deposit volume and mix can be affected by market interest rates as can the businesses of our clients.  Changes in levels of market interest rates could have a material adverse affect on our net interest spread, asset quality, origination volume, and overall profitability.
 
Market interest rates are beyond our control, and they fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies, in particular, the Federal Reserve Board.  Changes in monetary policy, including changes in interest rates, may negatively affect our ability to originate loans and leases, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately could affect our earnings.
 
Future expansion involves risks — In the future, we may acquire all or part of other financial institutions and we may establish de novo branch offices.  There could be considerable costs involved in executing our growth strategy.  For instance, new branches generally require a period of time to generate sufficient revenues to offset their costs, especially in areas in which we do not have an established presence.  Accordingly, any new branch expansion could be expected to negatively impact earnings for some period of time until the branch reaches certain economies of scale.   Acquisitions and mergers involve a number of risks, including the risk that:
·  
We may incur substantial costs identifying and evaluating potential acquisitions and merger partners, or in evaluating new markets, hiring experienced local managers, and opening new offices;
·  
Our estimates and judgments used to evaluate credit, operations, management, and market risks relating to target institutions may not be accurate;
·  
There may be substantial lag-time between completing an acquisition or opening a new office and generating sufficient assets and deposits to support costs of the expansion;
·  
We may not be able to finance an acquisition, or the financing we obtain may have an adverse effect on our operating results or dilution of our existing shareholders;
·  
The attention of our management in negotiating a transaction and integrating the operations and personnel of the combining businesses may be diverted from our existing business;
·  
Acquisitions typically involve the payment of a premium over book and market values and; therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future transaction;
·  
We may enter new markets where we lack local experience;
·  
We may incur goodwill in connection with an acquisition, or the goodwill we incur may become impaired, which results in adverse short-term effects on our operating results; or
·  
We may lose key employees and clients.

Competition from other financial services providers could adversely impact our results of operations — The banking and financial services business is highly competitive.  We face competition in making loans and leases, attracting deposits and providing insurance, investment, trust, and other financial services.  Increased competition in the banking and financial services businesses may reduce our market share, impair our growth or cause the prices we charge for our services to decline.  Our results of operations may be adversely impacted in future periods depending upon the level and nature of competition we encounter in our various market areas.
 
 

 
We are dependent upon the services of our management team — Our future success and profitability is substantially dependent upon our management and the banking abilities of our senior executives.  We believe that our future results will also depend in part upon our ability to attract and retain highly skilled and qualified management.  We are especially dependent on a limited number of key management personnel, many of whom do not have employment agreements with us.  The loss of the chief executive officer and other senior management and key personnel could have a material adverse impact on our operations because other officers may not have the experience and expertise to readily replace these individuals.  Many of these senior officers have primary contact with our clients and are important in maintaining personalized relationships with our client base.  The unexpected loss of services of one or more of these key employees could have a material adverse effect on our operations and possibly result in reduced revenues if we were unable to find suitable replacements promptly.  Competition for senior personnel is intense, and we may not be successful in attracting and retaining such personnel.  Changes in key personnel and their responsibilities may be disruptive to our businesses and could have a material adverse effect on our businesses, financial condition, and results of operations.

Technology security breaches could expose us to possible liability and damage our reputation — Any compromise of our security also could deter our clients from using our internet banking services that involve the transmission of confidential information.  We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data.  These precautions may not protect our systems from compromises or breaches of our security measures that could result in damage to our reputation and business.
 
We are subject to credit risks relating to our loan and lease portfolios — We have certain lending policies and procedures in place that are designed to optimize loan and lease income within an acceptable level of risk.  Our management reviews and approves these policies and procedures on a regular basis.  A reporting system supplements the review process by providing our management with frequent reports related to loan and lease production, loan quality, concentrations of credit, loan and lease delinquencies, and nonperforming and potential problem loans and leases.  Diversification in the loan and lease portfolios is a means of managing risk associated with fluctuations and economic conditions.
 
We maintain an independent loan review department that reviews and validates the credit risk program on a periodic basis.  Results of these reviews are presented to our management.  The loan and lease review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as our policies and procedures.
 
In the financial services industry, there is always a risk that certain borrowers may not repay borrowings. Our reserve for loan and lease losses may not be sufficient to cover the loan and lease losses that we may actually incur. If we experience defaults by borrowers in any of our businesses, our earnings could be negatively affected. Changes in local economic conditions could adversely affect credit quality, particularly in our local business loan and lease portfolio.  Changes in national economic conditions could also adversely affect the quality of our loan and lease portfolio and negate, to some extent, the benefits of national diversification through our Specialty Finance Group’s portfolio.
 
Commercial and commercial real estate loans generally involve higher credit risks than residential real estate and consumer loans. Because payments on loans secured by commercial real estate or equipment are often dependent upon the successful operation and management of the underlying assets, repayment of such loans may be influenced to a great extent by conditions in the market or the economy.   We seek to minimize these risks through our underwriting standards.  We obtain financial information and perform credit risk analysis on our customers. Credit criteria may include, but are not limited to, assessments of income, cash flows, and net worth; asset ownership; bank and trade credit reference; credit bureau report; and operational history.
 
Commercial real estate or equipment loans are underwritten after evaluating and understanding the borrower's ability to operate profitably and generate positive cash flows.  Our management examines current and projected cash flows of the borrower to determine the ability of the borrower to repay their obligations as agreed.  Underwriting standards are designed to promote relationship banking rather than transactional banking.  Most commercial and industrial loans are secured by the assets being financed or other business assets; however, some loans may be made on an unsecured basis.   Our credit policy sets different maximum exposure limits both by business sector and our current and historical relationship and previous experience with each customer.
 
We offer both fixed-rate and adjustable-rate consumer mortgage loans secured by properties, substantially all of which are located in our primary market area. Adjustable-rate mortgage loans help reduce our exposure to changes in interest rates; however, during periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase as a result of repricing and the increased payments required from the borrower.  Additionally, most residential mortgages are sold into the secondary market and serviced by our principal banking subsidiary, 1st Source Bank.
 
Consumer loans are primarily all other non-real estate loans to individuals in our regional market area.  Consumer loans can entail risk, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets. In these cases, any repossessed collateral may not provide an adequate source of repayment of the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy.
 
The 1st Source Specialty Finance Group loan and lease portfolio consists of commercial loans and leases secured by construction and transportation equipment, including aircraft, autos, trucks, and vans.  Finance receivables for this Group generally provide for monthly payments and may include prepayment penalty provisions.
 
Our construction and transportation related businesses could be adversely affected by slow downs in the economy. Clients who rely on the use of assets financed through the Specialty Finance Group to produce income could be negatively affected, and we could experience substantial loan and lease losses. By the nature of the businesses these clients operate in, we could be adversely affected by continued rapid increases of fuel costs.  Since some of the relationships in these industries are large (up to $25 million), a slow down could have a significant adverse impact on our performance.
 
Our construction and transportation related businesses could be adversely impacted by the negative effects caused by high fuel costs, terrorist attacks, potential attacks, and other destabilizing events.  These factors could contribute to the deterioration of the quality of our loan and lease portfolio, as they could have a negative impact on the travel sensitive businesses for which our specialty finance businesses provide financing.
 
In addition, our leasing and equipment financing activity is subject to the risk of cyclical downturns, industry concentration and clumping, and other adverse economic developments affecting these industries and markets. This area of lending, with transportation in particular, is dependent upon general economic conditions and the strength of the travel, construction, and transportation industries.

 
 
ITEM 1B. UNRESOLVED STAFF COMMENTS.
 
None
 
ITEM 2.  PROPERTIES.
 
Our headquarters building is located in downtown South Bend. In 1982, the land was leased from the City of South Bend on a 49-year lease, with a 50-year renewal option. The building is part of a larger complex, including a 300-room hotel and a 500-car parking garage. Also, in 1982, we sold the building and entered into a leaseback agreement with the purchaser for a term of 30 years. The building is a structure of approximately 160,000 square feet, with 1st Source and our subsidiaries occupying approximately 70% of the available office space and approximately 30% subleased to unrelated tenants.
 
At December 31, 2007, we also owned property and/or buildings on which 61 of the 1st Source Bank's and First National's 83 banking centers were located, including the facilities in Allen, Elkhart, Fulton, Huntington, Kosciusko, LaPorte, Marshall, Porter, St. Joseph, Starke, and Wells Counties in the State of Indiana and Berrien and Cass Counties in the State of Michigan, as well as an operations center, training facility, warehouse, and our former headquarters building, which is utilized for additional business operations.  The Banks lease additional property and/or buildings to and from third parties under lease agreements negotiated at arms-length.
 
ITEM 3.  LEGAL PROCEEDINGS.
 
1st Source and our subsidiaries are involved in various legal proceedings incidental to the conduct of our businesses. Our management does not expect that the outcome of any such proceedings will have a material adverse effect on our consolidated financial position or results of operations.
 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None
 
PART II

ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES.
 
Our common stock is traded on the Nasdaq Global Select Market under the symbol "SRCE."  The following table sets forth for each quarter the high and low sales prices for our common stock, as reported by Nasdaq, and the cash dividends paid per share for each quarter.
 

   
2007 Sales Price
 
Cash Dividends
 
2006 Sales Price
 
Cash Dividends
Common Stock Prices  (quarter ended)
 
High
 
Low
 
Paid
 
High
 
Low
 
Paid
March 31
$
32.62
$
24.27
$
.140
$
27.26
$
22.64
$
.127
June 30
 
27.92
 
23.32
 
.140
 
30.81
 
24.68
 
.127
September 30
 
27.00
 
18.41
 
.140
 
31.33
 
28.46
 
.140
December 31
 
24.47
 
16.28
 
.140
 
33.46
 
29.08
 
.140
As of December 31, 2007, there were 1,048 holders of record of 1st Source common stock
               

COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN*
 
Among 1st Source, Hemscott Market Weighted NASDAQ Index** and Peer Group Index***
 

Performance Graph
 
 
  *  Assumes $100 invested on December 31, 2002, in 1st Source Corporation common stock, Hemscott Market Weighted NASDAQ index, and peer group index.
 
 **  The Hemscott Market Weighted NASDAQ Index Return is calculated using all companies which trade as NASD Capital Markets, NASD Global Markets or NASD Global Select. It includes both domestic and foreign companies. The index is weighted by the then current shares outstanding and assumes dividends reinvested. The return is calculated on a monthly basis.
 
***   The peer group is a market-capitalization-weighted stock index of 61 banking companies in Indiana, Michigan, Ohio, and Wisconsin.
 
NOTE:  Total return assumes reinvestment of dividends.
 
 
 
The following table summarizes our share repurchase activity during the three months ended December 31, 2007.

 
       
Total Number of
Maximum Number (or Approximate
       
Shares Purchased as
Dollar Value) of Shares that
 
Total Number of
 
Average Price
Part of Publicly Announced
 may yet be Purchased Under
Period
Shares Purchased
 
Paid Per Share
Plans or Programs*
the Plans or Programs
October 01 - 31, 2007
4,225
 $
18.55
4,225
1,524,096
November 01 - 30, 2007
76,648
 
18.73
76,648
1,447,448
December 01 - 31, 2007
-
 
-
-
1,447,448
*1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on April 26, 2007. Under the terms of the plan, 1st Source may repurchase up to
2,000,000 shares of its common stock when favorable conditions exist on the open market or through private transactions at various prices from time to time. Since the inception
of the plan, 1st Source has repurchased a total of 552,552 shares.
 
 
 
Federal laws and regulations contain restrictions on the ability of 1st Source and the Banks to pay dividends.  For information regarding restrictions on dividends, see Part I, Item 1, Business - Regulation and Supervision - Dividends and Part II, Item 8, Financial Statements and Supplementary Data - Note R of the Notes to Consolidated Financial Statements.
 
ITEM 6.  SELECTED FINANCIAL DATA.
 
The following selected financial data should be read in conjunction with our Consolidated Financial Statements and the accompanying notes presented elsewhere herein.
 

                             
(Dollars in thousands, except per share amounts)
 
       2007 (2)
   
2006
   
2005
   
2004
   
2003
 
  $ 253,587     $ 208,994     $ 168,532     $ 151,437     $ 162,322  
Interest expense
    134,677       102,561       70,104       52,749       59,070  
Net interest income
    118,910       106,433       98,428       98,688       103,252  
Provision for (recovery of) loan and lease losses
    7,534       (2,736 )     (5,855 )     229       17,361  
Net interest income after provision for (recovery of)
                                       
loan and lease losses
    111,376       109,169       104,283       98,459       85,891  
Noninterest income
    70,619       76,585       68,533       62,733       80,196  
Noninterest expense
    140,312       126,211       123,439       127,091       138,904  
Income before income taxes
    41,683       59,543       49,377       34,101       27,183  
Income taxes
    11,144       20,246       15,626       9,136       8,029  
Net income
  $ 30,539     $ 39,297     $ 33,751     $ 24,965     $ 19,154  
Assets at year-end
  $ 4,447,104     $ 3,807,315     $ 3,511,277     $ 3,563,715     $ 3,330,153  
Long-term debt and mandatorily redeemable
                                       
securities at year-end
    34,702       43,761       23,237       17,964       22,802  
Shareholders’ equity at year-end
    430,504       368,904       345,576       326,600       314,691  
Basic net income per common share (1)
    1.30       1.74       1.48       1.10       0.83  
Diluted net income per common share (1)
    1.28       1.72       1.46       1.08       0.82  
Cash dividends per common share (1)
    .560       .534       .445       .382       .336  
Dividend payout ratio
    43.75 %     31.05 %     30.48 %     35.37 %     40.98 %
Return on average assets
    0.74 %     1.11 %     1.00 %     0.75 %     0.59 %
Return on average common equity
    7.47 %     10.98 %     10.12 %     7.81 %     6.12 %
Average common equity to average assets
    9.85 %     10.07 %     9.89 %     9.55 %     9.60 %
                                         
(1) The computation of per common share data gives retroactive recognition to a 10% stock dividend declared July 27, 2006.
                 
(2) Results for 2007 include the acquisition of FINA Bancorp, Inc. Refer to Note C of the Notes to Consolidated Financial Statements for further details.               


ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.

The purpose of this analysis is to provide the reader with information relevant to understanding and assessing our results of operations for each of the past three years and financial condition for each of the past two years. In order to fully appreciate this analysis the reader is encouraged to review the consolidated financial statements and statistical data presented in this document.
 
FORWARD-LOOKING STATEMENTS

This report, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements.  Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.
 
 

 
All statements other than statements of historical fact are statements that could be forward-looking statements.  Words such as “believe”, “contemplate”, “seek”, “estimate”, “plan”, “project”, “anticipate”, “assume”, “expect”, “intend”, “targeted”, “continue”, “remain”, “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.  Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date.  The forward-looking statements are based on our expectations and are subject to a number of risks and uncertainties.

All written or oral forward-looking statements that are made by or attributable to us are expressly qualified in their entirety by this cautionary notice.  We have no obligation and do not undertake to update, revise, or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.  We have expressed our expectations, beliefs, and projections in good faith and we believe they have a reasonable basis.  However, we make no assurances that our expectations, beliefs, or projections will be achieved or accomplished.  These forward-looking statements may not be realized due to a variety of factors, including, without limitation, the following:

·  
Local, regional, national, and international economic conditions and the impact they may have on us and our clients and our assessment of that impact.
·  
Changes in the level of nonperforming assets and charge-offs.
·  
Changes in estimates of future cash reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.
·  
The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board.
·  
Inflation, interest rate, securities market, and monetary fluctuations.
·  
Political instability.
·  
Acts of war or terrorism.
·  
Substantial increases in the cost of fuel.
·  
The timely development and acceptance of new products and services and perceived overall value of these products and services by others.
·  
Changes in consumer spending, borrowings, and savings habits.
·  
Changes in the financial performance and/or condition of our borrowers.
·  
Technological changes.
·  
Acquisitions and integration of acquired businesses.
·  
The ability to increase market share and control expenses.
·  
Changes in the competitive environment among bank holding companies.
·  
The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, and insurance) with which we and our subsidiaries must comply.
·  
The effect of changes in accounting policies and practices and auditing requirements, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board, and other accounting standard setters.
·  
Changes in our organization, compensation, and benefit plans.
·  
The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquires and the results of regulatory examinations or reviews.
·  
Greater than expected costs or difficulties related to the integration of new products and lines of business.
·  
Our success at managing the risks described in Item 1A. Risk Factors.
 
 
CRITICAL ACCOUNTING POLICIES
 
Our consolidated financial statements are prepared in accordance with U. S. generally accepted accounting principles and follow general practices within the industries in which we operate. Application of these principles requires our management to make estimates or judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates or judgments reflect our management’s view of the most appropriate manner in which to record and report our overall financial performance. Because these estimates or judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experience. As such, changes in these estimates, judgments, and/or assumptions may have a significant impact on our financial statements. All accounting policies are important, and all policies described in Part II, Item 8, Financial Statements and Supplementary Data, Note A (Note A), should be reviewed for a greater understanding of how our financial performance is recorded and reported.
 
We have identified three policies as being critical because they require our management to make particularly difficult, subjective, and/or complex estimates or judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the determination of the reserve for loan and lease losses, the valuation of mortgage servicing rights, and the valuation of securities. Our management has used the best information available to make the estimations or judgments necessary to value the related assets and liabilities. Actual performance that differs from estimates or judgments and future changes in the key variables could change future valuations and impact net income. Our management has reviewed the application of these policies with the Audit Committee of the Board of Directors. A brief discussion of our critical accounting policies appears below.
 
Reserve for Loan and Lease Losses — The reserve for loan and lease losses represents our management’s estimate of probable losses inherent in the loan and lease portfolio and the establishment of a reserve that is sufficient to absorb those losses.  In determining an adequate reserve, our management makes numerous judgments, assumptions, and estimates based on continuous review of the loan and lease portfolio, estimates of future client performance, collateral values, and disposition, as well as historical loss rates and expected cash flows. In assessing these factors, our management benefits from a lengthy organizational history and experience with credit decisions and related outcomes. Nonetheless, if our management’s underlying assumptions prove to be inaccurate, the reserve for loan and lease losses would have to be adjusted. Our accounting policy related to the reserve is disclosed in Note A under the heading "Reserve for Loan and Lease Losses."
 
Mortgage Servicing Rights Valuation — We recognize as assets the rights to service mortgage loans for others, known as mortgage servicing rights whether the servicing rights are acquired through purchases or through originated loans. Mortgage servicing rights do not trade in an active open market with readily observable market prices. Although sales of mortgage servicing rights do occur, the precise terms and conditions may not be readily available. As such, the value of mortgage servicing assets are established and valued using discounted cash flow modeling techniques which require management to make estimates regarding estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. The expected rates of mortgage loan prepayments is the most significant factor driving the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced. In determining the fair value of the mortgage servicing assets, mortgage interest rates (which are used to determine prepayment rates), and discount rates are held constant over the estimated life of the portfolio. Expected mortgage loan prepayment rates are derived from a third-party model and adjusted to reflect our actual prepayment experience. Mortgage servicing assets are carried at the lower of the initial capitalized amount, net of accumulated amortization or fair value. The values of these assets are sensitive to changes in the assumptions used and readily available market pricing does not exist. The valuation of mortgage servicing assets is discussed further in Note A under the heading "Mortgage Banking Activities."
 
 
 
 
Valuation of Securities — Our available-for-sale security portfolio is reported at fair value.  The fair value of a security is determined based on quoted market prices.  If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments.  Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment.  The review includes an analysis of the facts and circumstances of each individual investment such as length of time the fair value has been below cost, the expectation for that security's performance, the credit worthiness of the issuer, and our intent and ability to hold the security for a time necessary to recover the amortized cost.  A decline in value that is considered to be other-than-temporary is recorded as investment securities and other investment losses in the Consolidated Statements of Income.   The valuation of securities is discussed further in Note A under the heading "Securities."
 
EARNINGS SUMMARY
 
Net income in 2007 was $30.54 million, down from $39.30 million in 2006 and from $33.75 million in 2005. We declared a 10% stock dividend on July 27, 2006; therefore, all share and per share information has been adjusted accordingly.  Diluted net income per common share was $1.28 in 2007, $1.72 in 2006, and $1.46 in 2005.  Return on average total assets was 0.74% in 2007 compared to 1.11% in 2006, and 1.00% in 2005.  Return on average common shareholders' equity was 7.47% in 2007 versus 10.98% in 2006, and 10.12% in 2005.
 
Net income in 2007 was favorably affected by an 11.72% increase in net interest income over 2006.  However, this increase was more than offset by an increase in the provision for loan and lease losses, decreased mortgage banking income, investment securities impairment and increased noninterest expenses.  Net income in 2006 was favorably affected by a strong increase in noninterest income that was primarily related to solid progress in growing our leased equipment portfolio during the year and positive market valuation adjustments related to our investments in venture partnerships.  In addition, net interest income improved 8.13% for 2006 over 2005.  The improvement in net interest income was driven primarily by an increase in average earning assets; however, the higher cost of deposits greatly offset the increase in average earning assets.  Noninterest expense increased moderately in 2006 as compared to 2005
 
Dividends paid on common stock in 2007 amounted to $0.560 per share, compared to $0.534 per share in 2006, and $0.445 per share in 2005.  The level of earnings reinvested and dividend payouts are based on management’s assessment of future growth opportunities and the level of capital necessary to support them.
 
Acquisition of First National Bank, Valparaiso - On May 31, 2007, we acquired FINA Bancorp (FINA), the parent company of First National Bank, Valparaiso for $134.19 million.  First National is a full service bank with 16 banking facilities, as of December 31, 2007, located in Porter and LaPorte Counties of Indiana.  Pursuant to the definitive agreement, FINA shareholders were able to choose whether to receive 1st Source common stock and/or cash pursuant to the election procedures described in the definitive agreement.   Under the terms of the transaction, FINA was acquired in exchange for 2,124,974 shares of 1st Source common stock valued at $53.68 million and $80.51 million in cash.  The value of the common stock was $25.26 per share.  We believe that the purchase of FINA is a natural extension of our service area and is consistent with our growth and market expansion initiatives.
 
Upgrade of Core Systems — During 2007, we upgraded a majority of our core and ancillary data processing systems.  Numerous internal teams were formed to manage the installation and conversion of data and various systems.  The core technology includes a loan system, deposit system, general ledger system, and customer information file system.  Additionally, ATM networks, a voice response unit (VRU) system, and document imaging systems were installed.  Total 2007 expenses for this upgrade were $2.71 million.  We continue to work on increasing the effectiveness and efficiency of our operations since the completion of the core system upgrade.
 
Net Interest Income — Our primary source of earnings is net interest income, the difference between income on earning assets and the cost of funds supporting those assets.  Significant categories of earning assets are loans and securities while deposits and borrowings represent the major portion of interest-bearing liabilities.  For purposes of the following discussion, comparison of net interest income is done on a tax equivalent basis, which provides a common basis for comparing yields on earning assets exempt from federal income taxes to those which are fully taxable.
 
Net interest margin (the ratio of net interest income to average earning assets) is affected by movements in interest rates and changes in the mix of earning assets and the liabilities that fund those assets. Net interest margin on a fully taxable equivalent basis was 3.18% in 2007 compared to 3.29% in 2006, and 3.21% in 2005.  The lower margin in 2007 reflects higher funding costs, narrower spreads on loans, and lower levels of demand deposits.
 
Net interest income was $118.91 million for 2007, compared to $106.43 million for 2006.  Tax-equivalent net interest income totaled $122.53 million for 2007, an increase of $13.55 million from the $108.98 million reported for 2006.  The $13.55 million increase is due to increased volume of earning assets.
 
 
 
During 2007, average earning assets increased $537.63 million while average interest-bearing liabilities increased $534.67 million over the comparable period.  The yield on average earning assets increased 30 basis points to 6.68% for 2007 from 6.38% for 2006.  The rate earned on assets was positively impacted by a change in the mix of earning assets, with a 16.61% increase in average loans outstanding.  Total cost of average interest-bearing liabilities increased 37 basis points during 2007 as liabilities continued to reprice to current market rates.  The result was a decrease of seven basis points to net interest spread, or the difference between interest income on earning assets and expense on interest-bearing liabilities.
 
The largest contributor to the increase in the yield on average earning assets in 2007, on a volume-weighted basis, was the $426.32 million increase in net loans and leases.  The acquisition of First National accounted for $143.59 million of this increase.  The loan and lease portfolio contributed approximately $36.60 million to the change in interest income, while the portfolio's average yield increased 24 basis points from the prior year to 7.18%.
 
During 2007, the tax-equivalent yield on securities available for sale increased 65 basis points to 4.88% while the average balance increased $105.68 million.  The majority of the increase in the portfolio was due to the acquisition of First National.
 
Average interest-bearing deposits increased $500.41 million during 2007 while the effective rate paid on those deposits increased 42 basis points.  The increase in the average cost of interest-bearing deposits was primarily the result of the acquisition of First National and the timing of deposit product rate repricing and increased competition for deposits across all markets.  Average demand deposits decreased $1.15 million during 2007.
 
Average short-term borrowings increased $5.55 million during 2007; however, the effective rate paid decreased 11 basis points.  Average subordinated notes which represent our trust preferred borrowings increased $23.39 million during 2007, to fund our acquisition of First National, while the effective rate increased two basis points.  Average long-term debt increased $5.31 million during 2007 as the effective rate increased 25 basis points.
 
The following table provides an analysis of net interest income and illustrates interest income earned and interest expense charged for each major component of interest earning assets and the interest bearing liabilities.  Yields/rates are computed on a tax-equivalent basis, using a 35% rate.  Nonaccrual loans and leases are included in the average loan and lease balance outstanding.
 

         
2007
               
2006
               
2005
       
         
Interest
               
Interest
               
Interest
       
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
(Dollars in thousands)
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
ASSETS
                                                     
Investment securities:
                                                     
Taxable
  $ 523,931     $ 25,770       4.92 %   $ 470,447     $ 19,816       4.21 %   $ 515,992     $ 14,777       2.86 %
Tax-exempt
    225,849       10,800       4.78       173,652       7,416       4.27       186,614       7,682       4.12  
Mortgages held for sale
    28,913       1,892       6.54       53,034       3,549       6.69       82,174       4,779       5.82  
Net loans and leases
    2,992,540       214,725       7.18       2,566,217       178,125       6.94       2,348,690       143,295       6.10  
Other investments
    81,496       4,023       4.94       51,754       2632       5.09       18,765       666       3.55  
Total earning assets
    3,852,729       257,210       6.68       3,315,104       211,538       6.38       3,152,235       171,199       5.43  
Cash and due from banks
    82,451                       78,365                       84,517                  
Reserve for loan and
                                                                       
lease losses
    (61,555 )                     (59,082 )                     (61,072 )                
Other assets
    277,684                       217,914                       197,457                  
Total assets
  $ 4,151,309                     $ 3,552,301                     $ 3,373,137                  
LIABILITIES AND
                                                                       
SHAREHOLDERS’ EQUITY
                                                                       
Interest bearing deposits
  $ 2,918,756     $ 115,113       3.94 %   $ 2,418,344     $ 85,067       3.52 %   $ 2,217,923     $ 56,341       2.54 %
Short-term borrowings
    271,377       10,935       4.03       265,824       11,011       4.14       295,271       8,628       2.92  
Subordinated notes
    82,414       6,051       7.34       59,022       4,320       7.32       59,022       4,008       6.79  
Long-term debt and
                                                                       
mandatorily redeemable
                                                                       
securities
    42,265       2,578       6.10       36,952       2,163       5.85       18,270       1,127       6.17  
Total interest bearing liabilities
    3,314,812       134,677       4.06       2,780,142       102,561       3.69       2,590,486       70,104       2.71  
Noninterest bearing deposits
    351,050                       352,204                       392,475                  
Other liabilities
    76,472                       62,196                       56,553                  
Shareholders' equity
    408,975                       357,759                       333,623                  
Total liabilities and
                                                                       
shareholders’ equity
  $ 4,151,309                     $ 3,552,301                     $ 3,373,137                  
Net interest income
          $ 122,533                     $ 108,977                     $ 101,095          
Net interest margin on a tax
                                                                       
equivalent basis
                    3.18 %                     3.29 %                     3.21 %
 


 
The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.  The following table shows changes in tax equivalent interest earned and interest paid, resulting from changes in volume and changes in rates:
 
 
   
Increase (Decrease) due to
       
(Dollars in thousands)
 
Volume
   
Rate
   
Net
 
2007 compared to 2006
                 
Interest earned on:
                 
Investment securities:
                 
Taxable
  $ 2,386     $ 3,568     $ 5,954  
Tax-exempt
    2,422       962       3,384  
Mortgages held for sale
    (1,579 )     (78 )     (1,657 )
Net loans and leases
    30,264       6,336       36,600  
Other investments
    1,467       (76 )     1,391  
Total earning assets
  $ 34,960     $ 10,712     $ 45,672  
Interest paid on:
                       
Interest bearing deposits
  $ 19,125     $ 10,921     $ 30,046  
Short-term borrowings
    241       (317 )     (76 )
Subordinated notes
    1,719       12       1,731  
Long-term debt and mandatorily redeemable securities
    320       95       415  
Total interest bearing liabilities
  $ 21,405     $ 10,711     $ 32,116  
Net interest income
  $ 13,555     $ 1     $ 13,556  
2006 compared to 2005
                       
Interest earned on:
                       
Investment securities:
                       
Taxable
  $ (1,169 )   $ 6,208     $ 5,039  
Tax-exempt
    (568 )     302       (266 )
Mortgages held for sale
    (2,143 )     913       (1,230 )
Net loans and leases
    14,009       20,821       34,830  
Other investments
    1,576       390       1,966  
Total earning assets
  $ 11,705     $ 28,634     $ 40,339  
Interest paid on:
                       
Interest bearing deposits
  $ 5,395     $ 23,331     $ 28,726  
Short-term borrowings
    (747 )     3,130       2,383  
Subordinated notes
    -       312       312  
Long-term debt and mandatorily redeemable securities
    1,091       (55 )     1,036  
Total interest bearing liabilities
  $ 5,739     $ 26,718     $ 32,457  
Net interest income
  $ 5,966     $ 1,916     $ 7,882  

Noninterest Income — Noninterest income decreased 7.79% in 2007 from 2006 following an 11.75% increase in 2006 over 2005.  Noninterest income for the most recent three years ended December 31 was as follows:
 
(Dollars in thousands)
 
2007
   
2006
   
2005
 
Noninterest income:
                 
Trust fees
  $ 15,567     $ 13,806     $ 12,877  
Service charges on deposit accounts
    20,470       19,040       17,775  
Mortgage banking income
    2,868       11,637       10,868  
Insurance commissions
    4,666       4,574       4,133  
Equipment rental income
    21,312       18,972       16,067  
Other income
    8,864       6,554       6,463  
Investment securities and other investment (losses) gains
    (3,128 )     2,002       350  
Total noninterest income
  $ 70,619     $ 76,585     $ 68,533  
 
Trust fees (which includes investment management fees, estate administration fees, mutual fund fees, annuity fees, and fiduciary fees) increased by 12.76% in 2007 from 2006 compared to an increase of 7.21% in 2006 over 2005. Trust fees are largely based on the size of client relationships and the market value and mix of assets under management.  The market value of trust assets under management at December 31, 2007 and 2006, was $3.05 billion and $2.98 billion, respectively.  At December 31, 2007, these trust assets were comprised of $1.66 billion of personal and agency trusts, $0.84 billion of employee benefit plan assets, $386.34 million of estate administration assets, and $168.31 million of custody assets.  Growth in trust fees was mainly attributed to an increase in assets under management coupled with a stronger stock and bond market in 2007.
 
 
 
Service charges on deposit accounts increased 7.51% in 2007 from 2006 compared to an increase of 7.12% in 2006 from 2005.  The growth in service charges on deposit accounts reflects growth in the number of deposit accounts and a higher volume of fee generating transactions, primarily overdrafts, debit card and nonsufficient funds transactions.
 
Mortgage banking income decreased 75.35% in 2007 over 2006, compared to an increase of 7.08% in 2006 from 2005.  The decrease in 2007 was primarily due to a decline in production volume, non-recurring 2006 gains on the sale of mortgage servicing rights and a decline in loan servicing fee income.  In 2006, we recognized $4.75 million in pre-tax gains on bulk sales of mortgage servicing rights related to both governmental and conventional loans that occurred during the second and third quarters.  During 2007 and 2006, we determined that no permanent write-down was necessary for previously recorded impairment on mortgage servicing assets.
 
Insurance commissions were up 2.01% in 2007 from 2006 compared to an increase of 10.67% in 2006 from 2005. The increase for 2007 was mainly attributed to an acquisition of an insurance agency in the Fort Wayne area.  The increase for 2006 was mainly attributed to higher contingent commissions.
 
Equipment rental income generated from operating leases grew by 12.33% during 2007 from 2006 compared to an increase of 18.08% in 2006 from 2005.  Revenues from operating leases for construction equipment, various trucks, and other equipment increased as clients responded positively to our strong marketing efforts and entered into new lease agreements over the course of 2007 and 2006.
 
Investment securities and other investment losses totaled $3.13 million for the year ended 2007 compared to gains of $2.00 million for the year ended 2006.  In 2007, we took $4.11 million in impairment charges on investments in the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) preferred stock.  Late 2007 capital restructuring at the FNMA and the FHLMC and the impact of developments in the residential mortgage business resulted in impairment of these securities.  Due to the uncertainty of future market conditions and how they might impact the financial performance of the FNMA and the FHLMC, we were unable to determine when or if this impairment will be recovered.  Favorable market valuation adjustments on our venture partnership investments during 2006 were the main factor contributing to the 2006 gains.  In 2005, investment securities and other investment gains totaled $0.35 million as the result of gains on venture capital investments that were partially offset by other-than-temporary impairment of $0.61 million.
 
Other income increased 35.25% in 2007 from 2006 after remaining relatively unchanged in 2006 as compared to 2005.  The increase in 2007 was primarily due to increases in interest rate swap fee income, credit card merchant fees, and income on bank owned life insurance policies.
 
Noninterest Expense — Noninterest expense increased 11.17% in 2007 over 2006 following a 2.25% increase in 2006 from 2005.  Noninterest expense for the recent three years ended December 31 was as follows:
 
(Dollars in thousands)
 
2007
   
2006
   
2005
 
Noninterest expense:
                 
Salaries and employee benefits
  $ 73,944     $ 66,605     $ 69,767  
Net occupancy expense
    9,030       7,492       7,749  
Furniture and equipment expense
    15,145       12,316       11,418  
Depreciation — leased equipment
    17,085       14,958       12,895  
Professional fees
    4,575       3,998       3,362  
Supplies and communications
    5,987       5,496       5,462  
Business development and marketing expense
    4,788       4,008       3,630  
Intangible asset amortization
    874       1,910       2,663  
Loan and lease collection and repossession expense (income)
    1,123       704       (1,094 )
Other expense
    7,761       8,724       7,587  
Total noninterest expense
  $ 140,312     $ 126,211     $ 123,439  

Total salaries and employee benefits increased 11.02% in 2007 from 2006, following a 4.53% decrease in 2006 from 2005.
 
Employee salaries increased 13.25% in 2007 from 2006 compared to a decrease of 5.56% in 2006 from 2005.  The increase in 2007 is mainly attributable to a larger work force following the acquisition of First National and lower 2006 salaries due to the first quarter 2006 reversal of previously recognized stock-based compensation expense under historical accounting methods related to the estimated forfeiture of stock awards.  This one-time expense reversal, combined with the adoption of Statement of Financial Accounting Standards No. 123(R), Share-based Payment, (SFAS No. 123(R)) estimated forfeiture accounting requirements, resulted in a reduction in stock-based compensation of $2.07 million, pre-tax, for the 2006 year.
 
Employee benefits remained relatively stable in 2007 and 2006.  We were able to contain employee benefit costs during 2007 and 2006 by maintaining our group insurance costs close to 2005 levels.
 
Occupancy expense increased 20.53% in 2007 from 2006, compared to a 3.32% decrease in 2006 from 2005.  The increase in 2007 was primarily due to the increase in number of locations following the acquisition of First National.  The decrease in 2006 was primarily driven by lower depreciation expense than that experienced in 2005.
 
Furniture and equipment expense, including depreciation, increased in 2007 over 2006 by 22.97%, compared to a 7.86% increase in 2006 from 2005.  Higher software costs which were mostly related to implementation of upgrades to our core accounting and management systems, and higher debit card transaction expense were the significant factors contributing to the increased costs in 2007 and in 2006.
 
Depreciation on equipment owned under operating leases increased 14.22% in 2007 from 2006, following a 16.00% increase in 2006 from 2005.  In 2007 and in 2006, depreciation on equipment owned under operating leases increased in conjunction with the increase in equipment rental income as some of our clients opted to enter into new lease arrangements rather than purchase equipment.
 
 
 
Professional fees increased 14.43% in 2007 from 2006, compared to an 18.92% increase in 2006 from 2005.  The majority of the increase in 2007 was due to higher consulting fees paid in conjunction with our core system upgrade.  The majority of the increase in 2006 was due to higher legal fees and audit and examination fees which were mainly incurred in the normal course of business.
 
Supplies and communications expense increase 8.93% in 2007 from 2006 after remaining relatively unchanged in 2006 as compared to 2005.  The increase in 2007 was due to increased telephone and data line expense and increased freight expense.
 
Business development and marketing expense increased 19.46% in 2007 from 2006 compared to a 10.41% increase in 2006 from 2005.  The increase in 2007 was mainly due to strong marketing across our entire footprint area. The increase in 2006 was mainly due to robust marketing related to the opening of new branches and expansion of our business into the Kalamazoo area.
 
Intangible asset amortization decreased 54.24% in 2007 from 2006 compared to a 28.28% decrease in 2006 from 2005.   The decrease in intangible asset amortization for 2007 and 2006 was primarily due to the effects of the complete amortization of assets associated with acquisitions which occurred during 2001.
 
Loan and lease collection and repossession expenses increased 59.52% in 2007 from 2006 compared to a 164.35% in 2006 from 2005.  The increase in 2007 was mainly due to increased collection and repossession activity.  The increase in 2006 was mainly due to lower gains than in 2005 on the disposition of repossessed assets as we continued to dispose of our inventory of repossessed assets.
 
Other expenses decreased 11.04% in 2007 as compared to 2006 following an increase of 14.99% in 2006 from 2005.  2006 other expenses were higher largely due to losses related to an employee defalcation and expenses related to employee training and education and relocation.
 
Income Taxes — 1st Source recognized income tax expense in 2007 of $11.14 million, compared to $20.25 million in 2006, and $15.63 million in 2005. The effective tax rate in 2007 was 26.74% compared to 34.00% in 2006, and 31.65% in 2005.  The effective tax rate decreased in 2007 due to an increase in tax-exempt interest in relation to taxable income.  For detailed analysis of 1st Source’s income taxes see Part II, Item 8, Financial Statements and Supplementary Data — Note O of the Notes to Consolidated Financial Statements.
 
FINANCIAL CONDITION
 
Loan and Lease Portfolio — The following table shows 1st Source’s loan and lease distribution at the end of each of the last five years as of December 31:
 

(Dollars in thousands)
 
2007
   
2006
   
2005
   
2004
   
2003
 
Commercial and agricultural loans
  $ 593,806     $ 478,310     $ 453,197     $ 425,018     $ 402,905  
Auto, light truck and environmental equipment
    305,238       317,604       310,786       263,637       269,490  
Medium and heavy duty truck
    300,469       341,744       302,137       267,834       221,562  
Aircraft financing
    587,022       498,914       459,645       444,481       489,155  
Construction equipment financing
    377,785       305,976       224,230       196,516       219,562  
Loans secured by real estate
    881,646       632,283       601,077       583,437       533,749  
Consumer loans
    145,475       127,706       112,359       99,245       94,577  
Total loans and leases
  $ 3,191,441     $ 2,702,537     $ 2,463,431     $ 2,280,168     $ 2,231,000  
At December 31, 2007, 13.6% and 12.4% of total loans and leases were concentrated with borrowers in trucking and truck leasing and construction end users, respectively.

Average loans and leases, net of unearned discount, increased 16.61% and 9.26% in 2007 and 2006, respectively.  Loans and leases, net of unearned discount, at December 31, 2007, were $3.19 billion and were 71.76% of total assets, compared to $2.70 billion and 70.98% of total assets at December 31, 2006.
 
Commercial and agricultural lending, excluding those loans secured by real estate, increased 24.15% in 2007 over 2006.  Commercial and agricultural lending outstandings were $593.81 million and $478.31 million at December 31, 2007 and December 31, 2006, respectively.  This increase was mainly due to increased sales activity within the commercial loan and small business loan areas coupled with stable market conditions and market expansion.  The acquisition of First National accounted for $39.19 million of the 2007 increase.
 
Loans secured by real estate increased 39.44% during 2007 over 2006.  Loans secured by real estate outstanding at December 31, 2007, were $881.65 million and $632.28 million at December 31, 2006.  Loans on commercial real estate, the majority of which is owner occupied, were $530.45 million at December 31, 2007 and $412.52 million at December 31, 2006. The acquisition of First National accounted for $56.55 million of the increase at December 31, 2007.  The remainder of the increase was mostly due to business clients' continued investment in real estate for expansion or relocation of their commercial facilities. Residential mortgage lending was $351.20 million at December 31, 2007 and $219.76 million at December 31, 2006.  The acquisition of First National accounted for the majority of this increase with $124.23 million outstanding at December 31, 2007.
 
Auto, light truck, and environmental equipment financing decreased 3.89% in 2007 over 2006. At December 31, 2007, auto, light truck, and environmental equipment financing had outstandings of $305.24 million and $317.60 million at December 31, 2006.  Environmental equipment financing remained flat in 2007. Auto and light truck financing decreased 6.14% at December 31, 2007 compared to December 31, 2006, mainly due to our customers reducing their fleet size in an effort to improve their operating efficiencies.
 
 
-16-

 
Medium and heavy duty truck loans and leases decreased 12.08%, in 2007. Medium and heavy duty truck financing at December 31, 2007 and 2006, had outstandings of $300.47 million and $341.74 million, respectively.  Most of the decrease at December 31, 2007 from December 31, 2006 can be attributed to clients' making proactive decisions to contain their future costs by completing purchases of 2007 new tractor needs in 2006.  Most of our clients were affected by a new regulatory standard which mandated that, effective January 1, 2007, all Class 8 diesel trucks produced have emission compliant engines.  This requirement increased the cost of each vehicle approximately $6,000 to $9,000.
 
Aircraft financing at year-end 2007 increased 17.66% from year-end 2006.  Aircraft financing at December 31, 2007 and 2006, had outstandings of $587.02 million and $498.91 million, respectively.  The increase in 2007 was primarily due to focused sales efforts and an improvement in the general aviation industry.
 
Construction equipment financing increased 23.47% in 2007 over 2006.   Construction equipment financing at December 31, 2007, had outstandings of $377.79 million, compared to outstandings of $305.98 million at December 31, 2006.  The increase at December 31, 2007 from December 31, 2006 was mainly the result of continued strong commercial, industrial, and non-residential building industries, as well as, substantial Federal, state and local funding for roads, bridges, and general transportation projects upon which our client base relies for business.
 
Consumer loans increased 13.91% in 2007 over 2006.  Consumer loans outstanding at December 31, 2007, were $145.48 million and $127.71 million at December 31, 2006.  The acquisition of First National accounted for this increase with $18.83 million outstanding at December 31, 2007.
 
The following table shows the maturities of loans and leases in the categories of commercial and agriculture, auto, light truck and environmental equipment, medium and heavy duty truck, aircraft and construction equipment outstanding as of December 31, 2007.  The amounts due after one year are also classified according to the sensitivity to changes in interest rates.

(Dollars in thousands)
 
0-1 Year
   
1-5 Years
   
Over 5 Years
   
Total
 
Commercial and agricultural loans
  $ 277,126     $ 249,128     $ 67,552     $ 593,806  
Auto, light truck and environmental equipment
    129,508       168,693       7,037       305,238  
Medium and heavy duty truck
    93,083       201,915       5,471       300,469  
Aircraft financing
    180,267       376,374       30,381       587,022  
Construction equipment financing
    106,818       266,966       4,001       377,785  
Total
  $ 786,802     $ 1,263,076     $ 114,442     $ 2,164,320  


Rate Sensitivity  (Dollars in thousands)
 
Fixed Rate
   
Variable Rate
   
Total
 
1 – 5 Years
  $ 888,902     $ 374,174     $ 1,263,076  
Over 5 Years
    23,593       90,849       114,442  
Total
  $ 912,495     $ 465,023     $ 1,377,518  
 
Most of the Bank's residential mortgages are sold into the secondary market.  Mortgage loans held for sale were $25.92 million at December 31, 2007 and were $50.16 million at December 31, 2006.
 
CREDIT EXPERIENCE
 
Reserve for Loan and Lease Losses — Our reserve for loan and lease losses is provided for by direct charges to operations. Losses on loans and leases are charged against the reserve and likewise, recoveries during the period for prior losses are credited to the reserve. Our management evaluates the adequacy of the reserve quarterly, reviewing all loans and leases over a fixed-dollar amount ($100,000) where the internal credit rating is at or below a predetermined classification, actual and anticipated loss experience, current economic events in specific industries, and other pertinent factors including general economic conditions. Determination of the reserve is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows or fair value of collateral on collateral-dependent impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience, and consideration of economic trends, all of which may be susceptible to significant and unforeseen changes. We review the status of the loan and lease portfolio to identify borrowers that might develop financial problems in order to aid borrowers in the handling of their accounts and to mitigate losses. See Part II, Item 8, Financial Statements and Supplementary Data — Note A of the Notes to Consolidated Financial Statements for additional information on management’s evaluation of the adequacy of the reserve for loan and lease losses.
 
The reserve for loan and lease losses at December 31, 2007 totaled $66.60 million and was 2.09% of loans and leases, compared to $58.80 million or 2.18% of loans and leases at December 31, 2006 and $58.70 million or 2.38% of loans and leases at December 31, 2005. It is our opinion that the reserve for loan and lease losses was adequate to absorb losses inherent in the loan and lease portfolio as of December 31, 2007.
 
The provision for loan and lease losses was $7.53 million for 2007, compared to recovery of provision for loan and lease losses of $2.74 million for 2006 and $5.86 million for 2005. The recovery of the provision for 2006 and 2005 was due to increased loan recoveries and was consistent with our improved credit quality of the loan and lease portfolio.
 
 
-17-

 
The following table summarizes our loan and lease loss experience for each of the last five years ended December 31:

(Dollars in thousands)
 
2007
   
2006
   
2005
   
2004
   
2003
 
Amounts of loans and leases outstanding  
                             
at end of period
  $ 3,191,441     $ 2,702,537     $ 2,463,431     $ 2,280,168     $ 2,231,000  
Average amount of net loans and leases outstanding
                                       
during period
  $ 2,992,540     $ 2,566,217     $ 2,348,690     $ 2,240,055     $ 2,091,004  
Balance of reserve for loan and lease losses
                                       
at beginning of period
  $ 58,802     $ 58,697     $ 63,672     $ 70,045     $ 59,218  
Charge-offs:
                                       
Commercial and agricultural loans
    1,841       1,038       1,478       6,104       1,187  
Auto, light truck and environmental equipment
    1,770       340       630       2,408       2,789  
Medium and heavy duty truck
    569       -       15       352       69  
Aircraft financing
    378       1,126       2,424       3,585       6,877  
Construction equipment financing
    799       118       -       686       4,712  
Loans secured by real estate
    356       129       167       456       344  
Consumer loans
    1,654       1,203       858       1,090       1,560  
Total charge-offs
    7,367       3,954       5,572       14,681       17,538  
Recoveries:
                                       
Commercial and agricultural loans
    2,356       1,594       1,308       1,312       519  
Auto, light truck and environmental equipment
    446       430       1,140       1,277       1,182  
Medium and heavy duty truck
    64       59       174       14       -  
Aircraft financing
    1,779       3,612       2,255       4,460       1,698  
Construction equipment financing
    19       753       1,065       547       248  
Loans secured by real estate
    169       31       89       107       11  
Consumer loans
    421       316       421       362       523  
Total recoveries
    5,254       6,795       6,452       8,079       4,181  
Net (recoveries) charge-offs
    2,113       (2,841 )     (880 )     6,602       13,357  
(Recoveries) provisions charged to operating expense
    7,534       (2,736 )     (5,855 )     229       17,361  
Reserves acquired in acquisitions
    2,379       -       -       -       6,823  
Balance at end of period
  $ 66,602     $ 58,802     $ 58,697     $ 63,672     $ 70,045  
Ratio of net charge-offs (recoveries) to average net
                                       
loans and leases outstanding
    0.07 %     (0.11 ) %     (0.04 ) %     0.29 %     0.64 %

Net (recoveries) charge-offs as a percentage of average loans and leases by portfolio type follow:
 
   
2007
   
2006
   
2005
   
2004
   
2003
 
Commercial and agricultural loans
    (0.09 ) %     (0.12 ) %     0.04 %     1.14 %     0.16 %
Auto, light truck and environmental equipment
    0.40       (0.03 )     (0.17 )     0.43       0.62  
Medium and heavy duty truck
    0.16       (0.02 )     (0.06 )     0.14       0.03  
Aircraft financing
    (0.26 )     (0.54 )     0.04       (0.19 )     1.73  
Construction equipment financing
    0.22       (0.24 )     (0.51 )     0.07       1.67  
Loans secured by real estate
    0.02       0.02       0.01       0.06       0.06  
Consumer loans
    0.88       0.74       0.41       0.77       1.04  
Total net charge-offs (recoveries) to average portfolio loans and leases
    0.07 %     (0.11 ) %     (0.04 ) %     0.29 %     0.64 %
 
 
-18-

 
The reserve for loan and lease losses has been allocated according to the amount deemed necessary to provide for the estimated probable losses that have been incurred within the categories of loans and leases set forth in the table below.  The amount of such components of the reserve at December 31 and the ratio of such loan and lease categories to total outstanding loan and lease balances, are as follows (for purposes of this analysis, auto, light truck and environmental equipment and medium and heavy duty truck loans and leases have been consolidated into the category truck and automobile financing):
 

   
2007
   
2006
   
2005
   
2004
   
2003
 
         
Percent of
         
Percent of
         
Percent of
         
Percent of
         
Percent of
 
         
Loans and
         
Loans and
         
Loans and
         
Loans and
         
Loans and
 
         
Leases
         
Leases
         
Leases
         
Leases
         
Leases
 
         
in Each
         
in Each
         
in Each
         
in Each
         
in Each
 
         
Category
         
Category
         
Category
         
Category
         
Category
 
         
to Total
         
to Total
         
to Total
         
to Total
         
to Total
 
   
Reserve
   
Loans and
   
Reserve
   
Loans and
   
Reserve
   
Loan and
   
Reserve
   
Loans and
   
Reserve
   
Loans and
 
(Dollars in thousands)
 
Amount
   
Leases
   
Amount
   
Leases
   
Amount
   
Leases
   
Amount
   
Leases
   
Amount
   
Leases
 
Commercial and agricultural loans
  $ 17,393       18.61 %   $ 14,547       17.70 %   $ 15,472       18.40 %   $ 13,612       18.64 %   $ 9,589       18.06 %
Truck and automobile financing
    16,017       18.98       13,359       24.40       13,008       24.88       12,633       23.31       13,966       22.01  
Aircraft financing
    17,761       18.39       18,621       18.46       19,583       18.66       26,475       19.49       31,733       21.93  
Construction equipment financing
    6,171       11.84       5,030       11.32       4,235       9.10       4,502       8.62       9,061       9.84  
Loans secured by real estate
    6,320       27.62       4,672       23.40       4,058       24.40       4,187       25.59       3,798       23.92  
Consumer loans
    2,940       4.56       2,573       4.72       2,341       4.56       2,263       4.35       1,898       4.24  
Total
  $ 66,602       100.00 %   $ 58,802       100.00 %   $ 58,697       100.00 %   $ 63,672       100.00 %   $ 70,045       100.00 %
 
Nonperforming Assets — Our policy is to discontinue the accrual of interest on loans and leases where principal or interest is past due and remains unpaid for 90 days or more, 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, which are placed on nonaccrual at the time the loan is placed in foreclosure and consumer loans that are both well secured and in the process of collection. Nonperforming assets amounted to $18.48 million at December 31, 2007, compared to $17.67 million at December 31, 2006, and $22.04 million at December 31, 2005. Impaired loans and leases totaled $6.19 million, $12.32 million, and $16.87 million at December 31, 2007, 2006, and 2005, respectively. During 2007, interest income that would have been recorded on nonaccrual loans and leases under their original terms was $0.98 million, compared to $1.90 million in 2006. Interest income that was recorded on nonaccrual loans and leases was $0.26 million and $0.62 million in 2007 and 2006, respectively.
 
Nonperforming assets at December 31, 2007 increased 4.60% from December 31, 2006, mainly due to an increase in other real estate.  The increase in other real estate is due to $3.57 million of bank premises held for sale at First National.  This increase and the increase in loans past due over 90 days, loans secured by real estate, and consumer loans was partially offset by a decrease in aircraft financing and medium and heavy duty truck nonaccrual loans.